Monthly Update – March 2022

The last two years have thrown a lot at investors

1 – The COVID pandemic stimulus

The COVID pandemic was the first major shock to the global economy since the GFC. Markets initially fell sharply but this was quickly followed by a strong recovery, fed by an unprecedented level of global stimulus and household support.

Household savings reached an all-time high as both consumer and business confidence picked up. Businesses invested and hired more, creating a strong labour market and significant job creation.

2 – The demand driven jump in inflation

This jump in confidence and resulting rebound in consumer and business demand fed into the next major shock – increasing inflation. This was particularly felt in the US, where inflation recently reached 7.5%, the highest rate since 1982. The inflation rate in Australia has reached 3.5%.

Recently, inflation expectations have increased due to higher energy and food prices resulting from geopolitical issues in Europe. This rise in inflation needs to be considered in the context of historic low cash rates. In Australia, the cash rate remains at 0.25%, which analysts believe is a highly accommodative interest rate setting.

3 – It’s time to restore short-term interest rates to a normal setting

A further shock for investors is how to navigate the difference between the current inflation rate and the record low cash rates around the world and what this means for returns from equities as rates are normalised. Central banks globally have commenced raising short-term cash rates.

This was highlighted during the week with the US FED and the Bank of England making their first increase in the overnight cash rate. Analysts expect the US FED will continue with up to six more increases in the FED rate in 2022.

In Australia the RBA is expected to make its first move, increasing the cash rate around July/August this year.

4 – Geopolitics – the new shock for investors

The last major shock is geopolitical and is centred around the conflict between Ukraine and Russia. This is impacting the prices of key commodities and has flow-on consequences for inflation.

The current sanctions on Russia will also have an impact on global financial institutions as the aftershocks flow through the banking sector. European and US banks are particularly vulnerable should Russia default on its foreign debts.

In Australia, the cash rate remains at 0.25%, which analysts believe is a highly accommodative interest rate setting.

The RBA is expected to make its first move, increasing the cash rate around July/August this year.

How aggressively will central banks move short-term rates?

Investors need to consider debt levels held by governments, corporations and households which are at elevated levels. These debt levels have created huge vulnerabilities to higher rates. The sensitivity of borrowers to rising rates has increased as debt levels have increased.

This means that to achieve their aims central banks don’t have to raise rates as much as usual due to the higher level of sensitivity to rate increases. Small increases in short-term rates will have immediate flow-on consequences for economic activity.

Whilst the long-term (20 year) average cash rate may have been around the 5% mark prior to the pandemic, it is likely to be closer to 2.5% post-pandemic. This is a level of adjustment that would be reasonably well tolerated by investment markets.

The outcome of the Ukraine/Russia conflict

One of the major consequences of the current conflict will be a focus on the geopolitical necessity for economic resilience.

This resilience will include:

  • Onshoring some productive capacity – securing domestic supply of key production;
  • Expanding alternative supply sources – ensuring less reliance on one or two countries;
  • Insulating supply chains from geopolitical risks – diversifying supply chains to ensure continuity of supply; and
  • Building inventories of important commodities and goods – safeguarding adequate reserves of key commodities.

These moves have been highlighted recently by the Australian government’s provision of over $2billion in subsidies to Australian owned petrol refineries to shore up domestic petrol production.

This week the government provided $243 million in grants to protect the domestic supply and production of critical battery materials and rare earths.

The global trading system may split into two groups, centred around China and the US

Another likely outcome of the Ukraine/Russia conflict is the fragmentation of the global economy.

This will see Russia move more directly into China’s orbit, and the West reduce its ties with Russia.

The global trading system may split into two blocs, one centred around China and Russia, and the other around the US, UK and Europe. This will have implications for global economics as it plays out.

Whilst the long-term (20 year) average cash rate may have been around the 5% mark prior to the pandemic, it is likely to be closer to 2.5% post-pandemic. This is a level of adjustment that would be reasonably well tolerated by investment markets.

Located in the southern hemisphere and a major commodity exporter, Australia continues to be well placed given the geopolitical uncertainties

Fortunately for investors in Australia, our market continues to hold up well compared to others.

Australian equities fell around 9% from recent peaks, whereas most US markets were down around 20%. 

Australia continues to look attractive from a GDP growth outlook, as well as relatively low inflation. Our interest rate settings also remain supportive and the government continues with expansionary fiscal settings.

Dividends from Australian shares continue to look attractive. Australian companies have repaired the dividend cuts of the COVID pandemic, with the dividend yield of the Australian market now at above 4% – which looks attractive compared to offshore markets.

Kauri Wealth Management is a Fee for Service investment advisory business and as such my advice is built around ongoing personal relationships with my client base. Personalised independent advice is backed up by a breadth of industry knowledge.

I accept a limited number of new clients each year and would be happy to discuss this further with you. Please don’t hesitate to contact me.

Russell Lees
Senior Adviser
Phone: +61 439 852 963
Email: russell@kauriwealth.com.au

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