There has been more uncertainty and trepidation in the last two years than any period in recent times, caused by the COVID-19 pandemic and all the associated health, social and economic implications. Yet investment markets performed remarkably well during most of this time, seemingly favouring the longer-term growth potential, bolstered by aggressive stimulatory actions, over the shorter-term issues.
In 2022 similar market and economic constraints, risks and opportunities will likely persist. COVID-19 will stay at the forefront for some time, causing consternation and volatility, and weighing on public sector and health support infrastructure. A key consequence is the extraordinary and longer than expected effect on supply chains, with glitches and blockages being experienced at many of the pressure points between production and the consumer.
Inflation too is a polarising issue. The ‘is there’ or ‘isn’t there’ argument rages on, with one camp claiming inflation to merely be transitory and the other concerned about systemic price risks. Interest rates are innately linked to inflation, so valuations of investment assets are particularly sensitive. As with most issues the middle ground will probably prevail, meaning interest rates will likely rise a bit sooner than the Reserve Bank's current assessment, though not by very much, whilst inflation will spike for some products, but will generally be tamed by the heavily disinflationary forces of automation and globalisation.
Commodity price volatility was a feature of 2021. Some of Australia’s key export commodities have been unpredictable, notably iron ore which surged to an extraordinary high of more than US$200 per tonne, before halving within a few short weeks. Australia’s production of liquified natural gas (LNG) has increased significantly in recent years with the opening or expansion of facilities in Queensland, Western Australia, and the Northern Territory. The LNG price surged in late 2021 due to seasonal demand and supply chain issues, leading to improved financial outcomes for the exporters and a marked improvement in Australia’s terms of trade.
Agricultural commodities have also been strong, both in terms of price and favourable harvests. The fortuitous temporary absence of widespread drought, a feature of the present La Niña climatic conditions, has coincided with higher prices and a generally low Australian dollar. This combination has been powerfully beneficial to export volumes and values, and consequentially assisted the financial coffers of both the private and public sectors.
This supposition of strength in one of the core segments of the Australian economy - agricultural and mineral production and exports - combined with significant household savings and pent-up consumption demand underpins the outlook, and supports the markets for investment assets, notwithstanding the enduring COVID negativity.
The Australian stock market, as measured by the S&P ASX200 Index, had a volatile but ultimately directionless December quarter, up by just 1.5%. However, for the year the market was up a pleasing 13% plus dividends, which improved to about 3% and should rise a bit further in 2022.
Within the market subsectors, mining stocks had a good rebound, particularly BHP and Fortescue on the back of a recovering iron ore price, and the utilities/infrastructure sector, buoyed by takeover offers for Spark Infrastructure, AusNet Services and Sydney Airport. Bank shares were mixed, with Macquarie a standout due to their excellent profit result, and Westpac the laggard following their disappointing report. Interestingly, all four large banks have found themselves with excess balance sheet capital, leading to off-market share buybacks for CBA and Westpac, and on-market buybacks for ANZ and NAB.
Last August the stock market reached 7,500 index points (ASX200) but has struggled to breach this level since. This sideways performance has included some sharp ups and downs; the ups caused by COVID-ending dreams, low interest rates and takeover action, and the downs by COVID mutation concerns, and fears of higher interest rates. This rather directionless and conflicting pattern will likely persevere for the early months of 2022 with some volatile periods, during which investors should remain cautious but be prepared to buy when value presents.
Some other matters of importance to watch for in 2022 include:
- Elections. The Australian federal election is due by May but shouldn’t have a material impact on markets unless there are any dramatic policy pronouncements. Post-election, the Treasurer will need to turn to fiscal repair consideration, which may lead to taxation changes, including perhaps some sort of COVID levy. The US mid-term elections are due in November and will attract significant media and public scrutiny, particularly should polling indicate the House swinging back to the Republicans.
- Interest Rates. The Reserve Bank has been stoically maintaining its line that rates won’t rise till inflation normalises, probably not before end-2023. Market pricing suggest otherwise, and any material rate rise or earlier-than-expected policy directional change by the RBA could contribute to further market volatility. 2022 may be the year that the strange phenomenon of negative real interest rates ends.
- Inflation. For years inflation has trended lower than the long-term expectation, but the pandemic has caused a sharp increase in prices, particularly tradable supply chain related goods. Inflation announcements in the US and Australia will be keenly watched this year.
- Profits. There is likely to be a tempering of last years’ corporate profit resurgence, yet underlying earnings remain relatively strong. Some sectors will suffer cost pressures from supply chain pressures, input costs and labour problems.
Having considered the various positive and negative factors, and applied market valuation analysis, it is our opinion that markets in 2022 will perform less well than last year, perhaps single digit percentage gains with a fair value assessment of about 7,700 points for the ASX200. It might be that some volatility and negativity persist in the early months, followed by a more meaningful rally later in 2022.
In 2021 the MSCI world index rose by about 20%, which was remarkably strong. The good performance was driven by improved corporate profits, strong stimulatory support from central banks and fiscal support from governments.
Shares in the United States were particularly strong, up by 27% on the back of very strong profit growth in the technology, health and consumer sectors, and an increased penchant for risk by investors generally. Investors should maintain cornerstone holdings in the global leading technology companies such as Microsoft, Apple, Alphabet and Amazon, but understand that market valuations have matured, and gains ahead will likely be lesser.
European shares also performed well in 2021 with Germany up 15%, France up 28% and Britain up 14%. European stock valuations have generally been attractive and further gains are expected ahead. Healthcare stocks such as Roche, Sanofi, GlaxoSmithKline, and Novo Nordisk are considered good investments, as are industrials such as BMW, Kion, Siemens and others. Europe’s transition to renewable and sustainable energy and electric vehicles is rapid, so these sectors will offer appealing investment opportunities.
Asian shares underperformed considerably in 2021, particularly Hong Kong, which was down 14%. China and Japan each eked out a small gain of 5% and Korea 4%, but Singapore was better, up by 10% and India the best, up by 23%. The decline in Chinese/HK shares was due to more stringent regulatory interventions which weighed on leading technology shares such as Tencent, Alibaba and Baidu, and the debt implosion of some real estate development businesses in China, most notably Evergrande. Property and financial shares in Singapore remain attractive, as do the factory and industrial automation sector stocks in Japan, Korea, and Taiwan.
One of the key considerations for 2022 and beyond is the evolving trend in commercial real estate occupancy. Anecdotally, the major CBDs are suffering a significant decline in occupancy and foot traffic, caused by pandemic conditions. Most office buildings now have lease vacancies and many tenants have found themselves with contracted leased space surplus to their current requirements. Landlords are valiantly defending their valuations, but it is hard to see anything other than tough conditions, and perhaps a meaningful decline in some commercial real estate areas this coming year.
Meanwhile, industrial property is booming, led by ecommerce and logistics, and trends towards a more decentralised work environment. Retail based real estate is mixed, with suburban and regional shopping centres enjoying a very quick recovery in occupancy and customer visitations, but central city locations suffering from lockdowns and low tourism numbers.
On the stock market property securities have performed well – the relevant index recovering all losses from the 2020 pandemic sell off. The sector rose 21.6% in 2021 plus a further 4.5% from cash distributions. Of note is the extreme disparity in individual stock performance, ranging from +40% for Goodman and Charter Hall Group to -6% for BWP (Bunnings). Goodman is now more than twice the size of Scentre, the second largest listed property security and more than four times the market capitalisation of GPT and Stockland. This is a testament to Goodman’s success and acumen, but also a warning that the relative valuation is becoming stretched. This is partly due to Goodman representing 30% of the property trust index, and thereby attracting nearly a third of all investment via index styled funds.
Residential property has been a key beneficiary of supportive monetary conditions. Low interest rates and generally relaxed credit conditions have spurred buyers, yet banks have reported little deterioration in loan coverage ratios due to a corresponding increase in consumers propensity to save, causing offset account balances to swell measurably. Interestingly, the net wealth of Australians has noticeably increased due to higher dwelling prices, without much increase in overall liabilities, notwithstanding the pandemic. One would assume that an uptrend in interest rates would upset this comfortable situation quick smart.
Last February Australian 10-year government bonds, which had been about 1%, spiked upwards to 1.75% before settling back down as lockdown periods endured. In October they spiked again, this time to 2% and are currently about 1.8%. Clearly, market forces are willing rates higher, even though the Reserve Bank doggedly (or perhaps stubbornly) maintain their 0.1% cash target.
Inflation is the issue, or more relevantly the expectation of inflation. As each successive inflation statistic is revealed market interest rates will react. Now, some inflation is not the necessarily a bogey, as price increases mean widget prices rise, and manufacturers benefit. It is the fear of excessive inflation that bothers markets.
The yield curve, which reflects the difference and interpolation between short-term and long-term interest rates has steepened, reflecting obdurate control over short-term cash rates and inflationary forces tugging long rates higher. This is a positive scenario suggesting more confidence in future economic growth and preempts a probable surge in consumption spending, prices, and activity in the post-COVID period.
Good-value interest bearing securities are hard to find. Risk free assets such as cash, term deposits and short-term government bonds carry little, if any, yield. Riskier assets such as some mortgage securities and lesser quality corporate loans provide better interest returns, but elevated capital risk. Bank hybrid securities have become less risky as the banks’ balance sheets and financial viability is much improved, but market prices are full. Credit spreads are tight, meaning that the cost of debt is very low when compared to the relevant reference benchmark. Consequently, interest rate volatility is also low.
Looking ahead, the Reserve Bank will likely change its rhetoric as 2022 progresses and begin a gradual policy reversal, including further reductions in bond-buying programs and eventual guidance towards higher cash rates. They are unlikely to alter policy prior to the forthcoming federal election but may be spurred to action when the US starts raising rates, which is expected in the coming months. The RBA is also cognisant of the beneficial effect of a low currency on export values, so will be planning any rate adjustment with this in mind.
Financial markets in 2022 are likely to carry on as they ended 2021, beset by persistent pandemic concerns and inflation anxieties, but aided by underlying economic prosperity and a forthcoming surge in consumer demand. This is a recipe for volatility, during which opportunities for investment can be found.
Interest rates will likely rise in 2022, though not by much, as the Reserve Bank eventually succumbs to the inevitable cycle change.
We have been a net investor in shares in recent time, and we expect to redeploy more portfolio cash to acquire further shares during the coming months and do so with more conviction should there be a temporary market downturn.
Joseph Palmer & Sons
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