Investment & Economic Review April 2022

For investment prices, regrettably, the party from low interest rates is over. Share price performance ahead will need to contend with the higher relative hurdle caused by the increased bond yield rate, whilst real estate valuation capitalisation yields will need to increase. This doesn’t mean that investments perform poorly but will need to rely more on genuine economic and profit growth and will no longer receive such a fillip from low rates.

Inflation too is surging, caused by supply chain blockages and rampant commodity prices, exacerbated by the crisis in the Ukraine. The situation in the Ukraine remains fluid as I write, with no apparent short-term solution. This geopolitical situation stands as the most important global factor of 2022, and its day-by-day news will affect investment markets, risk mitigation strategies and volatility. Here’s hoping that the disaffected people find a lasting peace in the very near future.

COVID-19 risks are beginning to dissipate due mainly to higher vaccination rates, but there are some lingering economic consequences. The sharp economic contraction caused by COVID, followed by a spike in inflation has generally been satisfactorily handled by wealthier nations, but less so by others. Take Sri Lanka, for example, which recently defaulted on its foreign debt obligations for the first time since its independence in 1948 and has had to raise interest rates to 14.5% to stymie runaway inflation. This is a financial symptom of COVID and is regrettably being met with civil unrest. I suspect there will be more issues of this type in the years ahead, about which there is little that agencies such as the International Monetary Fund can do.

Many commodity prices have remained at elevated levels causing financial windfalls for uncontracted producers, and financial pain and inflation for buyers. Australia is in a sweet spot economically, benefitted enormously by high agricultural and mineral prices. It’s little wonder the Reserve Bank is delaying an interest rate rise decision – for every day they can stop the Australian dollar rising represents a boost to our terms-of-trade.

The Australian stock market, as measured by the S&P ASX200 Index, managed to eke out a small gain of 0.7% for the quarter, somewhat surprising given the sharp but temporary declines experienced in January and March. Many companies traded ex-dividend during the quarter, and dividend payments were generally higher, leading to a more pleasing overall return of 2.2% for the quarter.

In January the threat (quickly followed by the reality) of higher interest rates globally caused a rapid fall in stock prices, particularly those sectors that were priced with reference to future rather than current earnings. Stocks in the technology sectors were particularly harshly affected, as investors ratcheted up the discount rate applicable to future cash flows, thereby reducing the present value of many stocks. There was, and still is, a blowing off of the froth and bubble valuations previously found in the higher risk periphery of the investment markets, a welcome outcome that didn’t translate too deeply into more mainstream investments. 

Soon after the markets settled from the interest rate and inflation scare, the Russians invaded Ukraine, setting off a further bout of negative volatility and concern. Energy prices soared spectacularly, causing net consumers and importers of energy to suffer from high input costs and inflation, whilst net exporters and producers benefitted. The Australian stock market contains a higher proportion of ‘value’ style stocks than most global peers. These sectors include mining, energy and banks, all sectors that benefited from the rapidly changing conditions. Indeed, the Australian stock market has outperformed global averages so far in 2022, assisted by heavyweight mining and energy stocks such as BHP and Woodside. 

Within other market subsectors, healthcare stocks have been lackluster so far in 2022, despite their generally sound operational and financial condition. This has created an opportunity to increase investment in leading health stocks such as CSL, Ramsay and Sonic. Bank shares have staged a strong recovery, benefitted by the expectation of improved net interest margins as interest rates rise, relatively good credit conditions and a focus on lower costs. Bank share prices do not represent outstanding value at present but are good cornerstone portfolio holdings with improved franked dividends. 

Last quarter I mused that some market volatility and negativity would persist in the early months of 2022, followed by a more meaningful rally later in the year. There has certainly been volatility and a rally has commenced. Further market upside this year will need to contend with higher interest rates and the Ukraine crisis, so I am expecting further market instability in the months ahead, but a mostly positive outlook underpinned by sound economic activity and corporate profits and dividends.

In the March quarter the MSCI world stock market index fell by 5.5% as rising interest rates, inflation spikes and the Ukraine crisis negatively affected markets.

The United States broad market of large companies traded modestly lower, but the NASDAQ market, which contains many technology and emerging stocks, traded down 9.1% for the quarter. Some stocks were particularly hard hit, including Meta Platforms (Facebook) down 34%, PayPal down 38% and Netflix down 38%. The mega stocks Alphabet (Google) and Amazon were less affected, down 3.4% and 2.2% respectively.  

The US Federal Reserve is rapidly reversing its monetary policies and actions and will raise the US short-term interest rate on multiple occasions, whilst reversing its bond buying program. They are now acting assertively to combat rampant inflation and to provide monetary capacity to deal with future financial and economic stresses. Clearly, the cycle has changed, and investment markets need to deal with less accommodating central bank policies. 

Markets in Japan have had a tumultuous time. Japan is a net importer of energy and has been transitioning away from nuclear power since the Fukushima disaster in 2011. Consequently, they were caught out by the recent rapid increase in energy prices, exacerbated by the Ukraine crisis. Consequently, the Japanese Yen has collapsed by more than 10% this year, and they are defiantly retaining their 0.25% bond interest rate cap despite the inflationary pressures. The unusually weak Yen provides Australian investors improved buying power, so we are actively assessing and investing in quality Japanese shares.

Shares in continental Europe have suffered the proximity effect of the Ukraine crisis, and the resultant energy supply shock. Germany had effectively sponsored the new Nord Stream 2 gas pipeline from Russia but is now doing a rapid backtrack by denying certification, leaving Germany with a severe energy predicament, worsened by their decision to phase out all domestic nuclear power. German shares have weakened significantly, down 9% in the March quarter, which we see as a buying opportunity.

One clear outcome of the energy price and supply crisis and inflation is the acceleration of the renewable energy transition. Europe in particular has belatedly realised that they can’t rely on imported fossil fuel energy, particularly during periods of heightened geopolitical tensions and risks. Transitional energy and renewable energy stocks are likely to reward investors and should be part of a global stock portfolio.

The prices of listed Real Estate Investment Trusts (REITs) fell sharply in January 2022 and have not yet recovered. The cause of the decline was a combination of the generally weaker investment markets globally, and more specifically a ratcheting up in interest rate expectations.

Rising interest rates may lead to negative revaluations of some property, the reason being the capitalisation rates will also rise. The capitalisation rate is the percentage return on the annual rental flows of a particular property or the funds from operations for a property trust. As the comparative reference rate (bonds) rise, so too do cap rates.

However higher interest rates do not necessarily cause REIT investments to perform poorly as the structure of modern REITs are mostly stapled securities, often combining property management, development, and ownership structures. A well-managed and structured REIT, such as Dexus, can prosper notwithstanding rising rates, by astute property refurbishment, development, acquisition and disposal.

Foot traffic and sales turnover at the major shopping malls has increased considerably. The Australian Bureau of Statistics reported retail sales up by 9.1% for the last year, an improvement that is accelerating with the removal of most COVID restrictions. Elevated household savings and very low unemployment have assisted this surge in spending, with no immediate sign of a slowdown. Shopping centre owners and managers such as Scentre Group, GPT and Vicinity should report improved funds from operations in 2022. 

CBD office properties will struggle to maintain elevated valuations as growth in their funds from operations will be more difficult. Office head lease space hasn’t yet declined, but there is much more vacant space, partly representing sub-leases. Major tenants have indicated a preparedness to maintain flexible work arrangements but are also looking to increase the per square metre minimum for occupancy density, so its unlikely that commercial real estate will suffer too much. 

Residential property prices have remained high, bolstered by strong demand, benign credit conditions and ultra-low interest rates. This cycle will begin to change in 2022, first by increased supply crimping further price appreciation, then pockets of price decline coincident with successive interest rate increases.

The interest rate cycle has changed, unambiguously. Long-term bonds have risen to 3% (from 1.5%), and mid-term bonds are up to about 2.6%, effectively flattening the yield curve.

Meanwhile the Reserve Bank has doggedly maintained their 0.1% cash target, but not for much longer. Following its April policy meeting governor Lowe stated that ‘inflation has picked up, and a further increase is expected’. The RBA has a stated policy of using monetary levers to target inflation between 2% and 3% and seek full employment. Both objectives have largely been met, paving the way for multiple small RBA interest rate rises, perhaps the first being on the first Tuesday in June. The central banks of most other countries have already commenced interest rate increases, so it will be very surprising if our RBA doesn’t follow suit very soon.

Rising interest rates cause mark-to-market price declines in bonds, and this has been particularly evident in recent weeks. Pricing of bonds uses a concept called modified duration, which reflects the measurable change in bond prices in response to a change in market interest rates. For example, a bond with ten years to maturity has a modified duration factor of about 8, meaning that the present market price of such bond will fall by about 8% should market interest rates rise by 1%. Investors can be surprised by the extent of short-term price movement, though should also remember that an Australian government bond has the face value and coupon interest guaranteed, if held to maturity. As market rates have risen by about 1.5% recently, long bond prices have declined by a staggering 12%, a quick reversal of the capital appreciation enjoyed in recent years. For context, lesser duration bonds have commensurately lower price duration volatility, but also typically a lower running yield.

Unsurprisingly, lower bond prices (higher yield) create an opportunity to invest. Long bonds now provide a running yield of about 3%, higher than term deposit and cash rates and government guaranteed. For the first time in a few years, we consider government bonds to be a worthy component of the defensive component of a diversified investment portfolio. 

It’s more difficult to find good value in the corporate credit market, as risk has increased and risk-free assets such as term deposits and government bonds now offer improved yield. Bank hybrid securities remain popular and are relatively secure whilst banks’ financial condition is strong, but market prices are full. Credit spreads have begun to widen, meaning that the higher risk securities may experience more volatility ahead.

Looking ahead, the Reserve Bank will likely raise short-term rates on several occasions in the second half of 2022, then additional raises in 2023. This will have the effect of further flattening the yield curve, as we don’t expect material further rate rises in long dated interest rates. Market observers will be watching for an inverted curve, where 10-year rates become lower than 2-year rates. This scenario occurred recently in the United States and is seen as a possible precursor to an economic slowdown, or recession.