December 2021 Market Update
By Gary Lucas
Despite the recent arrival of the Omicron variant, the main issue affecting the markets remains inflation. Before we take a closer look at the different predictions concerning inflation, let's consider what we know about Covid at this point.
We all want to believe the theory that as viruses naturally mutate the more transmissible variants are and the less virulent they become. This may be the case with Omicron. But it may not. There is some reporting that supports this, but it is still early, and it is not all good news. The UK Imperial College of London’s recent research indicates that this is not the case. Even if it is less virulent, the increased number of people infected means that there may be more hospitalisations and deaths.
Trying to predict what will happen with Covid has been a complete disaster. Early in the pandemic, statements such as, 'it's just like the flu' or 'it will burn out in the northern summer' couldn't have been more wrong.
While it's fair to say that we all know more now than we did in early 2020, it remains challenging to predict what's ahead. However, there are some things we do know:
Omicron has been identified at an earlier point than Delta was, providing the opportunity for a more effective response.
The effectiveness of vaccines on both transmissibility and health impact remains uncertain.
Anti-viral medicines are edging closer to becoming readily available.
The economic impact of each wave of Covid has been reducing.
The global economy is in better shape than when the Delta wave came about.
Amongst all the talk about Covid, discussions around inflation have increased - with more than the occasional reference to stagflation.
Stagflation is defined as a combination of stagnant economic growth with high and rising inflation – a situation where you'll often see high unemployment. Right now, stagflation isn't evident in Australia and the US, and it doesn't look likely in the period ahead. However, as always in finance, no one knows with a degree of certainty whether that will remain the case.
Inflation is a different story.
Consequently, while much attention is given to inflation and many people keep themselves busy writing about it, what really matters is the impact it has on interest rates.
As a rule, a significant or unexpected increase in rates by the central banks will cause share markets to fall and negatively impact most investment assets.
So, how likely is this?
Our research consultant, Lonsec, has recently stated, 'While we're cautious on the prospect of inflation, our base case is not one of out-of-control inflation.'
Our largest allocation is invested in fund managers, Munro and Northcape. And they are broadly similar in their view.
Munro manager Nick Griffin believes there will be higher levels of inflation. But he doesn't think this means the US Fed will automatically raise interest rates. Instead, his opinion is based on increased debt levels creating a situation where rates can't be lifted in any meaningful way.
According to emerging markets manager Patrick Russell, Northcape takes a longer-term view. They believe that aging demographics in developed markets, increased automation, rising e-commerce, the debt levels of developed markets, recurring pandemics, and the decarbonisation outlook will reduce global economic growth for the next twenty years. On top of this, it's their opinion that these factors will lead to deflation rather than inflation – the result being that interest rates will stay lower for longer.
Bart Dowling, our portfolio manager for the DMG Diversified Portfolio, believes that the world is slowly putting the deflationary fears of Covid behind us, and that headline inflation is igniting around the globe. His outlook is that inflation worries will persist well into 2022 and that rates will rise, but not excessively, again due to the elevated levels of debt.
Just this week, Jerome Powell, head of the US federal Reserve Bank, announced their updated approach. They are looking at reducing their economic support in the financial markets and planning for three rate increases in 2022 of 0.25% each, followed by three more in 2023 and 2024. If that sounds alarming, it only brings the key US rate up to 2.1%. Communicating the expected increases is in part designed to limit surprises for the market.
One key point to keep in mind is that interest rates are unsustainably low and increasing to more normal levels should be expected.
As you can see, there are diverse opinions about inflation and inflation rate. Rest assured, our investment committees will consider all these opinions and more before reviewing our current portfolio allocations and making any decisions regarding changes to positioning.
Our two portfolios have different goals and target allocations, so our response in each fund will differ. The challenge, as always, is to find the right balance between managing risk and delivering a rate of return consistent with our targets.