29 Jun 2021
Market and Economic Update - June 2021
Written by Chris Lioutas
Inflation / Deflation
In a world of uncertainty it does feel strange to be talking about the prospects for higher inflation given central banks have failed in their efforts to generate inflation anywhere near their targets over many decades. The lack of inflation has been a function of a very strong combination of too much debt, poor and declining demographics, and the rapid pace of technological advancement (ie. technology being a substitute and/or replacement for labour).
That has not gone away. If anything, the structural tailwind for each of these 3 areas is now even stronger – that is, we have significantly more debt than we did pre-Covid, demographics will continue to worsen as health concerns and economic hardship impacts fertility rates, and we have seen a rapid acceleration in technological advancement since Covid begun which has likely brought forward at least 5 years of progress, possibly more.
Over the last couple of months, we have seen higher inflation in many countries around the world, which was always going to be the case given we generally get demand and supply imbalances in a recovery, especially in a recovery where the movement of goods, services, and labour are in some cases severely restricted by government virus polices.
Usually, these are temporary issues which are solved by demand and supply imbalances correcting as supply either catches up and/or demand starts to wane as the recovery is complete. However, this time around we have inflationary concerns that are more heightened than they would normally be because of large levels of government fiscal stimulus, which is still being provided under emergency measures. We are seeing this right now in the USA where inflation is running at an annualised pace well above 5% !
Whilst we do not believe these levels of inflation can be maintained, given demand will settle down once the levels of government stimulus return to normal levels, (which the election cycle should assist) and supply will increase once virus restrictions are removed, we do have to deal with a degree of uncertainty around the length of time these conditions may last for and the market’s reaction to such conditions which can be fairly extreme and violent as seen in the February/March bond market sell-off.
Whilst central banks have done their best to douse any medium and long-term inflationary concerns, the longer they keep printing, the more volatility we are likely to see in asset markets.
Central bank policy
Whilst the short-term issues in financial markets centre around inflation caused by government fiscal policy and virus policy-induced supply constraints, central bank policy is the key as it pertains to market support levels and continued asset price growth. Central banks will at some stage need to get us off the zero percent rates and will also need to slow the growth in their balance sheet expansions (i.e. money printing).
They have vowed to be very slow and very measured, thus allowing for higher interim inflation, learning from their mistakes since the GFC where every time they tried to normalise rates and their balance sheet, it sent investors into panic-induced market sell-off. This then resulted in central banks having to retrace their steps back to very easy policy settings, using more even more stimulus, thus making it a very circular exercise and putting them further behind the inflation 8-ball each and every single time.
We think the recent sharp increases in inflation are likely to be transitory in that for inflation to be sustainably at or above central bank inflation targets we need to see persistently and considerably higher wages growth (unlikely given technology) and/or velocity of money (i.e. the pace at which money moves around the economy), both of which are very low right now.
However, we do have to account for the fact that higher short-term inflation can and will test a central banker’s nerves, and the market itself (particularly the bond market) can and will test the courage of central bankers through the buying and selling of government bonds and currencies. This may create some short-term volatility which we would see as a buying opportunity.
Geopolitics
There are always geopolitical risks present and there are always ways of connecting these risks even when they seem totally disparate from each other. Whilst there is plenty to go on right now, we are focused on US-China, Australia-China, the Middle-East, and the European Union (versus elections in German and France).
The Australia-China conflict is obviously closest to home and the most problematic in that they are our biggest trading partner with no easy solution to the problem (we trust that they will strike a balance).
Overview
We remain favourable on the forward period in relation to the economic recovery, the market environment, and geopolitical tensions, but we remain concerned given the events of the last 12-15 months.
At this stage, there is nothing we are advertently avoiding, but we do currently favour less government bond exposure, a preference for unhedged global equities over Aussie equities, and a healthy allocation to property & infrastructure (with preference for the latter).
We favour active over passive investment management right now, while too much concentration will likely prove to be dangerous in the period ahead, hence sensible and impactful diversification is key.
If you’d like to discuss any of the points raised, please do not hesitate to contact PSK Financial Services on 9324 8888.
This information is provided by AMP Life Limited ABN 84 079 300 379 (AMP Life).
PSK Financial Services Group Pty Ltd (ABN 24 134 987 205) are Authorised Representatives of Charter Financial Planning Ltd (AFSL 234666), Australian Financial services Licensee and Australian Credit Licensee. Information contained in this article is general in nature. It does not take into account your objectives, needs or financial situation. You need to consider your financial situation before making any decisions based on this information.
