Crystal Wealth Newsroom
Tapering plans indicate recovery continues on track
Over recent weeks we’ve seen some concrete movements by both the Reserve Bank of Australia and the Federal Reserve in the US around tapering – the slowing of monetary policy – which is the precursor to raising interest rates. How long that tapering lasts is not locked in. The Fed said the tapering would take us to June next year – they might quicken it up or slow it down depending on the response – however it essentially tells us that Central Banks believe the economy continues to move into a recovery phase.
Of course, this creates speculation around interest rates. The RBA had said it wouldn’t raise rates until 2024, and now that’s back to 2023. This creates further speculation about a rise in November next year or even in mid-2022, when the tapering might end.
As a result, the whole yield curve has lifted and steepened, and the market has interpreted this as a sign that things will improve to a point where rates can begin to go up.
The question, of course, is just how much they do go up.
How this plays out depends on many factors – including the repurposing of supply chains, purchasing trends and employment participation rates – all impacted by the disruptive demand shock caused by Covid (i.e. with the focus on consumer goods, not services).
If the market can maintain the current recovery, in theory, it should support a higher interest rate structure, which will affect all asset classes, as asset prices take their lead from the risk-free discount rate used in valuation assumptions (typically the 10-year US Treasury bond yield). So the positive here would be continued economic growth in support of higher rates.
Importantly, the expectation of interest rate rises doesn’t automatically mean interest rates will increase significantly, and it certainly doesn’t mean it’s a linear movement. We could easily overshoot on the way up, and then rates have to come back a bit. There might be another Covid flare-up or market shock that quickly causes the recovery plans to be parked. This has happened before and is one tail risk scenario to manage in portfolios.
We can gain some insight from the 10, 20 and 30-year bond rates, which aren’t racing away at this time. The 30-year rate is still in its mid-twos – although a year ago it was around 1.8 per cent p.a. In percentage terms, that’s a significant move for that asset, but in absolute terms, mid-twos is still low as far as the term rate structure goes. It suggests in the longer term, the market expects rate rises to weigh on economic activity and subdue any short-term inflation impulses currently at play.
On balance, the overall economic data supports the view that we’re not at any recessionary moment – rather more likely moving into mid-stages in the recovery cycle – but we’ve come off a strong rebound from the lows. Hence, it’s unrealistic to expect the strength of the rebound to be maintained at the same growth rates.
GDP growth rates are expected to slow, which is already happening in some economies, but growth is still reasonable. In fact, if the growth rate didn’t slow, we’d likely see much stronger inflation and faster hikes in the cash rate. As major government policy stimulus begins to wane, the focus will be on underlying earnings growth to continue to support current prices.
If all goes according to the current brief, the inflationary impact is expected to ease over the coming year, but we are facing a regime with higher interest rates than we’ve had in recent years. This will be an important difference.
From an investment perspective, the question of where to put the next marginal dollar to work remains one that gathers much discussion. However, the answer is a lot more nuanced than it may have been previously. The introduction of the vaccine helped get markets going last year, and this has continued in 2021, with generally high positive correlations across most sectors. With the obvious exception of the services sector during lockdowns, the broader economy kept going supported by fiscal and monetary policy and fostering strong demand for goods (and online commerce). Bottom line, now you’re facing higher valuations across all sectors: property, fixed income and equities looking for that next dollar of earnings.
If your strategy was built around low interest rates supporting higher market valuations, and you weren’t so concerned about the underlying investment mix, then a rethink is needed as the fundamentals shift.
We’re already seeing a more discerning environment, and we are already seeing more volatility under the surface. It won’t take much in the way of policy announcements to drive valuations up and down, particularly the latter, nor see price volatility around the next great idea (think ESG, crypto just for starters). Markets will most likely overreact, particularly where companies don’t meet lofty expectations, and hence caution here is warranted. We expect higher individual volatility within portfolios and previous correlations to shift – meaning different parts of the portfolio will perform at different times now, not all in unison.
In terms of strategy, it’s imperative to start with a healthy acknowledgement of the changing environment, and that future longer-term return expectations are more moderate now than they have been previously. This helps resist the urge to chase returns that come with ever-higher inbuilt risk levels.
It’s also a good time to re-evaluate the investment mix on the back of strong returns. For example, residential property prices have increased around the country over the last year – with headline rises of 10, 15, 20 per cent rises or more in some cases. Further, you can find individual stocks and other assets without looking too hard that have matched, if not exceeded, these types of returns as well during this time (e.g. companies within resources, financials, healthcare and technology sectors).
The question, of course, is, would you invest all of your money in any one of those investments, or would you consider it simply too risky? (Noting that the amount of leverage inherent in most property assets – where debt is involved – makes them quite sensitive to interest rates) both up and down. It means a healthy balance within portfolios is important – being prepared to take profits and look for ‘fair value’ top-ups within your target allocations as the facts dictate.
Markets have repriced heavily on the back of stimulus and the maintenance of low interest rates – a market environment that shows signs of shifting with all the uncertainty you would expect. The key unknown is just how far and how fast.