2024: What just happened and what lies ahead

2024: What just happened and what lies ahead

2023 – the scorecard

2023 started off with all kinds of dire forecasts, there had never been such an overwhelming consensus that the US economy would slump into recession and take share markets with it. But not only did the economy power through, so did share markets, and despite a choppy start to the year, they finished with a powerful rally that saw respectable returns across the board – see chart 1.

As well as a strong performance out of the US, Japan had a storming year on the back of solid earnings growth, finishing at the highest since its legendary boom of the 1980s, and Germany, where the economy continues to flirt with recession, is also trading at all-time highs, as is India.

Chart showing bond yields trended down, resulting in a 40-year bull market, which went into reverse in mid-2020

The story of last year was pretty much the mirror image of the previous year: 2022 saw markets fall because of negative sentiment, known as “PE compression”, whereas 2023 was largely about PE expansion, or positive sentiment. What that means is that theoretically share prices should go up (or down) by the same amount as earnings growth + dividends, and anything more or less than that is attributable to sentiment, that is, whether investors are feeling bullish or bearish, which is measured by changes in the price to earnings (PE) ratio that people are willing to pay. The grey bars in chart 2 show just how much of a contribution that positive change in sentiment added to returns in 2023.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

It was all about inflation

The positive change in sentiment was all driven by changes in the outlook for inflation and interest rates, or more specifically, the market’s perception of whether central banks have finished increasing rates and, if so, when will they start cutting them?

Inflation rates across the world have indeed fallen considerably, but how much of that is attributable to central banks increasing interest rates is unclear. It’s pretty conspicuous that, despite the variability in when and how different central banks responded, the cycle we’ve just experienced has played out similarly across the developed world: inflation rates started rising sharply in 2020, peaked for most countries around the middle of 2022, and have been falling at a pretty similar pace since – see chart 3.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

There’s a school of thought that disruptions to the supply chain were a significant contributor to inflationary pressures. The New York Federal Reserve Bank compiles an index that tracks pressure across global supply chains, see chart 4, and it traces a similar path to the inflation chart above. For a little context, the COVID-induced bottlenecks in the supply chain saw the index peak at almost 4.5 standard deviations above the average, which puts it so far out of the norm that the theoretical likelihood of it happening is close to zero. That kind of event is inevitably going to have serious consequences.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

Likewise, raising interest rates aims to control inflation by reducing demand, but in the US, demand has remained very strong, indeed, GDP growth was 5.1% in the September quarter! So with demand going up, it’s hard to argue inflation coming down is because of higher interest rates.

Critically, in its last meeting for 2023, the US Federal Reserve acknowledged they think rates have peaked and the next move will be down. That lit a fire under financial markets, with both share and bond prices jumping, and kicking off furious speculation as to when the first cuts will come and how deep they’ll be.

Here in Australia, speculation is rife as to whether the Reserve Bank has also finished with rate rises, with some economists forecasting rate cuts before the end of 2024.

Lessons from 2023

As always, there are lessons to be learned (and perhaps relearned) from what happened in financial markets last year.

Macroeconomic forecasting is really hard (if not useless): at the end of 2022, there had never been such an overwhelming consensus among economic forecasters, and central bankers, that economies across the developed world were headed for recession. Forecasts for inflation were uniformly high, and for GDP growth, uniformly low. They weren’t even close.

There were dark mutterings from economists and central bankers reaching for the orthodox textbooks that unemployment rates were way too low for inflation to fall, and our new RBA Governor, Michelle Bullock, suggested Australia would need a jobless rate of 4.5% to relieve inflationary pressures, or a lazy 140,000 workers losing their job. Yet inflation rates have come down and unemployment rates remain at multi-decade lows.

The takeaway: the US Fed has hundreds of PhD economists and still can’t guess where inflation, unemployment or GDP growth will be less than a year out, but they continue to dominate headlines. You’re better off ignoring them, and certainly don’t let them influence your financial decisions.

It’s also worth bearing in mind, given markets have rallied on speculation of rate cuts, for that to happen implies not only that central banks believe inflation is under control, but that economic growth is softening to the extent it needs a boost from lower interest costs. There’s no guarantee on that.

Geopolitics is noise: there has been no shortage of geopolitical headwinds for financial markets to negotiate over the past couple of years. The Russian invasion of Ukraine was supposed to crush economic growth because of higher commodity prices, tension between the US and China had the media in a froth, and then another war in the middle east threatens to escalate. Yet markets have gone onwards and upwards.

The fact is, while wars are tragic and terrible and sabre rattling might keep us up at night, markets will only suffer enduring effects if corporate earnings take a hit.

Market concentration is not necessarily a bad thing: by the middle of last year, the US market had risen about 20%, but it had come entirely from the top 10 stocks. Bearish commentators were warning that investors in the US market were taking bigger and bigger risks because the weighting of the top 10 companies in the S&P 500 had never been so high, hitting 32%. By the end of the year, those 10 stocks had risen 62%, while the bottom 490 had gone up by a far more pedestrian 8%.

Australian investors should have no concerns about market concentration, given the top 10 companies in the ASX 200 account for more than 46% of the index.

It’s entirely possible the top 10 companies in an index could underperform or even fall, but if the rest of the rest of the companies in the index perform strongly, it will generate a good return. If a portfolio was comprised of nothing but the top 10 companies, obviously the risks are different, but some simple diversification can address those problems.

Bonds can be just as volatile as shares: traditional portfolio construction includes an allocation to bonds based on the theory that they reduce portfolio volatility and can act as a counter-correlated airbag to share markets.

While 2023 was nowhere near as bad for bonds as the record losses of 2022, they were still far more volatile over the year than shares, indeed, as chart 5 shows, the intra-year drawdown for US, German and UK 10-year bonds was around 40%, more than four times the drawdown of the S&P 500 and ASX 200 at their worst.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

The outlook for 2024

While there are still a few bears growling about potential recessions, most forecasts are for equity markets to rise in 2024, and it’s even easier to find bond market bulls (though a lot of them are bond fund managers, so you have to be wary).

Australia

Australian company earnings dropped by more than 8% in 2023, having gone up by 16% the year before. One of our asset allocation consultants, farrelly’s, estimates long-term trend earnings growth for Australian companies at 3% per year, so given the recent fluctuations, it’s hardly surprising the current forecast is for about 1.2% earnings growth for 2024.

Of course, Australian shares typically pay a generous dividend by international standards, of about 4.4%, add 1.2% to that and you’d get a 6.6% return, which compares to a 30-year average annual return of 9.2%. We could reach that higher number if the PE ratio continues to expand, or if earnings are better then forecast. Of course, for those who benefit from franking credits, you can add an extra 1.4% to those numbers.

The ASX 200 finished 2023 on a forward PE ratio of 16.4x – see chart 6, which compares to a 20-year average of 14.6x. On that basis, it looks a little expensive, but it could simply be the market factoring in an earnings recovery.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

United States

This is where things get really interesting. As noted above, in 2023 the US market was dominated by a handful of mega-cap tech companies, while the ‘bottom’ 490 stocks were pretty pedestrian by comparison.

The S&P 500 finished 2023 on a PE ratio of 19.5x, a hefty 17% premium to the 30-year average of 16.6x – see chart 7. However, if you break that down, the top 10 companies were on a PE of 27x, while the rest were on 17x. In other words, the ‘rest’ of the market is not expensive by historical standards.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

J.P. Morgan argues the market is not especially expensive given companies reported free cash flow margins 30% higher than they were only 10 years ago, with a lot of that growth coming from the big tech companies. US funds management group, GMO, also points out that US corporate profitability, as measured by return on sales, has averaged 7% since 1997, compared to 5% before that – that’s a whopping 40% higher.

For 2024, the average forecast for the US market across 20 different international financial groups is a gain of 10.2% – for what that’s worth (which isn’t much). Of more relevance, corporate earnings are forecast to grow by 11.5%, plus the S&P typically pays a dividend yield of around 1.5%, which comes to 13%, roughly in line with the last 15 years average return of 13.8%, but comfortably above the 30-year average of 10.1%.

Something that plays on every asset allocator’s mind is chart 8 – which shows how extreme the US’s outperformance compared to the rest of the world has been since the GFC. Not surprisingly, most allocators look at that chart and immediately reduce the weighting to US shares. There are many explanations for the outperformance, not the least of which is that areas like Europe have been mired in an austerity mindset since 2009. There are, of course, two ways the gap could close: the US could fall heavily, or the rest of the world could make huge gains – or the trend could keep going. Unfortunately, there is no way of knowing.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

Notably, in terms of valuations, the rest of the world (ex the US), is trading on a PE ratio of 12.9x, compared to a 20-year average of 13.1x, so fractionally on the cheap side. However, that’s a 34% discount to the US, which is the highest in at least 20 years.

Here are a few interesting observations, based on historical return for the US:

  • In late November last year, the S&P 500 made a new high since January 2022, i.e. it had been more than a year, and on the 14 previous occasions that’s happened, the market rose by an average of 14% over the following year and was positive 93% of those times
  • Since 1928, when the S&P has gone up by more than 20% in a calendar year, the average gain the following year was 11.4%, and it was positive 65% of the time
  • Since 1933, the fourth year of the presidential cycle has seen an average return of 6.7%, and is positive around 70% of the time
  • Deposits into money market funds last year were 13x more than what went into equities, taking total deposits to a record US$6 trillion, which on their own are expected to generate US$300 billion in interest income

Emerging markets

With a forward PE ratio of only 11.9x, the emerging markets look cheap compared to developed markets, however, that number is bang on the 25-year average and they’ve looked cheap for years and have underperformed the developed markets badly since the end of the GFC – see chart 9.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

At a 26% weighting in the EM index, China is the 600-pound gorilla in the asset class, and it had a miserable 2023, falling almost 13%. Much of that is because the government refused to inject COVID stimulus at the household level, unlike western governments, forcing families to draw on their savings to get through extended lockdowns, and leaving consumers reluctant to spend once restrictions were lifted.

On top of that, the property sector, which was estimated to have contributed as much as 20% to GDP growth, is in disarray. The government has actively supported the rapid development of the electric vehicle industry, and now China makes more EVs than the rest of the world combined. It is possible that will be a strong new source of growth for the economy over the coming years.

By contrast, India, which is 17% of the index, is shooting the lights out, returning 20.3% in 2023 and hitting a new all-time high, and 15.8% per annum for the last three years. A combination of favourable demographics and a booming tech sector has proven to be a terrific tailwind.

Emerging markets returns tend to go in long cycles and appear to be linked to long-term trends in the US$, and trying to guess where currencies are going is even harder than share markets. The bottom line is that when an asset class is as cheap as EM is at the moment, it makes sense to have at least some weighting.

Real assets

Traditionally one of the more interest rate sensitive sectors, real assets, like property and infrastructure, have been beaten up badly over the course of the current interest rate cycle, but they turned sharply at the first hint that rates have peaked. In late October last year, the VanEck Global REIT ETF (REIT) was down by almost 40% from its peak, but then rallied more than 40% by the end of the year.

Chart 10 shows the relative earnings multiple that global REITs is trading on compared to equities puts them very much on the cheap side relative to the long-term average. The level of EBITDA hasn’t changed significantly, but the multiple it’s trading on has been derated to levels similar to the GFC and the COVID sell off, which is all sentiment-driven.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment
Small cap companies

Small cap companies is another asset class that has been brutalised over the past couple of years, both in Australia and internationally, to the point where they are now trading at multi-decade lows relative to large caps – see chart 11.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

Notably, the US small cap index, the Russell 2000, jumped 26% from its lows at the end of October. Once again, since the index’s inception in 1979, there have been 21 previous occasions where it has rallied more than 20% in 50 days, and the average increase one year later was 16.5%, and it has never been lower. That compares to the average 12 month return of 10.5%.

Again, given how relatively cheap small caps are, it makes sense to have at least some allocation.

Fixed income

One of most popular sayings in financial markets recently has been, “Bonds are back!” The argument is that investors are now receiving a yield to invest in government bonds, unlike a few years ago where yields were approaching zero and, in many cases, actually went negative!

The prospects for bonds depends entirely on what happens with interest rates and inflation. Being paid to hold them is a start, but bond prices can be quite volatile – as discussed above.

Private credit continues to grow its share of the commercial lending market in the US, Europe and Australia. We remain strong supporters of well managed private credit backed by strong levels of security and low LVRs, with returns comfortably above those offered by bonds and, typically, zero volatility in the underlying unit price.

Conclusion

Financial markets have a knack for surprising, and 2023 was a great example of that. The headwinds that caused mayhem a couple of years ago have dissipated, but whether they become the tailwinds the market is hoping for is yet to be seen.

After what turned out to be a year of good returns in 2023, there are sound fundamental arguments to support a positive view on share markets for 2024, and there are certainly asset classes and sub-sectors that look relatively cheap.

To recess, or not to recess, that is the question

To recess, or not to recess, that is the question

There’s a saying on Wall Street that central banks keep pushing until something breaks. In other words, if central banks want to reduce inflation, they have a tendency to keep raising interest rates until some part of the economy gets into trouble.

Since the middle of last year, economists, strategists and experts of all stripes have been putting forward a bewildering array of seemingly contradictory arguments as to why Australia, the US, Europe and pretty much every economy in the world, is either eventually going to fall into recession or should somehow narrowly avoid it.

Quite simply, if a central bank keeps raising interest rates, eventually the cost of credit, which is the lifeblood of a modern economy, will reach the point where consumer spending falls in a hole and businesses are either unable to pass on the additional cost or can’t justify new borrowing based on potential return. That’s when an economy slides into recession, with the slowing of growth and usual rise in unemployment having the effect of reducing inflationary pressures, until the cycle goes the other way and central banks desperately try to revive growth by lowering interest rates.

After June’s surprise rate rise, the governor of the Reserve Bank, Philip Lowe, said he believes Australia “remains on the narrow path” to a “soft landing”, or avoiding recession. Mind you, in the next breath he warned there’s more work to be done to make sure inflation comes back to the target zone of 2-3 per cent, which can only mean more rate rises.

Investors generally loathe uncertainty, so it can be frustrating that something so fundamental as whether the economy will grow or not looks to be a guessing game. The Commonwealth Bank and HSBC Australia are both perched on the fence, placing the odds of a recession at 50 per cent. Meanwhile, UBS reckons it’s a 25 per cent chance, AMP is at 45 per cent and Westpac is punting we won’t.

It’s the same in the US, where in October last year Bloomberg Economics placed the odds of a recession within 12 months at 100 per cent. Then by April this year another survey of economists placed the likelihood at 64 per cent, but with predictions ranging from as high as 94 per cent to as low as 30 per cent. Recently the New York Fed put the odds of recessing at 70 per cent, and for good measure, Goldman Sachs rates it a 25 per cent chance.

As the saying goes, if you’re not confused by that then you don’t understand it.

So how much faith should you place in economists’ forecasts? In case you haven’t already guessed, not much. In 2018 the IMF reviewed forecasts covering 63 countries over the 22 years to 2014 and found only 3 per cent of economists correctly forecast a recession 8 months ahead and only 9 per cent just 3 months ahead.

On top of that, economists will always use history as their guide to forecasting current outcomes, but this time the inflationary event was preceded by many governments, including Australia’s, injecting massive fiscal stimulus to offset the effects of COVID lockdowns. Much of that money continues to slosh around economies and is a big reason why unemployment is running at multi-decade lows.

Also, in the US, somewhat ironically, the rise in interest rates has meant the federal government’s interest payments have risen to about $950 billion, increasing the deficit to a hefty 8 per cent of GDP. Combine that with the low unemployment and it’s perhaps not surprising the US economy is proving resilient.

Bearish forecasters argue a recession will whack company earnings and markets, especially share markets, will have to fall. The bulls argue share markets have already factored in the likelihood of a recession and, as usual, are looking to the future.

Smart investors need to weigh up whether they think economies will recess and, if they do, whether it’s already in the prices. If that sounds as difficult as it actually is, then there’s a good argument for remaining invested in shares, but maybe retaining an allocation to cash or fixed income both as a defensive strategy and to pick up a bargain should one come along.

 

Federal Budget Oct 2022 Summary

Federal Budget Oct 2022 Summary

This year’s Federal Budget focuses on providing relief for those with children, homebuyers and social security recipients whilst maintaining pre-election commitments. 

Note: These changes are proposals only and may or may not be made law. 

Summary 

Personal taxation 

  • No changes to personal income tax: The Budget did not contain any measures announcing changes to personal income tax. This includes:
    • no changes to the Stage 3 tax cuts which will take effect from 1 July 2024, and 
    • no extension of the Low and Middle Income Tax Offset, which ended 30 June 2022.
  • Helping enable electric car purchases: For purchases of battery, hydrogen, or plug-in hybrid cars with a retail price below $84,619 (the luxury car tax threshold for fuel efficient vehicles) after 1 July 2022, fringe benefits tax and import tariffs will not apply. Note: Employers will still need to account for the cost in an employee’s reportable fringe benefits. 

Home ownership 

  • Housing affordability measures: A key focus of the Budget were measures to help individuals secure housing. This is expected to occur largely via the Housing Accord – which will bring Federal, State and Local Governments together to work on housing affordability and homelessness. Measures announced include:
    • A commitment to the ‘Help to Buy’ scheme which will support first home buyers to buy a home with the Federal Government being a part owner, resulting in a lower balance to be funded by the individual themselves.
    • A Regional First Home Buyer Guarantee from 1 October 2022 which, similar to the existing First Home Deposit Guarantee scheme, is expected to provide up to 10,000 first home buyers with a guarantee over their mortgage, removing the need for lenders mortgage insurance.

Superannuation

  • Expanding eligibility to downsizer measures: Legislation has been introduced to reduce the downsizer eligibility age from 60 to 55. This measure will take effect from the first quarter after passing into law, which is expected to be 1 January 2023.
  • SMSF and tax residency: The Government confirmed its intention to continue with the 2021/22 Budget measure of extending the temporary trustee absence period from two years to five years and removing the ‘active member’ test. These changes will help SMSFs continue to maintain their Australian tax residency even while members are overseas, and allow them to continue to contribute to their funds even if they become non-tax residents.
  • Three-year audit cycle for SMSFs not proceeding: Originally announced as part of the 2018/19 Budget, it was confirmed the current Government will not proceed with this measure. 

Social Security 

  • Child care subsidy changes: As part of a package of reforms to encourage parents to return to the workforce, the maximum child care subsidy from 1 July 2023 will increase to 90% for families earning less than $80,000. For every $5,000 earned over this threshold the subsidy will reduce by 1% – reducing to zero for incomes $530,000 or above.

The higher rate of subsidy for families with multiple children in care will continue under its current arrangements, ceasing once the eldest child reaches six years old or has been out of care for 26 weeks. 

  • Paid parental leave increases: Announced before the Budget, from 1 July 2024 the Paid Parental Leave Scheme will increase the maximum period of leave by two weeks each year – reaching a maximum of 26 weeks by 1 July 2026.

Further, from 1 July 2023 both parents will be able to access leave at the same time or enter into more flexible arrangements than currently available under the limited Dad and Partner Pay limits, and requirements to take 12 weeks as a continuous period. The paid parental leave income test will also be extended to include a $350,000 family income test, which can be used to help families who do not meet the individual income test. 

  • Reducing assessment of former home proceeds: For individuals on social security benefits, the temporary assets test exemption of home sale proceeds is to be extended from 12 months to 24 months. Additionally, these proceeds will only be deemed to earn a return at the lower deeming rate (currently 0.25% per annum) for this period. Note: This exemption only applies to the portion of the proceeds expected to be used in a new home purchase.
     
  • Work Bonus deposit for older Australians: Announced as an outcome from the Jobs and Skills Summit, age pensioners and veterans over service pension age are expected to receive a one-off credit of $4,000 into their Work Bonus income bank. The Work Bonus typically offsets $300 per fortnight of income earned from employment or self-employment activities, allowing pensioners to receive a higher age pension whilst still working.
     
  • Increased income thresholds for Commonwealth Seniors Health Card: The Government has committed to increasing the income thresholds for the Commonwealth Seniors Health Card to $90,000 for singles and $144,000 combined for couples.
     
  • Deeming rate freeze: The Government has also confirmed its intention to retain the current deeming rates until at least 30 June 2024.
     
  • Plan for cheaper medicines: From 1 January 2023, the general patient co-payment for Pharmaceutical Benefits Scheme treatments is expected to reduce from $42.50 to $30. 

Source: budget.gov.au / Actuate Alliance Services

Business owners

  • Self-assessment of depreciating assets: The Government will not proceed with the measure to allow taxpayers to self-assess the effective life of intangible depreciating assets, announced in the 2021-22 Budget.
    • Reversing this decision will maintain the status quo – effective lives of intangible depreciating assets will continue to be set by statute. This will avoid the potential integrity concerns with the previously announced measure and contribute to budget repair.

Source: Macquarie

4 new super contribution opportunities

4 new super contribution opportunities

For older Australians, it has been more difficult to build up their superannuation balances. Once you are 67 years of age, there is a requirement to meet a ‘work test’ in order to continue to contribute. This work test forced you to work 40 hours over 30 consecutive days in order for you to make a lump sum contribution (known as a non-concessional contribution) of up to $110,000.

With these restrictions, it was important to carefully plan your superannuation strategy from a younger age.

However, the Federal Government sought to amend these restrictions.

May 2021 Federal Budget

In the May 2021 Federal Budget, the government announced a number of initiatives to assist Australians in building up their superannuation.

These included:

  • Removal of $450 monthly income threshold for super contributions.
  • Reduction in age to 60 for the downsizer contributions.
  • Removal of the work test for people aged 67-74.

It also increased the withdrawal limit for First Home Super Saver Scheme (FHSS).

Legislation has now passed both houses of parliament and will apply form 1 July 2022.

4 new super contribution opportunities

Removal of $450 monthly income threshold

The government has finally scrapped the $450 superannuation guarantee threshold. This should make approximately 300,000 people eligible for super contributions from 1 July 2022.

Lower Age for ‘Downsizer’ contributions

In selling the family home, couples have the ability to contribute $300,000 each into superannuation as a personal contribution. The age for this contribution was 65, however, it has been lowered to 60. As of May 2021, 22,000 Australians have taken advantage of this opportunity to boost their retirement balances. It should also be noted that these contributions are not restricted by the $1.7m transfer balance cap.

The lowering of age to 60 will come into effect from 1 July 2022.

First Home Super Save increased capacity

This is a great opportunity for couples who are saving for their first home. This scheme allows people to make voluntary contributions to superannuation to save for this purchase. The current caps on these contributions are $15,000 a year and $30,000 in total.

However, it has been passed to allow voluntary contributions (both post tax or through salary sacrifice) up to $50,000 in total.

So a couple will have access to $100,000. It’s important to remember compulsory employer contributions are excluded. Only voluntary contributions may be withdrawn.

This will commence from 1 July 2022.

Removal of work test for 67-74 year olds

The most significant superannuation opportunity announced in the May 2021 Federal Budget was to allow 67-74 year olds to make a personal contribution to superannuation without meeting the current work test. This has now been passed and will come into affect on 1 July 2022.

However, not only will older Australians be able to make a personal contribution of $110,000 pa, but they will also be able to take advantage of the bring forward rule and contribute $330,000 as a lump sum.

Inflation gives investors the chance to profit from shares

Inflation gives investors the chance to profit from shares

Inflation is once again in the headlines, after Australia’s September quarter CPI data showed prices increased by more than three per cent over the year. The Reserve Bank looks through the more volatile prices, like food and energy, but even its preferred ‘core measure’ came within its two to three per cent target range for inflation for the first time in six years.

Underlying the spike in inflation are higher energy prices, especially across the northern hemisphere, colliding with ongoing supply chain pressures, which were frequently referred to in recent results by both US and Australian companies, due largely to a global spike in demand for goods underwritten by the enormous levels of government stimulus pumped into the economy to offset COVID pressures.

Inflation is like kryptonite for bond markets, and its re-emergence has really spooked them. The Australian 10-year bond yield just about doubled in the two months to the end of October, to a yield of 2.08 per cent, while the US yield tripled to 1.56 per cent (remember, if a bond’s yield is going up, that means its price is going down). Bond markets are seen as betting the Reserve Bank, along with other central banks, will be forced to raise interest rates much earlier than they have been guiding since last year.

The sharp negative response in bond markets has not really been reflected in equity markets. Over the same period, the ASX200 fell four per cent from its recent all-time high (which included going ex a record amount of dividends), while the US’s S&P 500 rose three per cent to reach a new all-time high.

There has been a lot of commentary and speculation that equities markets are being too complacent in the face of a potential change in the inflationary picture and the risk of rising interest rates. Before rushing to make any decision on that either way, it pays to look at how shares have performed in past periods of high or rising inflation. The results may surprise you.

Table 1 shows that in the 12 years that reported the highest annual rates of inflation since 1960, which were all clustered around the 1970s to 1980s, there were five years where the All Ordinaries index fell, with the worst being a drop of 27 per cent, while the strongest year saw a mighty increase of 67 per cent. Overall, the average rate of inflation was a touch over 11 per cent, while the average share market return was more than 18 per cent. It’s fair to conclude there is no discernible relationship between the two.

Table 1

When looking at the 12 years that reported the highest annual increase in inflation, they were more scattered across the six decades. Of the four years where the All ordinaries fell, the worst was 2008, with a drop of more than 40 per cent, while the best year was 1986, which saw a rise of more than 52 per cent. The average increase in inflation was 2.6 per cent, while the average increase in the share market was 6.5 per cent. Again, there is no discernible relationship between the two.

Table 2

Importantly, smart investors should be aware that when the inflationary environment changes, the companies that drive share market returns may also change. In a low inflation environment, companies that can generate growth independently of macro considerations, known as ‘growth’ companies, will do well. This is exactly what we’ve had over the past five to ten years. Conversely, when inflation strikes, it’s those companies that have pricing power and can pass on higher costs, which are usually ‘value’ companies, whose earnings will be least affected.

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