Cautious optimism rules as markets stay strong

Cautious optimism sums up our feeling, both economically and socially, as we head into the final quarter of 2021. Sydney and Melbourne are emerging from their long lockdowns, summer is coming, and Australian vaccinations rates are high and moving higher. If we look to similar countries overseas, high vaccination rates are increasingly allowing people to move back towards the lives they’re used to living. The pandemic is moving off the front pages and lower in people’s consciousness.

In Perpetual Private’s quarterly investment update for July to September 2021, we look at the returns for Australian and global markets, where opportunities lie and gauge the risks to a broadly diversified portfolio in the remainder of 2021.

Markets and economies are following a similar theme. Economies around the world are reopening and border restrictions are loosening, though supply chain pressures remain. Global equity markets continue to rise: the MSCI All Country World index rose 3.9% over the last quarter and Australian equities increased too, albeit at a slower rate. The S&P/ASX 300 Accumulation index gained 1.8% over the period.

So far, so fine, but now for the cautious bit.

Three main areas are causing consternation, with the potential to destabilise the recovery. Firstly inflation, which continues to be furrowing brows as it creeps higher. Is it a transient blip, or do we need to bring it down? Secondly, geopolitics - China and the US continue their high-level jockeying for position, gradually increasing tension and drawing other countries into the struggle. Thirdly, equities, still the shining light for investors as ultra-low interest rates continue, but how long can the bounce-back continue?

Inflation – still likely to be a short-term problem.

In many ways it’s a good thing that we’re talking about inflation. Deflation, its opposite, is generally thought to be much more concerning and harder to turn around. The central-bank consensus is that 2% inflation is a suitable level for constructive growth, when it gets much above that for long periods of time then it’s a cause for concern. Prices are certainly rising in some parts of the economy, however mostly these are due to short-term pressures caused by COVID, especially disruption to global supply chains. As the world reopens then it’s likely that these pressures will ease and prices will stabilise. The risk is that these short-term problems will persist, causing even steeper price rises and potentially causing governments and central banks to intervene. The prevailing view is still that the inflationary pressures will ease, the IMF says that: “inflation is expected to revert to pre-pandemic levels by mid-2022”[1]. If this is the case, then it’s likely that governments will continue to provide support to push forward the economic recovery and interest rates will remain low.

Geo-politics – ongoing tension, low likelihood of major incident.

China and the US continue to ratchet up tension as their battle for global economic superiority goes on. The awkwardly named AUKUS, and Australia’s plan for nuclear-powered submarines, has again drawn Australia into the middle and caused a further deterioration in Australia/China relations. These kinds of disputes are likely to continue to occur as the world adjusts to a new order where the US is not the only superpower, but either has to share the stage, or cede top position, to China. The danger, of course, is that sharp words escalate into actual conflict.

We give a low probability to the chance any serious conflict will occur in the next few years. It is not in the best interest of the US or China to engage in conflict, they are both likely to lose more than they gain.  And even if conflict does occur, this doesn’t necessarily mean that markets will be dramatically affected. Markets can continue to rise while major armed conflict occurs, as happened in the early stages of World War II. Of course, a major armed conflict between two superpowers would have terrible consequences for the world, but that looks unlikely at this point.

Equities – still the place to be.

Equities have continued to be the first port of call for most investors as ultra-low interest rates drag down returns in most other asset classes. The emergence of the Delta COVID variant, and subsequent slower economic reopening, has dampened, but not put out, the equity glow.

We think that conditions are, on the whole, positive toward equities continuing to deliver healthy returns. While expectations of a services boom as economies rebound may be overblown, we expect that pent-up demand for travel, hospitality and entertainment will increase consumer spending in many countries. Just as the great lockdown created many winners (home delivery, electrical goods, internet services) and losers (tourism and hospitality) we expect the same in reverse as countries reopen. This is likely to cause markets to continue to rise overall, but with considerable turbulence beneath the surface as companies’ individual fortunes differ markedly as they readjust to a new phase of the COVID pandemic.

Looking ahead – some risks, but nothing to keep you up at night.

While risks remain, including the geopolitical, inflationary and equity risks outlined above, we think the outlook for financial markets is largely positive. Governments look set to continue their economic support packages and central banks seem similarly set on keeping interest rates low as long as possible. This is likely to drive a surge in economic activity as countries and economies reopen and both businesses and consumers feel freer to spend.

It’s quite possible that this will drive interest rates to the high end of 2-3% range, which will be unusual territory for countries now used to very low inflation. In turn, this can cause inexperienced investors to take greater risks chasing higher returns. This will not be our approach. We will continue to balance risk and return forour clients’ investments to achieve sustainable long-term growth.

In Perpetual Private’s quarterly investment update for July to September 2021 we look at all these issues in greater depth, as well as detailed analysis of individual asset classes including fixed income, real estate, currency and alternatives.