Welcome to our Summer edition of On the Marc. In this edition, we will review markets for the final quarter of 2021 and consider the outlook for the new year.

Market update 

2021 has been a very positive year for markets both in Australia and offshore, with the ASX 200 returning 17.2% over the year (well above the ~30-year average return of ~11%) and the S&P500 and Dow Jones returning 29% and 21%, respectively, both ending close to all-time highs. Over the last decade, the continued decline in interest rates and the significant easing in fiscal and monetary policy have supported a bull market that has ‘front-loaded’ returns and catapulted gains in growth stocks, bonds and property. This has also resulted in a ‘melt-up’ in equity indices, which has supported passive/index investment performance.

We believe these market tailwinds peaked in 2021 with interest rates now near zero in most developed economies and extreme fiscal and monetary stimulus starting to moderate.

Inflation

The chart below outlines the consensus estimate for U.S. CPI in Q4 2021 and illustrates how forecasts rose from ~2.5% in March/April 2021 to ~6.5% by calendar year-end as the market adjusted its view that the inflation spike was likely to be far bigger than expected. At the end of November 2021, U.S. Federal Reserve (‘Fed’) Chair, Jerome Powell retired the use of the word ‘transitory’ to describe the inflation outlook and acknowledged that the ‘risk of higher inflation has increased’.

The Fed pivoted to a much more hawkish tone over the quarter, with a tapering of its bond-buying program announced in November and a further acceleration in December in response to an exceptionally tight labour market and higher inflation risks.

As we enter a central bank tightening cycle that may see the first U.S. rate hike in March and potentially three or four rate hikes across 2022, we continue to believe that short duration (value/cyclical) stocks remain better placed than long duration (growth/defensive) stocks given that backdrop. Furthermore, many of the fund managers continue to have an allocation to positions in energy, gold and commodities which have tended to outperform in a higher inflation environment. These sectors remain under-owned and are still trading ‘cheap’ versus the broader market.

Vaccine recovery

From a vaccine perspective, despite the emergence of the Delta and Omicron variants over the year, we have confidence that the reopening story remains on track and is not fully factored into market expectations. With the recent emergence of the Omicron variant, research indicates that while the Omicron variant is more contagious, it is much less likely to cause severe illness or death.

Existing vaccines have also been shown to provide strong protection from severe illness with booster doses further enhancing protection. An additional factor that is a ‘game-changer’ in the fight against COVID-19 is the encouraging data from antiviral treatments such as Paxlovid from Pfizer. Paxlovid has been shown to deliver an 88% reduction in COVID-19 related hospitalisation or death in trials of unvaccinated COVID-19 patients when taken within five days of the first symptoms of illness. The treatment should remain effective against the Omicron variant and received FDA approval in late December with Pfizer planning to produce 120 million courses by year end.

Merger & Acquisition Activity

The 2021 calendar year saw major M&A cycle not seen since 2007. Our anecdotal feedback from conversations with investment bankers, private equity investors and M&A lawyers strongly supported this view with consistent feedback of deal pipelines being at record levels. As illustrated in the chart below, 2021 turned out to be a banner year for Australian M&A and exceeded even our bullish expectations with $450b worth of deals announced over the year, compared with a 10-year average of $206b. Example of takeover offers (or merger proposals) include Z Energy, Oil Search and Link.

We expect this robust environment to continue in 2022 with market feedback continuing to indicate a very robust environment for deal making supported by improved corporate confidence, cheap debt and equity funding, and a supportive economic backdrop.

Market returns for major indices

Below is a table showing the percentage returns of the major market indices to 31st December 2021.

The outlook for the year ahead 

Omicron looks set to dent growth and after a bounce, slower and more ‘normal’ quarter-on-quarter rates of growth look likely over the rest of 2022. Fiscal policy is already less supportive, monetary policy is on a tightening path and households are seeing a hit to real income growth given still high rates of inflation. Healthy aggregate household and firm balance sheets will help though, and significant vaccination coverage in developed economies should help keep economies on a smoother (and less inflationary) track as the year goes on.

Inflation is expected to fall in 2022, but strong short-term inflationary pressure looks set to persist well into 2022 as supply chain problems and labour market shortages linger. Investing in a range of companies from different sectors and stages of their lifecycle has never been more appropriate and will allow performance to continue to be driven more by the success of their hunting for undervalued long term cash flows than by the prevailing winds of the macroeconomy, or factors such as growth or value styles being in vogue.

As vaccination programmes continue to roll out and economic conditions normalise there are opportunities for the underlying stability of many of the businesses to be better reflected in valuations. The crisis will result in strong companies (high returns, strong balance sheets and good ‘moats’) getting stronger as they are better able to take advantage of opportunities, whether through new areas of demand or having better balance sheets to navigate through lower levels of cash generation as quantitative easing programs begin to unwind.

Did you know?

Financial market expectations for future interest rates have gone up significantly in the last quarter. In October 2021 it was possible to fix a home loan for three years at 1.98%. With that same lender, the three year fixed rate today is 2.84%!

The following chart shows the outlook for Australian interest rates for the next fifteen years. It compares the expectation from March 2020 (blue line) with current pricing (orange line). To give you an idea of how this is likely to impact your home mortgage interest rate add two percent to the figures in the orange line. E.g. In four years from now, the variable home loan rate is likely to be ~3.50%.

Final reMarc

While our outlook for markets remains constructive in the near term, we expect index returns to moderate over the next few years as we enter a central bank tightening cycle. Accordingly, we think bottom-up stock picking will become an even more important driver of returns going forward making active management attractive. Continuing to invest in sustainable businesses where company revenue and profits are expected to increase over time with little to no debt continues to be the cornerstone of the fund managers, we invest in.

“It’s fine to celebrate success but it is more important to heed the lessons of failure.”

Bill Gates

Key Facts & Figures

1. Australian Cash Rate remains at the record low of 0.10%.

2. The RBA Cash Rate is poised to remain at present levels until 2023 however money markets are pricing in an earlier rate rise.

3. Our annualised inflation rate is 3.0%. This is at the upper end of the RBA’s target band of 2 - 3%.

4. Australia’s unemployment rate is 4.2%.

5. The Federal Reserve cash rate is at the record low range between 0% and 0.25% in the US. There is expected to be three to four rates rises in 2022.