An investment strategy for the times………. for the times they are a- changin’

  • War on Ukraine and Covid lockdowns in China fuelling inflation
  • Rising inflation – is it transitory or entrenched?
  • Australian economy is resilient; low unemployment, lower inflation, and exports are strong
  • Favourable corporate earnings outlook supports positive investment market outlook

Australian Equity Market Outlook

Following a prolonged period of extraordinary low interest rates, no sign of inflation and consistent economic growth around the world, the outlook for investment markets has changed significantly in recent months.

Today inflation in the US is running at 8.3 percent, the annual Eurozone inflation rate hit a record high of 7.5% in March, and Australia’s most recent inflation data is showing a headline inflation rate of 5.1 percent. The underlying inflation rate in Australia is 3.7 percent, but this is well outside the Reserve Bank of Australia’s (RBA) stated inflation target range of 2-3 percent. This is why the RBA has embarked on an interest rate tightening cycle that is likely to see the official interest rate increase from the current 0.35 percent to at least 2.5 percent by the end of 2022. This will add more than 2 percent to residential mortgage rates.

However, the COVID-related lockdowns in China and the war on Ukraine are complicating factors which the RBA must contend with in formulating its response to rising inflation. The issue for the RBA (and investors) is whether the inflationary impact of these two events is transitory or entrenched.

The stringent COVID lockdowns in China are causing supply chain bottlenecks that are creating shortages of essential components of manufactured goods, pushing up the price of many imported goods. The war on Ukraine, is pushing energy and food costs higher, adding to the inflation rate. The other complicating factor is Australia’s historically low unemployment rate is at 4 percent, being a 40 year low. The tight labour market may lead to wage rises in compensation for increased living costs, which appear to be higher than the stated inflation rate. Higher wages, which are a significant input cost of manufactured goods and services, lead to higher inflation. The uncertainty created by these factors has led to investors deserting capital markets, reducing market liquidity, and consequently adding further to market volatility.

The Commonwealth Bank recently observed in its March quarter profit announcement that the strong Australian economy had enabled the bank to grow home loans by 8.5 percent and business loans by 12.6 percent over the past 12 months. However, the bank stated that it is adopting a cautious approach to lending in response to higher interest rates, inflationary pressures and supply chain disruptions. Australia’s largest bank is considered a reliable barometer when assessing Australia’s future economic outlook and so investors can do well by being aware of the bank’s assessment of the economy.

Implications for Investors

When markets conditions and the market outlook change, investors must decide on an investment strategy suited to the times. It was only a few weeks ago that the RBA Governor Phil Lowe lamented as “embarrassing” and that “we should have done better”, in reference to his assertion earlier this year that interest rates would not rise before early 2023.

Investors are aware that the impact of higher interest rates to fight inflation, runs the risk of slowing a fragile global economy dealing with a global pandemic that threatens the orderly supply of goods around the world. Rising inflation driven by supply chain shortages and elevated energy and commodity prices, together with rising interest rates, leading to a slowing economy, are the seeds of stagflation. It maybe early in this chain of events to point to stagflation, however it a factor affecting investor confidence globally.

Fortunately, the Australian economy is in a better position than many other countries around the globe.

Firstly, although elevated by Australian standards, inflation in Australia is lower than in many other countries. Secondly, Australia is a major beneficiary of higher commodity prices for exports like iron ore, petroleum gas, coal and wheat. Thirdly, interest rates are rising because the economy can afford them while unemployment is low and household consumer demand, which represents 60 percent of the economy, remains strong.

These conditions support a growing domestic economy and a positive outlook for corporate earnings. Corporate earnings, driven by a growing economy, are the underlying driver of equity markets. The global economy, despite short-term fluctuations, has grown throughout history, and Australia being an export economy, is leveraged to this global economic growth.

To the extent that the global economy continues to expand, and growth is steadily maintained over the medium term, the outlook for Australian corporate earnings is favourable. History tells us that it takes more than a few interest rate rises, particularly when markets are braced for any increases, to impair corporate earnings beyond a short adjustment period, when the economy is already on a steady footing.

This is the advantage of having an investment strategy in place with the guidance of a financial advisor to gain independent and objective insight as to what is occurring in the investment market.

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