December 2021’s equity bounce back ensured that, for shareholders, the calendar year closed on a high note. Global equities posted an annual growth of 24%, while locally we saw a climb of 17%. The year ahead already tells a different story—leaving investors wondering, “What changed so quickly?”.
Since the beginning of this year, markets quickly shifted to a bearish mindset. This is largely due to the above average rise of inflation and the need for central banks to adjust their monetary policy direction.
What is inflation?
Put simply, it’s the increase in average price on a selection of goods and services, over a specific period. The Reserve Bank of Australia (RBA) has long held an inflationary target of 2-3% p.a., which they believe to be low enough not to distort economic decisions, to provide an element of certainty for the private sector and discipline for monetary policy decision making.1
The Australian Bureau of Statistics (ABS) recently published that inflation rose 1.3% in the December 2021 quarter and 3.5% over the twelve months2, whereas in the U.S. (the world’s largest economy), inflation hit a 39-year high of 7%3. This significant uptick in inflation demonstrates that Australia has now exceeded the RBA’s target, which if sustained will lead to an increase in interest rates.
Interest rates are important because they are the foundation of financial markets and have been on a steady decline over the past decade. Inflation and wage growth has been somewhat subdued since the GFC. As a result of the pandemic, they are now extremely low, as governments around the world adopted loose monetary policy to drive growth and employment.
Whilst the low interest rates have been in place to stimulate economic growth, they have also had a secondary impact and increased the value of assets—think Sydney house prices over the last twelve months.
Currently, the threat of higher interest rates is the more near-term concern for equity market. A material lift in interest rates and so a lift in bond yields will make it much harder to justify current market valuations, particularly at the higher growth end of the equity style spectrum, for example, big US tech stocks like Meta (Facebook) and Google.
To date, central banks have shown a willingness to let inflation run its course, to see whether it will be sustained or transitional and have generally operated behind market expectations in terms of the timing of policy tightening. However, there is a point at which inflation may become too high and too persistent for central banks to avoid surprising markets with larger than expected interest rates lifts. Their hand may be forced sooner than we think, generating uncertainty in the market.
What else is happening?
Whilst rising interest rates and inflation is having a significant impact on the markets, our day-to-day lives continue to “open up”. Once again, we enjoy a sit-down meal at our favourite local pub bistro albeit a bit more expensive due to inflation. It is easy to forget the significant physical and mental health, economic and social impacts of COVID-19, on the world’s populous over the last two years.
10 billion COVID vaccines delivered world wide, 400m global COVID cases and 5.5m deaths to date.4
Linked to what has been termed a once-in-a-100-year pandemic, these numbers of epic proportions shroud the true impact and uncertainty of COVID in the years to come which will lead to more volatility in share markets.
In addition, the Russian President Vladimir Putin has amassed more than 100k (est.) military personnel on the border of Ukraine. The U.S. and its European allies have warned that a Russian invasion could be imminent which is currently being downplayed by the Ukrainian President.
There is no doubt there are a number of risks knocking on the door of equity markets at the moment whilst markets are generally forward looking they are often also overreacting. This will lead to a heightened period of volatility which is likely to continue throughout 2022.
Investors will ultimately need to see above trend economic and earnings growth globally, to justify equity valuations in the face of increased interest rates. The underlying earnings yield on equities is higher than that offered by bonds and other defensive assets and should be supported over the longer term, by continued global economic and productivity expansion—even if higher inflation in 2022 causes some short-term adjustments in valuations. Whilst defensive investments are somewhat destined to achieve low returns, linking to record low cash interest rates, they do play a part in a diversified portfolio, especially when drawing money out or looking for future opportunities.
Considering your risk tolerance, investment horizon, tactical asset allocation and what you are really trying to achieve is key to any financial plan. They should be constantly reviewed with your dedicated financial adviser as you transition through this great journey we call life. It’s commonly said that three things in life are certain; death, taxes and investments go up and down (I added the sideways bit).
Feel free to contact myself or one of the team at Navigate Financial Group who are here to support your financial decision making, leading you confidently into your financial future.
References/ footnotes:
1. rba.gov.au/inflation/inflation-target.html 2. abs.gov.au/statistics/economy/price-indexes-and-inflation/consumer-price-index-australia/dec-2021
3. bloomberg.com/news/articles/2022-01-12/inflation-in-u-s-registers-biggest-annual-gain-since-1982 4. bloomberg.com/graphics/covid-vaccine-tracker-global-distribution
