We begin the New Year with some interesting times in the market (has it ever been different?). Inflation Stateside is running at the highest pace in nearly four decades (i.e. 1981), the markets are expecting a tightening by major central banks, the PBOC being the outlier in going the other way in being increasingly accommodative, and Omicron continuing to gain traction. These are just a few of the headlines grabbing investors’ attention. So, with that in mind, let us go back to a basic question to begin the year, where to next? And more importantly where do we allocate? This week we seek to look at two elephants in the room, in answering these questions: monetary policy and geopolitics (which may very well present the next leftfield event).
It is always a rather precarious decision to try and predict which way the markets are headed in the short-run. But as investors we do need to make some sort of a decision after all. For most of us, valuations consistently get higher while headlines tell us reality is something altogether different. With that said, on we go!
Before we proceed further into our views on monetary policy, we would like to begin by saying something perhaps rather controversial. The advent of Covid, while being a humanitarian disaster, has not in any way changed the policy tools or the mechanisms in which decisions are made. Easy central bank policy has arguably been a constant for a good three decades now and while the newer non-conventional open market operations are less so, it has been a dilemma in terms of unravelling. You may remember the taper tantrum of 2018 (Q4) which effectively forced the Fed to step back on its rhetoric.
So what is it that central bankers are trying to do? Taking inflation numbers into account, real rates around the world are deeply negative and, in the advent of a new crisis, there is arguably very little breathing space to effectively cushion the economy going forward. On the other hand, raising (or at least going too quickly) could result in a situation were asset prices take a disproportionate hit. Most would argue that this is not within the RBA or any other central bank’s mandate. Consider the fact that financial markets today are substantially larger than the real economy and, with an increasingly aging demographic across most of the developed world, there is very little choice but to take your cues from asset markets. The feedback loop into repo and treasury markets is very real and can be disastrous (hence the historic back-peddling by the Fed in 2018).
So, can we expect continued rate hikes and, if so, by how much? Firstly, let us touch on two things: QE, that is the use of open market transactions (including the purchase of treasuries and more recently even corporate debt) to inject liquidity into the market, and the headline cash rate (the federal funds rate in the US). On the first, we are certainly going to see at least a slowdown; we doubt there will be a tightening (i.e. the sale of already existing assets from the balance sheets). In terms of the fed funds rate/cash rate at home (and where it's headed), the simple answer is we cannot tell and, in all honesty, neither can most central bankers.
Why is that? The key is that current policy makers are neither trying to be expansionary nor contractionary. What they are trying to do is to find what is called the R* or the rate at which the economy continues as is without inflationary pressures. Where that particular rate is, you can’t tell (and it can seem rather arbitrary). You basically keep pushing and tinkering until something breaks. We can however guarantee one thing; if asset prices were to correct substantially and continuously, there will be little choice but to backpedal. Moreover, doing so at a time when the fiscal delta, or the proportion of public expenditure to GDP, is declining will almost certainly lead to recession.
Despite what you may hear in the media about pent up demand and a roaring economy/labour shortages, we would suggest that, while there may be something to it, it must be taken with a grain of salt. Yes, the goods sector has been growing substantially and has been exacerbating inflation but this may be due to supply bottlenecks and it remains to be seen whether consumer demand remains as fiscal stimulus declines. Stateside, services still remain 10% below pre-pandemic levels. Back home in Australia, the situation is rather more drastic. Why?
Consider the amount of household wealth and debt in this country tied up in the property market, then consider the multiplier effect of rate normalisation on house prices (which then certainly has an impact on consumer sentiment and thus spending). A 50bps rate hike could, in our opinion, lead to a decline in overall property values up to 10%. Moreover, this nation is by no stretch of the imagination encumbered by the same issues as the US. The participation rate (i.e. the amount of working age population that is in the labor force) remains high, wage growth is not particularly mind boggling (remember, wage growth is required in order for second round inflation to occur). Despite what the market continues to predict, we can safely assume that the RBA will continue to be a laggard when it comes to rate hikes. The US on the other hand will push the envelope until the fist sign of something breaking. Expect some volatility going through 2022.
At no point has the world of geopolitics been more important for the investor than now, not even during the tumultuous Trump era and associated trade war (the policies of which the new administration has seen fit to continue). So, let’s get to what's at stake and why it is important for the Australian investor to be paying attention.
We shall begin with Russia and Ukraine. Without going into too much depth at the risk of boring you with history. Suffice it to say, this is as much about Putin's domestic politics as it is about foreign policy. A man that rose from a relative nobody to the highest position in the country, he has always relied on image and carefully orchestrated PR; initially (arguably) creating and escalating the second Chechen War and then during the 2000s and the associated high oil prices to justify rule based on economics. As the oil price declined and economic troubles ensued, the justification then turned to a Russian form of “Make Russia Great Again”. The first indication of this was the annexation of Crimea followed by hardline stances against the US and her allies. That said, there is some “justification” from a Russian perspective as was put in unfortunate terms by Germany’s Naval Chief (now ex-Naval Chief due to these comments) in the US’s constant backtracking when it came to promises given about Eastern Europe and keeping out of that region. The equivalent here (as we saw in the Cuban missile crisis) is say Russia or China installing military installations in the Panama. Nevertheless, this is one situation that must be watched closely by the investor. Not least because neither party can afford to backdown. Putin and his strongman image and, on the other side, the US and its resolve.
We are also positive that this is a situation Beijing is watching closely, not least to see the direction it can take pertaining to Taiwan and their disputes in the South China Sea. A US and Europe that doesn’t stand firm might be seen as a greenlight for China to push the envelope in terms of her own agendas. Again, why does all this matter for the Australian investor?
For one, Russia accounts for close to 40% of Europe’s natural gas supply and any disruptions to that could significantly derail global growth. On a closer to home front, an expansionary China that sees any lack of Western resolve as an opportunity could take more aggressive approaches in Australia’s backyard. On the flipside, an escalation here may derail central bankers’ normalisation policy.
To sum up, monetary policy will tighten but perhaps not as much as some of the hype is making out. By how much? Even the central bankers won’t know, keep poking until something breaks is the nature of the game (this is an art, not a science). In real terms though, we make the call that rates will remain negative. On the point of geopolitics, this maybe a stalemate as neither side can afford to backdown and there are also a number of other players involved. An outright conflict (doubtable) would have significant impact on global growth, this may however perversely slow down monetary policy tightening, allowing asset prices to hold up more than would otherwise be the case (hint: energy maybe a good allocation in either scenario).
Where and how to allocate?
Let’s begin with where not to allocate, in this environment we continue to believe traditional fixed income offers little opportunity. On the other hand, equities continue to be interesting. Even should the discount rate come through to a normalised level of say 1%, it still makes equities attractive. That said, we can definitively say that the easy money has been made. As liquidity drains out of the system (at least somewhat, through less aggressive QE or QT) we should see high PE stocks get hit disproportionately. That’s not to say some of these companies dont have secular tailwinds. In fact, most of the FAANGs should continue to see exceptional earnings growth over the next decade, but you would effectively be buying long-duration at a time of volatility and higher rates (granted only nominally).
Energy continues to be interesting and we have previously predicted that oil would hit triple digits by the end of the year. We stand by that. The shale boom effectively financed by the Fed is over, OPEC has no incentive or appetite to increase production and, as the Green revolution enters its next phase, we should see peak oil come to fruition before its gradual decline. Interesting opportunities also lie within smaller companies as opposed to larger (increased government intervention). The geopolitical environment also creates opportunities for the discerning investor as nations build up barriers to entry and reshore supply chains, a case in point being rare earths; Syrah Resources (SYR.ASX) and Albemarle (ALB.NYSE) were two securities we spoke of last year. Aside from these sectors, staples will be interesting, as energy prices continue to rebound we can almost guarantee that there will be an upward swing in the Food Price Index (i.e. think back to the 2000’s).
Markets & Commentary
At TAMIM we are committed to educating investors on how best to manage their retirement futures.
Sign up to receive our weekly newsletter:
TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.