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Rising bond yields complicate the COVID recovery

COVID-19 will soon have been with us for two full years. Since the pandemic started, the course of investment returns has differed greatly from what was initially expected in investment markets.

What now lies ahead for investment markets? Here are some thoughts for investors contemplating how to allocate across the main asset categories. But first a brief review of what’s happened, and why.

A brief retrospective

When the pandemic broke out, share markets plummeted, for around five weeks. Since then, most equity markets have made substantial gains, and at the time of writing were trading at or close to record levels.

Bond yields initially rose for a week or so before falling to record lows. They’ve now moved modestly higher (with quite a lift in recent weeks, particularly at the 2 year tenor); however yield curves remain upward sloping and spreads continue to be skinny.

Commercial property initially slumped but has since risen unevenly, producing some spectacular gains in particular sectors (notably warehouses) while average residential housing has shot up in price.

Exchange rates haven’t varied as much as was expected in the pandemic’s early days. Commodity prices have been volatile – especially prices of energy, iron ore and inputs into renewable energy production – but for the most part the super-cycle in commodities has continued. With strong terms of trade and weak capital spending, Australia is running huge surpluses on trade and current accounts.

The strong recovery in the prices of most assets since early April 2020 reflects three main influences:

  • The massive - and sustained - easing in fiscal and monetary policies around the world (noting that accommodative monetary policies also mean investors must live with cash rates at near-zero levels).
  • The speed with which efficacious vaccines were developed (mainly benefitting wealthy countries and China).
  • Exaggerated fears, initially, that the global economy would suffer a depression or structural stagnation. (Recall the scorn directed at early suggestions that the slumps in economic conditions and shares would be V-shaped. As it turned out, both the economy and share market have not only exhibited V-shaped recoveries, but the deepest and narrowest V-shapes in history).

The investment outlook

Looking ahead, here are some thoughts on key influences on prospective investment returns.

The shape of the pandemic: Population-wide mass vaccination has been critical in containing COVID, particularly in developed economies and China (but not as yet in most developing economies). With this uneven access to vaccinations, with the risks of further mutations, and with all governments now having swung from eliminating the virus to “living with COVID”, prospects for case numbers, hospitalisations and deaths remains highly uncertain.

The global economy: Provided infection numbers stay reasonably contained in the major economies, and governments and central banks do not move too quickly to tighten policy settings, the big economies - North America, Europe, China and Japan - seem unlikely to tip into recession in the near future. That’s a bold forecast. It reflects these inputs: fiscal and monetary policies are currently stimulatory, yield curves are upward sloping, liquidity is abundant, and gains in asset prices have added to household wealth (albeit unevenly).

China’s economy is likely to be soft for another quarter or two because of problems in property markets led by Evergrande, but GDP is unlikely to fall, even for a quarter. These supportive economic conditions should bring about modest growth in aggregate earnings to labour and capital.

Valuations: All major asset classes are highly valued – especially when assessed by way of price-earnings ratios and price-to-book. However, share market valuations look more comfortable to investors who expect some continuing growth in profits (most importantly in the US, where Q3 earnings remain encouraging) and who expect real interest rates to remain ‘low’ relative to past trends.

But investors need to allow that momentum has driven valuations higher – and not only for ‘quality’ stocks but also for many start-ups, ‘meme stocks’ and cryptocurrencies.

Macro policies: Budget and monetary policies are extremely stimulatory in most countries. Expansionary fiscal policies provide a strong boost to economic activity when inflation is non-existent and savings are high (conditions seen in the 1930s when Keynes penned his ‘General Theory’).

Expansionary macro-policies don’t, however, do much to raise GDP and jobs when inflationary expectations are high and savings are low (as Gough Whitlam and Jim Cairns learnt in the 1970s). Winding back budget deficits to sustainable levels will be a hard slog for many governments.

Monetary policy’s traditional instruments (cash rates and open market operations) and its unconventional measures (quantitative easing (QE), yield curve control, forward guidance, special funding of banks) remain highly accommodative.

Central banks will face immense challenges in raising interest rates, in tapering QE and in reversing other recent moves. In financial markets, expectations of monetary policy shifts will likely increase, and over-reactions may become more frequent.

Inflation: In recent years inflation has been stubbornly low in most major economies. Lately however, market expectations for this continuing have been surprised on the high side. The prevailing view of central banks and bond investors has been that the recent increases in inflation were mainly transitory. That view, increasingly, looks to be wrong.

Supply side issues and disruptions - including from higher energy prices, the enormous jump in shipping costs, breakdown in international supply chains, and now wage increases likely to result from labour shortages - are building up.

Announcements made at the recent COP26 Summit are also likely to be more inflationary than the majority of participants will admit. Demand-side influences will also likely sustain inflation in the US, Europe and Australia in 2022 and beyond.

In my view, inflation will be an increasing concern over the medium and longer terms in most major economies. It is possible that Australia could see inflation ranging between 3% to 5% in 2023, and potentially even moving a notch higher in 2024.

Stagflation: Stagflation, whereupon low economic growth couples with high inflation, was a horror for many countries in the 1960s and 1970s. In my view, the prospect of a re-emergence of stagflation is real, though on a lesser scale.

There are some similarities with the conditions that produced earlier bouts of stagflation. They include: heavy spending in the US on social security and defence accompanied by big budget deficits; disruptive supply shocks; signs of an acceleration in wages; high commodity prices; and the widespread view that inflation is only temporary.

The main difference, this time around, is inflationary expectations have so far remained subdued – and more-so in wage negotiations than in bond markets.

COP26: Many people claim committing to renewable energy rapidly and at scale will serve three purposes: arresting the trend in higher global median temperatures, providing cheaper energy and creating lots of ‘green’ jobs.

In my view, the reality is much harsher: yes, global warming is real – but the likely costs of effective policies to contain it are much, much higher than will be recorded by the majority of people participating in the Glasgow discussion on climate change.

The implications for shares, bonds and property

In my view, shares still offer positive, but modest, returns on a twelve-month outlook. That’s because risks of an early global recession are limited, real interest rates are historically low, and the initial rebound of inflation is usually a positive for share prices.

But we are in the stage of the investment cycle for shares when investors need to focus on companies with high or sector-leading return on equity, low balance sheet gearing, high spending on R&D and new technologies, high and sustainable growth in earnings per share, and some pricing power.

On bonds, it seems prudent to be a little underweight; to prefer shorter-dated or floating rate bonds and inflation-linked bonds; to be careful of sub-investment grade bonds; and to hold some bank-issued hybrids while banks have strong balance sheets.

Quality property offering warehousing and inventory management appeals. The boom in house prices is likely to cool.

 

Don Stammer has been involved in investing for many decades as an academic, a senior official of the Reserve Bank, an investment banker, a fund manager and the chairman of nine companies listed on the ASX. He is currently an adviser to Stanford Brown Private Wealth. This article is general information and does not consider the circumstances of any investor.

 

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