Here is the conundrum

The US Federal Reserve is between an economic policy rock and a hard place. They are committed to reducing inflation to 2%. To do that they need to raise interest rates. They have increased interest rates from 0.08% Nov 2021 and are now at 5.33%. Inflation is falling. In the USA, inflation was 9.1% Jun 2022 and is now 3.7%. But it’s not at 2% yet. As much as it’s come down, hitting the target is proving to be sticky.

So, that is the conundrum. To solve it, the Fed can take one of two paths:

A. They raise rates until they get to 2% inflation, or

B. They raise rates and stop before it gets to the target hoping that momentum carries it through to the 2% target?

The problem is that there is a very real time lag between raising rates and seeing its effects flow through to the economy.

With option A, if they increase and hold rates until the targeted inflation rate is reached then it is almost certain that the months that follow will see the time lag impact the economy very significantly. It will likely cause a recession. Interest rates will then need to be cut quickly to offset the damage. But there will certainly be economic damage.

With option B, the risk is that inflation rears its head again if they stop too soon. It also begs the question of when you stop raising and how long they should hold rates for before realising inflation isn’t going to reach the target. Higher inflation, if it becomes entrenched, is an economic cancer that will riddle a nation’s stability.

Right now, in spite of all the interest rate increases, the US economy is surprisingly quite strong. Normally a strong economy is good news for investors because it generally translates into good business conditions and in turn good returns for shares. It would normally be bullish for the share market.

So why am I bearish when the US economy is relatively strong?

It’s because it means that while inflation has come down, the underlying strength of the US economy indicates that so far, the rate increases haven’t yet slowed the economy enough. To get to the 2% inflation rate sustainably will require some economic pain. At the moment, too many of the key indicators such as unemployment and GDP still seem to be running too hot. Unless the US economy starts to slow, I think it means that rates in the US may go up further during 2024.

After trying to manage the inflation issue using option B, I think that in the end the US Federal Reserve will need to revert to option A. It will result in significant economic consequences including a recession. That’s why I am bearish on stocks and the economy. I think the relative strength we continue to see only means that the interest rate environment stays higher for longer until they get inflation well under control. Achieving that will ultimately mean the central bank will break something in the economy.

General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Why Unemployment Will Rise

So far, 2023 has been a surprisingly good year for equity markets and investors. While there are some positive signs in the global economy, there are many more reasons to remain cautious. China’s economic slowdown, corporate debt defaults, retail slow down and office property valuations are just a few examples. The good news this year has been that inflation rates across much of the world have fallen reasonably quickly from their peak in mid-late 2022. The big question for the rest of 2023 and beyond is whether inflation continues to fall and ultimately gets to a sustainable 2%-3%. There is still some way to go until victory can be declared. Central banks are hoping they have done enough and are banking on the lag effect on rate hikes coming through to finishing the job. The danger being that after the pause in rate hikes, inflation is lower but still elevated.

Unemployment is the key.

The unemployment rate realistically needs to be in the range of 4%-5%. Then you get a balance in the power dynamic between employees and business. When the economy is operating at 3.7% unemployment, it creates distortions and difficulties for businesses in a multitude of ways. No one wants to see people out of work, but the reality of the world is that labour is driven by supply and demand like any other force in the market. If there is no supply, prices go up, but then company profit falls, businesses start to struggle, and they stop expanding and investing and growth falls.

It’s a fallacy that unemployment is always better being lower. The opposite is true when unemployment is too high of course. Everyone understands that when too many people are unemployed, in other words an oversupply of labour, that shifts the power balance to the employers. They increase profits but also find there are no longer enough consumers with jobs to spend so business and the economy falter. There comes a point where balance is lost if unemployment is either too high or too low. Finding the balance between inflation and unemployment is the current conundrum for central banks across the world.

Of course, it’s always a very delicate and misunderstood topic when you are effectively saying it’s better for the overall economy if unemployment is higher. High profile property investor, Tim Gurner, found this out the hard way last week when he outlined exactly this in more blunt terms. His message was broadly right in my view, but the backlash was significant. New RBA chairperson, Michelle Bullock has previously stated on the record that unemployment will have to rise to 4.5% in order to tame inflation. She also articulated it far more diplomatically when she said that the RBA needs to rein in inflation while keeping as many jobs as possible. That is a far more politically correct way of saying that to beat inflation it will cost jobs. It doesn’t matter how you say it, the reality is there will be a cost to the economy and the people to beat inflation and job losses will occur. But higher inflation is worse.

At times like this, it’s the prospect of higher interest rates being required later that unnerves the stock market when stronger than expected jobs data comes through. Ordinarily, good jobs data means a strong economy. A strong economy generally means good conditions for business, and typically that is good for the value of the shares in those businesses. However, when central banks are increasing interest rates to slow the economy enough to reduce inflation, the by-product is going to be job losses. So, when the jobs data is strong, and unemployment stays low, it’s a sign that the rate increases are not having the desired impact on slowing the economy. It’s hard to know if that is just a lag effect or if it means interest rates ultimately need to go higher. For investors, it’s worth keeping this in mind as it’s the primary reason the share market tends to fall if unemployment data is stronger than expected in this environment.

Overall, two of the key areas to watch are obviously inflation and unemployment but there are many other variables at play that all impact these as well. Recently the price of oil has jump and there are going to be adverse implications from this on the headline rate of inflation. While at the same time the retail slowdown is real, and I expect it to be the catalyst in the months ahead to push the unemployment rate higher and subsequently then see inflation fall further in in 2024.

General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

China Slowdown

The much-heralded China economic reopening doesn’t seem to have materialised in the way markets anticipated. At various points during Covid, the prospect of China reopening for business post covid sent markets rallying higher on the expectation of higher demand driving the global economy. But so far, the reality has been underwhelming and it appears there are more economic challenges ahead for China than many anticipated.

Yesterday’s inflation figures for China show the once-powerful engine of global economic growth to now be heading for deflation. The CPI rate of -0.3% for the period was lower than expected and the flow-on effects are massive. Lower inflation and the prospects of lower economic growth are genuinely problematic for a nation that has been all about growth for the past 30 years.

In the past, China has had many long-term trends playing into their favour driving their growth. But suddenly there are a number of these trends are being reversed and we are now starting to see these factors impacting the country negatively. China has been the biggest beneficiary of globalisation over the past 20–30 years. Combining that with a huge population and rapid urbanisation sparked decades of investment that turned China into the world’s second-biggest economy.

Yet what China faces now is a totally different situation, and I am not sure the world has really considered what all of these variables combined really mean. All these issues are well known but China has been such an economic juggernaut it’s difficult for people to look at the situation with fresh eyes and consider what all these issues converging really mean for China and the world.

The catalyst for changing these trends was Russia’s invasion of Ukraine effectively waking the world up to the economic consequences of a conflict on the global supply chain. National security became the number one issue for every nation in the world and overnight it commenced the slow reversal of globalisation. As countries extricate themselves and their supply chain dependency from China this new trend will weigh on the Chinese economy as decades of investment is slowly unwound.

Meanwhile, emerging economies such as Mexico, India and Vietnam are booming as the USA and other Western nations are reshoring their supply chains and manufacturing. Make no mistake the process of untangling the global supply chain is still underway. The global supply chain dependence on China is a bigger vulnerability for the Western world than Germany’s dependence on Russian energy. There is no quick fix so all sides are working as quickly as they can to mitigate their risk. That’s a problem for China’s long-term economic growth.

Another overarching theme is their changing demographics. China’s population is aging and by 2035 an estimated 400m people will be over 60. Population won’t be the driver of growth it once was. But the trend that really accelerated the Nation’s growth over the last 20–30 years was the urbanisation of China. As people moved from the country to the city there was massive investment in infrastructure and property. Entire cities were seemingly built overnight. But simply developing infrastructure and buildings isn’t sustainable, in fact, it might be part of the current problem.

China is now at a crossroads.

The spectre of large amounts of debt has hobbled the economy. Economic growth has been lower than expected and in the past that was the signal for stimulus from the government. More often than not in the form of infrastructure and property development. It’s unlikely to be the case this time around and those past actions are part of the problem. Large debts at all levels of government, especially local government, were used to build projects that didn’t necessarily stack up financially. There are large amounts of infrastructure and property development that provided economic stimulus and jobs at the time but sit vacant or barely used now they are completed.

This is a serious problem.

It means that many of these projects haven’t delivered the returns needed to pay for themselves. But more importantly, faced with slowing growth, it may stop the government from being able to roll out the old playbook because they have effectively over saturated the market. The property and debt issue in China has been lurking since the collapse of Evergrande back in late 2021 and there remain serious problems and questions with regards to the entire sector. I am sure grand announcements of government stimulus and investment packages are coming but China need a new strategy to reignite growth.

By way of investing in Chinese equities, I still believe the country remains uninvestable. As I’ve previously said in these notes before, regardless of how big the opportunity may seem I am not interested in investing funds where a country’s government can torpedo entire companies or even industries overnight on a whim. Business is difficult enough at the best of times and I have no interest in the space and wish those brave, naïve, greedy or silly enough to invest there good luck.

With all of these long-term trends reversing, it will be extremely difficult for China to grow in the same way they have for the past few decades as they go forward. It’s time for investors to think carefully about what these changes mean and reevaluate what the flow-on effects are not just for China but more importantly for the companies in your investment portfolio that are heavily exposed to China. Australia has benefited enormously from the growth of China but if the Chinese economy faces a genuine slowdown and they are unable to resort to their usual ‘just build more playbook’ in the same way they have in the past there are huge implications for Australian companies of all sizes.

General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Why I’m Selling this Rally

In a world beset by geopolitical tensions, high inflation and interest rates, banking collapses and uncertainty, the stock market has been surprisingly resilient this year. So far in the calendar year 2023, the Australian stock market is up 3.8% while in the USA the S&P500 is up 6.9%. The NASDAQ is up an astonishing 19.4%! That’s more than resilient, that’s almost a bull market. Now obviously stock markets are still well off their highs of 2021, but it does highlight the difference between what is evolving in the global economy and how stock markets are reacting.

I’ve said before that the share market looks out 6 to 18 months ahead of current economic issues. So, does this recent rally indicate that the market is comfortable with where the global economy is heading? I think the answer to that is a simple no. I also think that there is so much uncertainty in the world right now that the usual playbooks have been ripped up and it’s almost become every investor for themselves. Investors are confused and there is little advantage in knowing what others are doing because, well, they are probably wrong.

The big question is are we through the worst? I think that’s unlikely. I think we are only getting to the end of the beginning. As tricky as the last 12-18 months have been, the real economic woes are yet to play out and until we have that phase underway, share markets will continue to be confused. Right now, that confusion has resulted in stocks being higher than they probably should be. I believe this is an excellent opportunity to sell further and add to the cash in our client portfolio’s.

While share markets have been relatively resilient, we are seeing real volatility in markets that are traditionally very stable. For example, the yields on 2- and 10-year US bonds have been moving up and down like a yo-yo in response to the re-rating of risks from bank collapses to inflation expectations. The yield on the 2-year US bond has moved from 4.06% to 5.05% and back to 3.79% over the last 10 weeks. These are incredible moves that are anything but normal. It highlights the conflicting nature of much of the data coming through and just how difficult it is to get a read on critical data. How the data ultimately plays out will determine the direction of both the economy and the share market.

I am still convinced that the share market will pull back as it becomes clearer that we are heading into a global slowdown. I expect the market to retest those lows of 2022 and possibly head lower. To me, there is so much evidence that points to a slowdown that I think it’s prudent to sell further into the current strength we are seeing in the share market. It’s impossible to know where markets go in the short term so you can only ever make decisions that are prudent for the long term. Cash remains king. If the market continues to go up after we sell a little, I am more than happy to sell some more.

As resilient as the share market has been I don’t believe that this is an accurate reflection of where the market should or will be. One of the simplest tests for whether you have enough cash when you enter a downturn is how you feel as the market falls or when the next crisis arrives. Are you excited because of the opportunities you see becoming available or are you worried as markets fall? If you’re feeling nervous, then that’s a pretty good sign that you don’t have enough cash.

Our current focus for our client portfolios is weighted to protecting capital and minimising losses in the event of a market downturn. This is a unique time in the history of the world. There is really no precedent for the current situation and so it is difficult to predict how badly the global economy will be impacted. A lot of this is mitigating those risks and being ready. It is not about making money right now; it’s about protecting it. If in the next year or so the world has muddled through and it turns out there is no major downturn, then that’s great. There will always be opportunities to make more money when times are good or at least more predictable. But in the next year or so we will know for sure just how all the current events and variables have collided and their impact on the global economy. Sometimes treading water is what you need to do to ensure you survive.

General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Balaji’s Bet

Amidst the emergence of the banking issues, US entrepreneur and former partner at prominent Silicon Valley venture capital firm Andreessen Horowitz, Balaji Srinivasan made a very public bet on Twitter. He bet $2m that the price of bitcoin will go to US$1m in 90 days. Given the price of bitcoin at the time was about US$26,000, it’s an aggressive bet and it certainly gained a lot of attention. The good news is that we will know very quickly just how clever he is. The bad news is that if he is right then the world is in far more trouble than anyone is prepared for. I’ve had a few people ask me about this, so I thought I'd provide my thoughts more publicly. 

Over the past decade, Balaji has amassed a huge following in tech and cryptocurrency circles. He also gained prominence over the past few years for his predictions on a range of topics including how Covid would play out. He is a smart guy and is very influential within the tech and VC space. His views on the banking system and the pace of change are extreme. His rationale for his position is his prediction of imminent hyperinflation, his concerns around the bond losses the banks hold and ultimately the collapse of the USD. He views bitcoin as the likely replacement.

For the record, I think he’s completely wrong for several reasons but it's worth exploring his rationale and the counter points. Financial markets are always a melting pot of diverse views and sometimes the most unusual perspectives prove to be right. Considering different viewpoints in a critical manner is always worthwhile even if it is especially unusual or extreme. It’s always worth understanding the rationale behind someone's position.

Firstly, in the short term, a US banking crisis is likely to be deflationary rather than inflationary. The real risk for the economy right now is if banks tighten their lending criteria and start to hoard cash for their own liquidity. That potentially starves businesses, consumers and the economy of the capital that generates economic activity. This would more likely lead to an old-fashioned credit crunch which would hammer economic growth. So, an escalation of the banking crisis he predicts is not inflationary at all and may well ‘cure’ the inflation problem. 

Secondly, in anticipation of a credit crunch or recession, the impact on interest rates is more likely to change from rate rises to cuts very quickly. The bond market is already telling us rate cuts are coming with 2-year bond yields dropping from about 5.05% to 3.94% in a matter of 3 weeks. Bond markets are now pricing in several rate cuts in 2023 even though the Fed’s position is that this is unlikely. The implications are that the tightening in the banking sector is effectively acting like added interest rate hikes which will further dampen inflation. The hyperinflation argument seems extreme and unlikely. 

Thirdly, any interest rate cuts would quickly erase a sizeable part of the unrealised bond losses that many institutions are carrying on their balance sheet. These unrealised bond losses are a big part of the problem at the banks, and a central part of the Balaji thesis. Whether interest rates come down due to market forces or because the Fed deliberately changes course is largely irrelevant. If interest rates do come down, it will reduce the bond losses that banks carry, which will alleviate the pressure on the bad bond investments in the banking system.

The unrealised bond losses are a significant issue for banks, but it's not necessarily the existential issue Balaji seems to fear. The US govt can simply choose a different interest rate policy. If push comes to shove and the Fed must choose between addressing a bigger issue in the banking system or inflation its likely they choose the biggest immediate threat. That would mean dropping rates due to banking issues and dealing with inflation later.

While there are not many tools at the disposal of the Fed to fight inflation, they have lots of tools to deal with bank issues. In the face of Bitcoin appearing as a threat to US hegemony, I would say that laws in the US would change rapidly. I'm not saying that’s a good thing but I'm a realist. As great as all the tech and VC gurus think bitcoin is for the future of a utopian world, if it’s a threat to the US and its dominance, they will restrict it and suffocate it, or even make it illegal if needed. I would not underestimate the US govt ability or willingness to protect itself by any means necessary if its position is threatened.

While I do think cryptocurrencies may be the future of money, I am not convinced that it will be bitcoin. Even if it should be, the control of the monetary system is far too important for governments to relinquish control. Additionally, there is a major risk in holding bitcoin that it has no intrinsic value and that its price is simply determined by the flow of money in and out. If a more technologically advanced and energy-efficient cryptocurrency ends up being adopted, then bitcoin will end up worthless as everyone moves across to the new coin. 

I think that Balaji’s prediction is a combination of self-promotion combined with limited downside risk. He knows that as money moves out of banks, some will certainly find its way into bitcoin, limiting the downside risk, while all the publicity and uncertainty puts upward pressure on the price. Overall, I suspect as part of the Silicon Valley clique that is very bullish on cryptocurrencies and exposed directly to the collapse of Silicon Valley Bank that he’s just a little too close to the situation to see the forest for the trees. A little like a conspiracy theorist who goes down a rabbit hole and continually reaffirms their theories in an endless stream of combined confirmation bias and group think. 

What’s certain is that you’ll increasingly hear and read these types of Armageddon predictions as the global economy head into recession. But there is an enormous difference between a recession, even a bad one, and the type of predictions the most extreme people will start to espouse. In times of uncertainty fear mongering escalates and is an easy way to grab attention and headlines.

General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Lowe needs to go.

When you’re in the top job in any organisation if you don’t get it right, you’re out. Whether it’s the coach, CEO, or Prime Minister, they are the first to go when things go wrong. So, it’s beyond comprehension that after getting it so wrong so often that Phillip Lowe is still the chairman of the RBA (Reserve Bank of Australia). He got it wrong on inflation. He got it wrong on rates. He got it wrong when he told the Australian public as recently as 2021 that rates won’t go up until 2024. He’s getting it wrong again now. He is still hoping that inflation is transitory. Even in his speech today he’s indicated a pause in rate rises as soon as May. Yet with interest rates at only 3.6% following yesterday’s interest rate increase, there is a long way to go before the RBA tames inflation at over 7.8%. 

Here's the thing. If you’re too tough on inflation you can drop rates quickly but if you are too soft on inflation and it becomes entrenched it’s a recipe for economic disaster. I appreciate that many of the initial drivers for inflation have been on the supply side and there isn’t much the RBA can do about that. However, inflation is an insidious cancer. If you don’t do everything to remove it, it will find its way into other parts of the economy. This is a genuine concern. This is already happening in the USA where as recently as January it was thought inflation was starting to be tamed. Yet just a month later, data has shown it is likely to re-emerge. Many say Lowe’s doing too much, but everyone continues to underestimate inflation. I don’t think he’s done enough. 

After some horrendous missteps, Lowe now seems more worried about managing expectations rather than inflation right now. Why else would you increase rates by only 1.25% over the last 6 months and say there is still more to come? The RBA are compounding their initial mistake of being far too slow to act by now being far too slow to raise rates. Their argument that it takes time to see the economic impact of rate increases would have been better served by front-loading the rate hikes and doing 0.5% in Oct, Nov and December 2022. It’s a slightly higher overall increase but now they would have had 3 months to observe the effects instead of still talking about what theoretically may happen. 

If Lowe thinks there are more rate increases to come, then get on with the job and increase rates by the amount needed to make an impact. We should have rates at well over 4% right now. There’s far too much mollycoddling all around in my view. If people with mortgages are going to suffer financial pain because they listened to him the first time and borrowed too much, then so be it. That’s how markets work. There’s too much trying to signal intentions and too many cleverly crafted speeches for people to interpret the language. He’d be better off playing it with a straight bat. There are winners and losers. It’s not his job to worry about consumers’ feelings or mental health, it’s his job to manage inflation and that means making the hard decisions that are needed. The overall consequences will be worse if he delays. 

There are really two ways to kill off inflation, the first is by raising interest rates. By doing so Central Banks seek to increase borrowing costs sufficiently that it reduces spending, dampening demand for goods and ultimately slowing the economy and the pace at which prices go up. There is a second, less common solution and that is simply inflation itself. If left to run rampant inflation eventually leads to demand destruction for goods and services resulting in a similar effect to that of rising interest rates, except it's uncontrolled. 

I’d liken raising interest rates to the back-burning of forests. Back-burning results in deliberately burning forests in a controlled, planned manner that is designed to mitigate a disastrous bushfire that engulfs everything. Letting inflation run wild is the equivalent of an out-of-control bushfire with no back-burning. Central banks slowing or pausing rate hikes in anticipation of a slowing economy is the equivalent of not fighting a fire because you hope there is rain coming. Maybe it does, maybe it doesn’t but you can’t afford to take the chance. You fight the fire with everything you’ve got while it’s burning. 

What we’ve got currently are the most difficult set of inflationary economic pressures in 40 years. There is no easy solution. The reality is either way there is going to have to be pain here. Either it’s the pain of inflation or the pain of rate rises. One results in controlled inflation, and one doesn’t. The fact that raising rates will cause many financial pain and hardship does not mean it’s the wrong path. That soft approach to dealing with economic problems only leads to a bigger problem later. At the first sign of pain, the outcry leads to short-term fixes, not long-term solutions. 

Lowe has repeatedly shown he is not capable of getting the basic decisions right. Nor has he been able to navigate the political tensions that arise with making conditions tougher for the economy in the short term for its benefit in the long term. He didn’t take the pain early and now whichever way he turns there is a bigger problem. Conveniently for the Government, when public outrage hits fever pitch later this year because either inflation is too high, or interest rates are, it will be Lowe’s fault. So, the government will not remove him until it is politically necessary. Regardless of that, Chairman Lowe has got it wrong too many times and needs to go. 

General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Why High Inflation Is a Big Deal

In Australia, our inflation rate has been moving up fast, hitting 6.1% in figures released today. In the US, UK, and Europe inflation is even worse, in the range of 8% to 10%. At that level, it can start to become quite entrenched and destructive.

This is why Central Banks across the world are in a mad scramble to raise interest rates. Once inflation gets out of the 2%-3% range it’s time to nip it in the bud. Central banks got the inflation call wrong initially, they sat on their hands for too long and inflation got away from them.

The only real way to get inflation under control is to raise interest rates. Otherwise, inflation becomes so high that demand is destroyed because no one can afford to buy any goods or services anymore. That’s a far more precarious position for an economy to be in. Prevention is far better than the cure.

But first, why does high inflation matter so much?

From an individual’s perspective, inflation reduces your buying power, your standard of living and your wealth in real terms. If you earn $100,000 a year and inflation is 6% you need a pay rise of 6% and an income of $106,000 just to stay in the same position. If you get a pay rise of 4% you actually went backwards by 2%. If your income doesn’t keep up with rising prices your standard of living falls because you can’t afford what you could before.

From a business perspective, inflation means rising costs and unless you can pass them all on to the customer then it means your profit margins are going to be squeezed. Even if a company can pass price increases on it may result in less sales as you raise prices and so profits reduce anyway. If profits fall so do company valuations.

From a national economy perspective, if inflation becomes embedded it can destabilise the currency and if left unchecked lead to hyperinflation and economic collapse. While that’s something more often associated with developing nations, these are the types of risks that can occur if inflation runs rampant for an extended period. As living standards fall, all sort of economic and social unrest comes into play.

The bottom line is high inflation must be dealt with – whatever the cost. Getting inflation down to 5% to 7% range in the US and Europe will be a big improvement, but that’s still way too high. Inflation also tends to roar back to life quite quickly if you don’t extinguish it properly the first time. Inflation must be brought under control properly to create price stability in the global economy.

It has taken far too long for Central Banks across the world to understand that. It does appear that finally the penny has dropped. Central banks have now collectively realised they need to choose whether they tackle inflation or assist financial markets and economic growth. They can either raise interest rates and kill inflation or they can keep them low to support the economy.

But you can’t do both.

The usual situation, historically, would be raising rates in a strong economy to slow it. Often the result is a recession. The balancing act is raising rates while trying not to pull the hand brake on too fast, damaging the economy in the process. That’s easier said than done. Usually, central banks tend to raise rates too high and leave them high for too long. Usually, it is because they’ve been too slow to act initially.

The current situation is far more difficult. We’ve not seen a situation where central banks have had to raise interest rates going into a weakening global economy. The real risk, especially in Europe and even in the US is that the level of rates needed to tame inflation is higher than the economy can cope with. The potential result being that the choice to raise rates to stop inflation will have dire economic consequences.

So, the reality is this process will still take many months to play out. For some reason markets still talk about Central Banks to engineering a perfect soft landing. Great if it happens, but I’m not sure you can expect the same people who were unable to identify the problem and address it in a timely manner to suddenly thread the needle when it matters most. I am hopeful for a shallow recession but preparing for worse. 

Regardless, I would rather they eliminate the threat of inflation. It will make for a more difficult downturn, but the world economy will eventually recover. If you let the inflation genie out of the bottle, then you risk all sorts of potential unintended consequences evolving and ultimately a far worse economic situation later. Unlike the past 15 years, I would hope central banks have learnt their lesson and will take their medicine sooner rather than later. 

General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Feels a Lot Like a Bear Market

In a bull market, momentum relentlessly drives stocks higher. You’ll get occasional pull backs and profit-taking but then it just goes again. We’ve seen that for much of the past decade. Bear markets are basically the opposite and are typically defined as the market falling by 20% from its highs. So far this year, the S&P500 in the US is down about 13%, so we are not there yet, but I think that’s where we are heading soon enough.

One of the problems as you progress through a bear market is that no one wants it to be the case. They want the good times of the bull market to keep going. So, when markets bounce as they did in mid-March everyone likes to think everything is back to normal. Denial kicks in, but the inevitable drop after the bounce comes soon enough. This is called a ‘dead cat bounce’ for exactly the reason the imagery of the phrase conveys.

The S&P500 in the US fell steadily from Jan-March. But then surprisingly (to me at least) it rose 11% in the 2 weeks to the end of March for no good reason, only to fall by the same amount in April. Dead cat bounce. There were a whole range of factors contributing but the most surprising part was just how much it went up. I raise it only to point out the vagaries of the stock market and why you need to be more cautious in bad markets and difficult times. In a bull market, you can buy the dip. In a bear market that is generally a mistake. In a bear market you are best served by waiting. You buy when there is blood in the water.

Perhaps being so cautious will mean you miss out on some upside if the global situation suddenly changes. If that happens, then so be it. The aim of the game in this environment is the preservation of capital in the first instance. Genuine bear markets are not all that common, but they do happen from time to time. As they unfold investors will find every way to talk themselves out of it until it’s impossible to deny. We are getting closer to that point now. Frankly, it’s kind of obvious.

In a bull market, investment and business conditions converge to provide stocks with all they need to rise ever higher. Everything about the economic and geopolitical conditions are favourable and trending up. Currently, the opposite is true, everything looks ugly and is trending the wrong way. Inflation is high and will force central banks across the world to hike interest rates far more dramatically than many expect. The war in Ukraine is causing all sorts of significant flow on effects. Many won’t be felt for months, some years. China’s economy is forecast to slow dramatically especially on the back of their massive lockdowns with covid. The list goes on.

The likelihood of recession globally is increasing. Markets won’t wait for the recession to be here to retreat. They are already retreating in anticipation and as it becomes more apparent in the weeks and months ahead, they will retreat further. So, make no mistake, markets are forward looking. By the time the consumers and businesses across the world are dealing with the reality of a hard economic landing at some point in 2023, markets will already be looking ahead to the recovery. So do not confuse the current economic conditions with what the share market will do. They are operating on different timelines. One (the economy) is the actual conditions and the second (the share market) is anticipating the future conditions.

The earnings numbers for last quarter and guidance for the following one coming from the mega tech this week will be critical to just how quickly markets adjust. Normally, I don’t put that much weight on the quarterly reporting and prefer to focus on the long term. But in this market the quarterly numbers are going to have an outsized impact on the market from here. We’ve seen it recently with Netflix being smashed after failing to deliver. If the mega tech companies report revenue and profit in line with expectations or better, markets probably hold up ok for now. But a miss will be a completely different story.

I expect the next couple of months to be tough. Markets need only a couple of bad news events to really drop their bundle from here. A reality hit confirming what most are concerned about, a consumer lead recession, will sharply turn sentiment negative and potentially push markets into bear market territory. Right now, there are several risk factors that can easily flare up in the next month or two and become the catalyst for the market to react negatively and take a further leg down. There will be great opportunities once markets settle but for now, I remain cautious.

We remain defensively positioned expecting further downside risk. We are overweight cash, floating rate notes, and commodities, especially energy.

General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Are You Ready for What's Coming?

To quote the well-known pugilist and lesser-known philosopher Michael G. Tyson “Everyone has a plan until they get punched in the face”.

Right now, we are on the cusp of a once in a generation adjustment as the world moves from low inflation and low interest rates to high inflation and high interest rates. So, are you ready for what comes after you’ve been hit? Because inflation and interest rates are about to punch everyone in the face, consumers, businesses, governments and yes, investors.

Central banks around the world had their chance to deal with inflation proactively and they missed it. Inflation in the US is now at 8.5% and its 7.5% in Europe. There is an inflationary wildfire raging across the world and so far, central banks have turned up to fight it in clown suits with water pistols.

Yet, most are sleep walking into the situation unfolding. They have their heads in the sand, are in denial or simply not thinking objectively enough to assess what is happening. Individuals and institutions with vested interests talk in theory and forecasts on spreadsheets. They make the numbers fit their narrative.

This is a problem. They don’t understand how this really impacts the economy and society.

When I first started in the investment industry as a 21-year-old in 1997, it had been 10 years since the 1987 crash. Over the next several years as markets rose, the more seasoned investors would lament the fact that the younger generation had never seen a crash. They’d argue that it caused them to be overly optimistic in the face of rising risks as they had not experienced a genuine bear market.

The old heads were right. Nothing prior could prepare you for living and breathing in the moment of an actual crash. Not just a fall but a market that completely capitulates into free fall. The GFC provided everyone with that experience, and you become a better investor because of it.

Just as when I was a young adviser, as part of a generation of advisers and investors who had not experienced a crash, there is now a similar dynamic at play. Today, there is an entire generation of advisers and investors and for that matter businesspeople, bankers and executives who have never experienced high inflation and high interest rates.

This is a problem. They don’t know what they don’t know.

I continue to see people wheel out advice, commentary and strategies that may have worked for the last 15 years but are no longer appropriate for the way the world has changed going forward.

I’ve said this before, but I cannot emphasise it enough – high inflation and high interest rates are a game changer for investment portfolios. Most asset classes will need to adjust values lower, bonds, shares, and property. You’ll want to be positioned more defensively during that transition until the one-off adjustment occurs for asset values.

The level of complacency on this topic and impending adjustment astounds me. Most are completely underprepared for what’s coming and seem to prefer passive reassurance that all will be ok than preparing proactively for the inevitable. It is difficult but necessary to be proactive with the preparation of the transition from low interest rates to high interest rates.

This is a generational adjustment.

To a large degree, a big part of the problem is the misconception about what low rates and high rates actually are these days. The fatal flaw of those new to markets in the last 15 years is that they frame those questions within the context of their own universe of relative experience. However, we are breaking out of that cycle.

Ask anyone if interest rates can potentially go to 5% and I will be able to tell you how long they have been investing or advising for based on their answer.

Most with under 15 years of experience will dismiss such a suggestion out of hand as ridiculous. They say this not because it is ridiculous but because they’ve never seen it and the ramifications of that move are so significant that they refuse to consider it.

Conversely, anyone who remembers the 1990’s will say something like ‘It wouldn’t surprise me’. That’s because they remember what historically high interest rates look like at 15% plus and that historically normal interest rates are more likely between 5%-10%.

The last 15 years were the anomaly, not just the last 2 years.

Until everyone understands that the new interest rate cycle will see interest rates move towards more normal levels in the historical sense then they will continue to be underprepared for the problems that continue to evolve before us.

There will always be opportunities for long term growth, but it is critical to ensure you understand when pivotal moments of economic change require a more patient and defensive approach to portfolio management.

General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

What Happens Next as Interest Rates Rise?

Interest rates are going up across the world and it will impact all asset classes. While we are currently seeing stock markets reacting negatively, higher rates are going to flow through to the real economy and impact everyone from businesses to consumers, as well as asset values for bonds and property. This isn’t simply market movement that comes and goes. We are witnessing the end of a 15-year period of historically low interest rates, never seen before and unlikely to be seen again. With that comes an entire generation of investors, advisers and fund managers who have not experienced a rising inflation and rising interest rate environment and certainly not a high inflation, high interest rate environment.

Looking back over the long term, the RBA reduced rates over the last 15 years from 5% to virtually 0%. But in the 15 years prior to that (1992-2007) rates were consistently between 5%-7%. Go further back to the 70’s and 80’s and the RBA rate ranged between 6% and 17% for the entire period. Since the GFC, the absence of inflation allowed rates to continue at ridiculously low levels. That changes if inflation starts to dig in for the long term. If inflation gets away from governments, interest rate rises become the primary weapon to fight it and rates will rise to whatever level is needed to curb it. From such a low base a return to ‘normal’ rates in historical terms would be a major problem. I don’t expect that but the move to higher interest rates is a permanent change.

While stocks have fallen significantly over the last month or so there is probably still further to fall before markets settle. But the asset bubbles that emerged globally over the last several years are not limited to stock markets, they include property and bonds too. My view is that the value of fixed rate bonds and property will fall significantly over the next couple of years as interest rates increase. A fall in the price of property seems fairly straight forward. Higher interest rates are going to put pressure on property owners. Banks started lifting their rates last year and tightening their lending criteria.

Residential property is especially vulnerable to a serious downturn. Sky high prices and many property owners are already overextended even with record low interest rates. Borrowers tend to ask the bank ‘how much can we borrow?’ as the starting point for their property purchase and upsell themselves from there as they progress through the process. I expect that residential property will see a similar re-rating to that of the share market, and I wouldn’t be surprised by a fall of 10%-20% or more over the next year or 2. This has significant implications for the entire economy.

I am also cautious of REITs and property trusts across the board, but especially those that use high leverage to generate higher yields. These all look great on the spread sheets and in the prospectus forecasts but that great yield starts to look quite different in an environment that combines soft rents and rising interest rates. Factor in structural issues such as working from home for office property and online shopping for retail centres and it’s going to be more important than ever to be selective with your exposure to REITs and property. 

Fixed interest bond values will be under pressure too. In simple terms, if you bought a 10-year bond for $100 last year and it pays 2% pa no one is going to want to buy it from you at that price if the new bonds issued in a year at $100 are paying 4% pa. So, investors are going to be stuck with either 10 years of much lower income if held until maturity or a significantly lower value on the bond if they sell. I prefer bonds and notes with a floating interest rate so that as rates increase so do the rates on the security. This provides investors with an inflation hedge and a welcome pay rise as rates increase.

Be careful with unlisted investments. Investors are often attracted to these investments because their values are more stable. This is one of the dumbest investment misconceptions I have ever heard, and it’s perpetuated by those with a vested interest in the assets. Asset managers from small asset managers to the large industry funds like unlisted assets as they appear more stable. But the reality is that it’s just not valued every day the same way assets listed on the share market are. If interest rates rise and asset prices fall then those unlisted assets won’t be worth as much if you sell them. It’s as simple as that. There is a lag time here to be mindful of.

As interest rates rise, share markets will continue to be volatile. But share market investors do expect volatility and do expect markets to fall from time to time and occasionally crash. It has happened repeatedly over the decades. It is not abnormal. Markets run too far in the good times and then retreat, usually too far, in the down times. It presents opportunities and I look forward to buying at more reasonable levels.

What I am more concerned with right now are the other asset classes where bubbles have evolved and will also come to an end as rates now rise. Property, bonds, and unlisted markets and their investors are far more complacent than the share market in this regard because these markets do not usually experience the level of volatility that is ahead. It means there is likely to be systemic risks within those markets that have developed over many years. The fallout from rising interest rates may well be more harshly felt than many investors and stakeholders in these areas expect going forward.

General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

The First Domino to Fall

Wednesday last week, Domino’s was the first major company here in Australia to flag seeing inflationary pressures such as rising food prices and labour shortages. The market reacted poorly to this news with the stock down 18% for the day. Domino’s is a great business, and while and a drop like that was probably an overreaction, it is the sort of re-rating we can expect if inflation takes hold.

Higher inflation has certainly arrived. The only question is how long it is here for. I’ve previously outlined my view that this bout of inflation is primarily a result of supply chain issues and that it will ease in due course. Overlay the slowdown from China and I believe inflation is most likely a 6-to-18-month issue. Ultimately, 1 of 3 scenarios will play out. I’ve listed these below with my view on their likely probability:

1. 20% likely inflation subsides within 6 months and markets continue bull run.

2. 60% likely inflation is a consistent theme for 6-18 months and causes a significant correction before inflation eases and markets continue their bull run.

3. 20% likely inflation stays and causes a fall a permanent re-rating of all asset prices of 20% or more. The bull run is over, and we have an inflation problem.

If you look at the breakdown of the scenarios more deeply, you see the conundrum investors are faced with. When combining scenarios 1 and 2 my view is that it is 80% likely inflation is dealt with within 18 months. At the same time, if you combine scenarios 2 and 3, I also think there is an 80% chance that markets will see a significant correction due to markets re-rating on inflation concerns.

The reason this is my view is that unless there are signs that inflation will ease within the next 6 months, investors are going to start getting nervous. The prevailing view in equity markets seems to be that the inflationary pressures are going to be transitory. But 18 months is a long time. Once we enter the next phase at some point within that 6–18-month time frame, markets are going to lose their nerve on inflation, and we’ll see a correction.

I am also mindful that central banks and Governments around the world are typically not great at managing these situations and can make them worse. They are almost always reactionary and rarely brave enough to be proactive. They act too slowly, then too quickly. This is why interest rates are still at zero when they should be higher and why a massive stimulus package has been approved in the US when the global economic recovery is already well underway. It only adds fuel to the inflationary fire now.

The data in the year ahead is going to provide very mixed messages on both growth and inflation. Labour shortages and increasing wages are next and that just adds another layer of inflationary pressure. While equity markets are currently expecting inflation to be transitory, I think this sentiment will change over time as doubts creep in. We will see over the next 12 months more knee jerk reactions like that seen by Domino’s as concerns around inflation persist and are flagged more and more frequently by companies. This will be a buying opportunity in my view.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.

Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.

Is Rising Inflation Here to Stay?

Inflation is rising. In the US, it now sits at 5.4% pa and just last week New Zealand confirmed a rate of 4.9% pa. These are the highest levels of inflation in over a decade. The main concern evolving in financial markets right now is whether the inflation genie is out of the bottle permanently.

Complicating the issue is that many investors have long been worried that governments around the world are creating serious inflationary pressure with quantitative easing, asset purchases and money printing over the past 10-15 years.

Over the course of the pandemic, the price of many goods and commodities have skyrocketed. The biggest question now facing financial markets is whether these increased prices, combined with supply shortages, will lead to a permanent jump in inflation. If inflation does increase significantly and leads to interest rate rises, it will be a problem for everyone.

If interest rates go up, and go higher, it is a real concern and with serious implications. It would result in a one-off re-rating of asset prices across the world. Almost all assets would fall in value as markets adjust. Bonds would fall, as would most stocks, especially high growth stocks. High inflation is a big deal.

In relation to the money printing impact, my view is that we are still years away from seeing the inflationary impact of this. The reason being is that the quantitative easing money wasn’t pushed into the consumption economy. Instead, been captured within assets for now and while its forced asset prices up around the world it is going to take many more years to flow through into the economy and create price inflation.

So, in my opinion, that’s a separate issue from the current inflation spike. It’s a problem, but not today, and it isn’t the source of the inflation we are dealing with now.

I think the current bout of inflation brewing is really just due to supply chain disruption caused by repeatedly closing and opening parts of the global economy as the world went into lock down. Combine that with the unusual buying patterns that followed from consumers and businesses in the past 18 months, and you’ll obviously have supply chain bottlenecks as a result, forcing prices higher.

However, everyone brought forward a lot of spending on goods while stuck at home. They don’t need more. But no one was spending on services. That’s going to change in 2022. I expect spending on goods and commodities to fall in 2022, while spending on services increases as the global economy reopens.

If so, we will see the current supply chain bottle necks and the congestion at ports around the world start to ease. This will all work itself out in my view. It will just take time. That’s good news for inflation. In fact, there are four main reasons I am not overly concerned with the inflation we are seeing now.

The first is as I mentioned, supply chains will rectify themselves and we will likely see less demand for goods than normal in the coming 12 months. Prices are more likely to come down as supply and demand normalise.

Second, as people realise that the demand for goods is falling, a major component is removed from the inflation equation, expectations of higher prices. This removes the need for people to rush to buy before prices go up which perpetuates inflationary pressures. If prices start coming down, they will wait.

Third, ongoing impact of technology is deflationary. Shortages in any area whether its labour or energy or commodities accelerates technology trends and creates permanent additional capacity.

Fourth, the slowdown in China is real and it’s going to impact global growth. It will especially impact the Australian economy, subject to the degree to which the property sector there slows.

Regardless of how it plays out, the spectre of inflation will make for a relatively difficult 12 months with the market coming to grips with the real story as it unfolds. In my view, inflation pressures will likely subside in due course. For Australia, I am far more concerned about the impact of the slowdown in China in 2022. I think that is the emerging headwind for the Australian economy next year.

This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you.