Equity markets strengthened in October. Developed markets outpaced emerging ones, with the MSCI World Index (in local currency terms) increasing 5.5% relative to the MSCI Emerging Markets Index, which climbed a modest 0.9%. A strong start to the earnings season in the US saw the S&P500 jump 7.0%, outperforming other global equity markets. On the other hand, the Australian market underperformed, as fears that the RBA will hike interest rates earlier than expected drove the ASX200 down 0.1%
In fixed income, rising inflation and hawkish rhetoric from central banks have resulted in a repricing of rate markets. This has been particularly acute in Australia. The higher-than-expected September quarter Consumer Price Index (“CPI”) print induced markets to bring forward expectations of a rate hike, resulting in a steep 59bps jump in the 10-year bond yield to 2.08%. Positive interest rate differentials and strengthened commodity prices supported the Australian dollar, which appreciated 4.0% relative to the USD, now buying 75 US cents.
A combination of the ongoing international energy shortage and a weaker US dollar saw commodity markets strengthen. Copper prices rose 10.1% to $9,955/t while Zinc shot up 14.6% to $3,455. Iron Ore, while still down 22% year-to-date, rose a modest 1.3% as some of the concerns surrounding the Evergrande debacle faded. Gold also strengthened 1.5% to $1,769/oz.
A myriad of demand/supply imbalances have caused energy prices to skyrocket over the past nine months. Brent Crude oil has risen 64% in the year to date and now trades at $84.40/bbl. Similarly, WTI Crude is 72.8% higher in the year to date at $83.60/bbl. The price of Natural Gas has risen 113% over the past 12 months, now at $5.40/Mmbtu.
A combination of economic re-opening momentum, depleted inventories of durable goods (causing producers to increase production) and weather impacts (particularly as the Northern Hemisphere has moved into winter) have all worked to bolster demand for energy. At the same time, the lowest capital expenditure in the sector for over a decade, the transition to renewables and political factors (including China seeking to reduce its reliance on Coal as its primary source of energy) have constrained supply. The result is a textbook example of excess demand causing a significant increase in price as the market moves back towards equilibrium.
There is some concern within markets that these recent spikes, similar to the 1960s and 1970s, could lead to an inflationary spiral and derail growth. We would argue that this is unlikely. Unlike the 1970s, dependence on energy in advanced economies has fallen considerably. Furthermore, since adopting inflation targeting as their primary goal, central banks have tended to look through fluctuations in oil prices when making policy decisions. Ultimately, as supply slowly catches up with demand, we expect markets to clear and energy prices to normalise.
Inflation – is it here to stay?
Global CPIs have surged above market expectations and the measure of long-term inflation, defined by the 10-year breakeven rate, climbed to a 15-year high in October (Chart 4). This caused many investors to question whether this was a structural shift, forcing global central banks to react and bring forward the normalisation of monetary policy by accelerating the tightening cycle. However, many argue that the current increase in inflation is transitory and can be fully attributed to the pandemic disruptions. Indeed, the higher inflation prints followed a strong increase in energy and durable goods prices, both caused by constrained supply due to supply chain bottlenecks. This is likely to reverse once inventory levels return to long term averages, albeit energy prices may take longer to fall. Overall, we expect that current inflationary pressures will ease over the next 12 months. What should be acknowledged, however, is that the expected decline in inflation may only be temporary. Over the long term, structural forces, like tight labour markets, would likely cause wage pressures and a shift to a more sustained inflationary regime.
While we acknowledge that equities had a strong run year to date, with some market indices reaching new all-time highs in October, we remain constructive on stocks over the medium-term. Stocks remain attractive on valuation relative to bonds, and are likely to continue generating strong returns, supported by post- pandemic acceleration of economic activity and accommodative fiscal and monetary policies.
Structurally higher inflation over the long term presents a risk to portfolios. This can be mitigated by remaining well diversified and including allocations to property, infrastructure, gold and other commodities.
We continue to see government bonds as largely un-investable, given that most global central banks are likely to start tightening monetary policy in the coming year. We prefer various alternative investments that add diversification to portfolios whilst helping to achieve income and growth targets.
We encourage you to contact us should you wish to discuss this further or if you have any questions about how these trends are impacting your portfolio.