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Equity Strategy: Into The Headwinds

Feature Stories | Nov 04 2021

As central banks begin to tighten policy amidst a slowdown in the global economic recovery, it will not be such smooth sailing for equities in 2022.

-Inflation high as economies slow
-Supply shortages set to linger
-Central banks begin to tighten policy
-Chinese policies driving structural slowdown
-Where to invest?

By Greg Peel

If there is one word generating fear among financial market investors right now it is “inflation”. Given inflation is remaining stubbornly high on a global basis when delta has brought about a slowing the pace of economic growth out of last year’s turmoil, market commentators are even using the word “stagflation”.

This expression was coined in the 1970s as a mix of economic “stagnation” and high inflation. Investors have every reason to fear stagflation – from January 1966 to May 1982 the Dow Jones Industrial Average fell -73%.

But what the world is experiencing right now, can it honestly be called stagflation?

Living in The Seventies

I got my driver’s licence in 1979 in my HSC year. I abruptly found myself stuck in a queue for petrol. At that time I could only buy petrol on even-numbered days as my number plate ended in an even number.

Making the situation more frustrating was the fact that Sydney train drivers were almost constantly on strike. When there were no trains I had to drive to school, if I could buy some petrol. It wasn’t just train drivers. Airport workers, post office workers, brewery workers… it was a long list…were also frequently on strike.

Australia had enjoyed a post war boom, not just in babies but in the economy, as households bought their first car, fridge, washing machine, television and all else to go in their first house in the suburbs. The economy was also “riding on the sheep’s back”, until the mineral boom took over.

Back then, central banks had no mandate to control inflation. Inflation had already begun to rise on the back of the economic boom but when the first Arab oil shock hit in 1973, after Nixon scrapped the US dollar’s peg to gold, and another in 1979, due to the Iranian Revolution, OPEC embargoes sent the price of the most important economic input soaring and inflation ran into the double-digits.

The seventies saw a deep global recession. Unemployment levels also rose into double-digits. Angry unions demanded pay rises and brought the economy to its knees. An upward wage-price spiral ensued. The Australian dollar was pegged to the US dollar. There were no listed banks, insurers, telcos, supermarkets – if not privately owned, they were owned by the government.

Let’s just say life, and financial markets, in the decade that fashion forgot were very different to what they are today.

Which is why economists are scoffing at the notion of 2021 “stagflation”.

Not Living in the Seventies

Life was also very different back in 1918 when the last true global pandemic hit. Today we marvel (or despair) at the pace of technological growth but consider that in the early twentieth century, a lot of what we now take for granted was still very “new”. Think steel, electricity, telephones, automobiles, aeroplanes and the oil required to fuel engines, rather than just provide for kerosene lamps.

Economies were very different, and so too financial markets, which is why covid may not be unique but Aviva Investors is happy to say the current global economic expansion is indeed unique.

The decline in economic activity in 2020 was unprecedented, but more astounding has been the speed of recovery into 2021. The Spanish flu also had a more deadly second wave, but back then there was no support from central banks and little support from governments still reeling from the First World War. Unemployment benefits were first introduced in the Depression.

The US economy has already surpassed its pre-covid level of activity, notes Aviva, and Europe and the UK are expected to reach that point by year-end. These economies will all thus have regained their pre-crisis GDPs within about 18 months of the deepest recession on record.

That compares to a spread of 3-7 years to recover from the GFC. Forecasters, Aviva included, expect most other economies to return to pre-covid levels by the end of 2022, something that many never achieved post-GFC.

Monetary policy support and fiscal support have been both extraordinary and unprecedented. The extent of Fed quantitative easing (bond purchases) has since last March been a multiple of that spent following the GFC. Throw in an explosion in post-lockdown consumer demand and both the rapid pace of economic decline and the rapid pace of recovery are indeed unique.

Delta Blues

Earlier this year that consumer demand explosion met the delta variant. New lockdowns ensued in some countries, such as Australia, but more significantly in Asia – the global hub of manufacturing. This led to factory closures, which caused supply shortages, and port closures, which led to supply delays and soaring freight costs.

Thus followed surging wholesale price inflation, flowing into surging consumer price inflation.

Three factors conspired to exacerbate the problem, Aviva notes: under-investment in the post-GFC period, zero-covid policies in Asia, particularly China; and “just in time” inventory management.

While most major economies have decided it is better to “live with covid” in order to prevent any further economic damage, Asian countries are still determined to reach “zero-covid”, if that might ever be possible, through further snap lockdowns leading to factory/transport closures.

“Just in time” inventory management has been heralded in the last decade as a saviour against the risk of manufacturers and distributors getting caught with too much inventory ahead of a demand downturn. But in 2021 it has come back to bite. Surging consumer demand has met empty shelves and long delays for resupply.

Underinvestment has also led to surging oil and gas prices. Post-GFC the WTI crude price peaked over US$100/bbl in 2012 and had fallen to US$30/bbl by 2016, thus ending the US shale explosion. By 2018 it was back at US$70/bbl but was already struggling again when covid hit, sending many marginal oil producers bankrupt.

In 2021, supply cannot keep up with post-lockdown demand. OPEC-Plus could still raise its production quotas, except that some members can’t even meet reduced quotas due to delta. Investment in new production could step up, except that the ESG investment trend has made fossil fuel companies pariahs, unable to secure either fund manager or bank funding, at a time renewable energy does not yet have the scale to provide sufficient balance.

Again, high energy prices are feeding into wholesale and consumer inflation.

And even the technology boom of the twenty-first century has come back to bite. Just about everything these days needs a computer chip. The vast bulk of the world’s chips are made in Asia.

The combination of all of the above has meant what was a unique global economic recovery has since earlier this year peaked, and slowed. Economists have reduced their 2021-22 global growth forecasts to 5-6% in 2021 and to 4-5% in 2022.

That is not, clearly, economic “stagnation”. Far from it. Inflation has nonetheless surged, but to nothing like the numbers seen in the 1970s.

So forget “stagflation”, it’s only a word anyway. The real question hanging over the global economy is just how long will the covid-driven surge in inflation last?

Yes – that other word

In FNArena’s prior Equity Strategy article published in early October (link below) I wrote:

“The great inflation debate centres not specifically on whether inflation spikes are ‘transitory’, as transitory has no definition in time, but on whether having peaked, inflation settles back to pre-pandemic levels or to a structurally higher level.

“Mathematically, monthly annual measures of inflation must ease as each month cycles away from the deflation brought about by last year’s lockdowns and towards the ensuing months of economic recovery. Hence no one is suggesting current elevated levels are here to stay.”

The issue of where inflation levels might settle back to and how long that will take is the subject of much debate, and the subject of a current dichotomy between financial market implicit forecasts and stoic central bank assumptions.

Before we delve further, we might return to the subject of “living with covid” versus “zero-covid”.

Health experts refer to covid-19 as SARS-Cov-2 in recognition of the original SARS outbreak early this century. The remarkable aspect of SARS-Cov-1 is that a vaccine was never found. The virus just faded away.

On the other hand, history records that the Spanish flu pandemic ended in 1920, but the reality is it never really ended – the world suffers from new strains of the flu every year and every year thousands die, without much making the news.

The flu is a coronavirus. Whether or not the covid coronavirus was originally man-made, health experts are leaning towards the expectation it will never go away, which supports the thinking of “living with covid” strategies. It is only one year since Moderna/Pfizer announced they had found a vaccine, and already booster shots are being rolled out.

The assumption, at this stage, is that covid vaccination will be required every year, just as flu vaccinations are offered every year.

But the world is being vaccinated, and the major economy vaccine “haves” are stepping up support for the “have-nots”, recognising that no country can truly be isolated from a pandemic.

Vaccination is the key to reducing inflation.

But zero-covid policies threaten to extend periodic lockdowns despite vaccination rates, and some Asian countries are seeing high levels of hesitancy. However, the policy tide is turning.

From this week, South Korea will begin to live with the virus despite thousands of new confirmed cases every week. In Tokyo, curfews were lifted for bars and restaurants at the end of last month, despite hundreds of new cases across the country every day. While both Japan and South Korea continue to maintain strict border controls, including quarantines for most international arrivals, from this week Thailand will welcome back tourists from 63 countries, as long as they can prove they are fully vaccinated and have tested negative.

Thailand reported 7572 new cases on November 2, and 78 deaths.

Even Jacinda Ardern is buckling, acknowledging this week New Zealand can no longer completely get rid of covid.

China, nonetheless, remains stoic.

Despite fully vaccinating more than 75% of its population, China is sticking to its stringent zero-covid strategy, including closed borders, lengthy quarantine measures for all international arrivals and local lockdowns when an outbreak occurs. This week the city of Lanzhou, population four million, was locked down after six new cases were reported.

Beijing has already announced foreign spectators will not be allowed to attend the Winter Olympics in Bejing in February.

China’s determination to eradicate the virus it gave the world will only extend supply shortage/delay and freight cost issues. But that’s not the only problem China presents for the global economy.


Last month, Chinese property developer Evergrande somehow managed to pay the interest due on two bond issuances (or at least part pay – news out of China is often vague), thus staving off liquidation.

For now.

The two payments are but drops in the bucket of Evergrande’s ongoing US$400bn debt obligations. It is unclear what Beijing’s ultimate plan for Evergrande is, but it is clear the government is intent on managing a slowdown in the Chinese economy’s biggest growth driver – property investment.

Citi is among the chorus of those dismissing the notion of global “stagflation”, but said last month “The ‘stag’ problem in China does still worry us”.

“The data is weak, and likely to get weaker when we see the full effects of the power shortages there, and Chinese authorities seem quite determined to wean the economy off its dependence on real estate investment. That could prove an additional drag on global activity in 2022.”

Power shortages have come about due to the previously surging price of thermal coal, making electricity generation uncommercial for China’s coal-fired power stations. This has shut down factories, but then Beijing’s strict emissions reduction policy has also forced factory shutdowns, and so have covid lockdowns.

The government has taken measures to ensure the thermal coal price will fall, and it has, dramatically. Of course there would be no problem if China lifted its ban on Australian thermal coal imports. As for emissions reduction, that is ongoing.

As for “weaning the economy off its dependence on real estate investment”, see Evergrande’s Risk To The Australian Economy (link below).

Slower Growth and High Inflation

Had the delta variant never emerged it would likely be safe to assume 2021 would have seen a gradual slowdown in the extraordinary and “unique” pace of global economic recovery as the impact of pent-up consumer demand during 2020 was exhausted, and the world returned to something approximating “normal”.

Normal would include no more lockdowns, reopened borders, and everyone back to work and school. It would also mean the end of covid-specific fiscal support from governments, and the winding down of monetary stimulus, even if central bank rate hikes were still not expected until everything was just as it should be.

We would still have seen high inflation readings in the first half of 2021, simply because each month would have cycled from the deflation brought about by 2020 lockdowns. But the ensuing months of rebound would see those numbers subside through 2021. By now it would be likely inflation would be back in its box.

Delta has caused the global economic recovery to slow in pace more abruptly, and inflation to remain high. The full release of pent-up consumer demand has been stymied by new lockdowns, and that demand is now meeting supply constraints.

Those constraints include not just goods but also labour. Aviva Investments  notes surveys in the US, Europe and UK all indicate that businesses are having more difficulty sourcing labour than at any time in the past thirty years. This has economists scratching their heads, given unemployment rates are still elevated.

Aviva points to two likely reasons for the job vacancy/unemployment gap. Firstly, covid-related bonus unemployment benefits and job furloughs are only just now rolling off. The final US support measures, for example, expired mid-September. Secondly, factories, offices, shops and hospitality venues are great places to catch covid, hence there is likely a level of delta fear keeping people from risking a return to the workplace.

In the former case, the gap should by now be beginning to close. In the latter case, rising vaccination levels should serve to alleviate the fear.

However, if people have left the labour market permanently, warns Aviva, then there is a potential for wage pressures — which are already relatively high for this stage of a recovery – to increase further.

This presents a dilemma for central bank policy. Central banks have two mandates: full employment (seen as around 3-5% unemployment) and price stability (seen as inflation steady at 2-3%). If full employment proves elusive and inflation remains stubbornly high, central banks will be forced to raise interest rates in order to stave off a wage-price spiral.

Rates hikes would come as the economy is slowing, when typically they come when the economy is growing. While both the Fed and RBA still see a first rate hike as at least two years away, this is not the case elsewhere.

Many emerging nations have already hiked. New Zealand has hiked – twice. The Banks of England and Canada have signalled they’re both preparing to hike. Financial markets are pricing in the first US and Australian rate hikes as early as next year.

The reason in each case is fear of “sticky” inflation. Most economists believe current inflation pressures will ease through 2022, but confidence on that front has begun to wane a little.

“We have revised up our inflation outlook for this year and next,” says Aviva, “reflecting the temporary impact of supply constraints in 2021 and early 2022 but more robust underlying inflation through the course of 2022. We judge the risks to the inflation outlook to be to the upside”.

Citi has left its global inflation forecast for 2021 at 3.2% but increased its 2022 forecast to 3.3%.

Investment house T. Rowe Price chimes in:

“Although most central banks believe inflation will prove temporary, prices could remain elevated for an extended period – perhaps too long for them to hold onto their words and not take action.”

Wilsons Asset Management believes currently high inflation will moderate “fairly significantly” over the coming year as a number of transitory pressures fade, but admits “expectations can be wrong, sometimes by a wide margin.”

“We think the ‘risk case’, at least over the coming year or so, is not so much that the world ends up in a period of stagflation but that inflation surprises the current consensus to the upside.”

So, how should an investor prepare for a period of slower, but still above-average global growth, and the risk inflation remains sticky, leading central banks to concede to raising rates sooner rather than later?


Before we answer that question, consider that throughout 2021, Wall Street investors have swung from favouring cyclicals/growth over value, to favouring value over cyclicals/growth, to favouring defensives over risk, then risk over defensives, back and forth and back and forth.

This can only reflect uncertainty. Yet still US stock markets have ground higher all year. September saw hesitation, but only momentarily. On October 2, all of the Dow Jones, S&P500, Nasdaq and Russell 2000 small cap indices closed at new record highs.

Irrespective of which side of the Growth/Value fence one should be on, market participants agree there is one single underlying force: There is no alternative. The stock market is the only place one can achieve positive real returns (positive real dividends, as opposed to negative real returns from fixed income and cash), and easy monetary policy and the promise of more fiscal stimulus provides safety nets to the risk of capital loss.

But the problem with TINA is valuation. In the US, the S&P500 has marked thirteen consecutive months in which a new high has been recorded (one in early September before the pullback), and is now 45% above the pre-pandemic high set in January 2020.

While this year’s US corporate earnings results have consistently surprised to the upside, there is little disagreement the significant driving force has been ultra-low interest rates. Even now Fed tapering is set to begin, Wall Street is still forging ahead despite the market pricing in a first rate rise as early as next year.

We could look at the first rise in two ways: (1) OMG it’s the end of Fed support; or (2) is a rate of 0.25% compared to zero really going to lead to the sky falling in?

The ongoing positives for Wall Street, suggests T. Rowe Price, are healthy consumer balance sheets and a high savings rate (noting the US economy is consumer-driven), exceptionally strong earnings growth, a likely increase in infrastructure spending (if the Democrats can ever get their act together) and an apparent peak in delta spread.

The negatives are elevated stock and bond valuations (low yields), elevated corporate and government debt levels, the beginning of the end of Fed support, covid-based fiscal support has peaked, and (again if the Democrats can get their act together) corporate taxes are likely to rise.

For Australia, T. Rowe sees positives in the labour market and sentiment indicators being more resilient than recent lockdowns might suggest, a high vaccination rate boding well for a full re-opening, and the RBA also tapering but remaining overall dovish.

The negatives are that earnings momentum is weak and likely to get weaker (December quarter results will still reflect lockdowns/restrictions), the Chinese economic slowdown will have a direct impact, those stocks that benefit from re-openings are already well-priced, consumer behaviour is cautious and valuations are not as favourable as they used to be.

(T. Rowe’s strategy report was published on September 30, when the ASX200 was -200 points below where it is now.)

Expanding on the China threat, which is not overly relevant for the US but is fundamental to Australia, T. Rowe is concerned that economic data continues to surprise to the downside and that the slowdown is structural rather than cyclical, driven by government policy in particular for the property market, environmental restrictions and a zero-covid strategy.

China’s consumer spending is still lagging the recovery and below expectation, as consumers act cautiously in the face of uncertainties. Beijing’s clampdown on the property sector and its forced power cuts threaten contagion risk.

Heading into year-end, T. Rowe Price remains “modestly underweight” equities and favours Value.

Aviva Investments remains “broadly pro-risk”, and “modestly overweight” equities, although not quite as overweight as previously due to “the growing pains economies are now experiencing”. The fund manager is “tilted” to a mix of defensive sectors (including healthcare) and cyclicals (including energy and industrials).

And just to underscore the uncertainty of where to invest in 2021, Amundi Asset Management recommends staying “neutral” on equities and “search for possible entry points at lower levels”, but be aware of risks and keep hedges amid phases of higher volatility, should growth deteriorate further and/or central bank communications be weak.

Amundi likes Value stocks with tested inflation-proof business models.

With a more local focus, Macquarie had been forecasting ongoing economic expansion into 2023, then followed by a downturn, matching each of the four economic cycles preceding covid. But now the broker foresees a downturn, or mid-cycle slowdown, in the second half of 2022, with the key risk being the Fed forced to hike into a downturn.

Volatility tends to increase in a downturn, Macquarie notes, but this does not imply only negative returns. Downturns tend to be the best period of a cycle for defensives. While Macquarie cites Fed hiking as a key risk, the broker also notes bond yields tend to fall in a downturn, which favours bond proxies such as REITs and infrastructure funds, as well as Growth stocks and gold.

Macquarie has not wavered from its stance of preferring offshore earners among Australian stocks.

“We still see Fed tapering and the risk of higher bond yields as a key near-term market driver, as higher yields would be a valuation headwind and may lead to market volatility. Based on the 2013 experience, we could see a peak in yields soon after the Fed taper starts, as yields fall in line with the cycle. We will wait for Fed tapering to start and commodity price spikes to pass before updating our portfolio to position for a possible downturn.”

The Fed has since announced it will begin tapering asset purchases by -US$15bn per month, from a current US$120bn, which implies the end of QE by July 2022.

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