As outlined in previous newsletters, we have entered a new economic world of increasing interest rates with asset prices adjusting accordingly. The US Federal Reserve raised their target Fed Funds Rate (akin to the Australian Cash rate) by 0.75%, and with US inflation over 8% interest rates must go higher. Similarly, the Reserve Bank of Australia (RBA) has flagged its intention of increasing interest rates as inflation is predicted to reach 7.1% by Christmas 2022. The bottom line is that real returns remain negative and will continue to be so until interest rates are higher than the inflation rate.

Limitations of Central Bank Activities – Impact on demand not supply

Central Banks including the RBA can directly impact demand for goods and services through monetary policy, e.g., increasing interest rates. An increase in interest rates has an immediate impact on household budgets, as there is less disposable income available for discretionary spending, thereby affecting demand. Conversely, central banks have no ability to directly impact the supply of goods and services, although if demand falls then companies will reduce supply.

Tightening Liquidity

Prior to 2007/8 the short term global interbank debt market operated on trust, i.e., that a “known” counterparty was “good” to borrow unsecured money overnight, as the funds would be returned the next day. With the collapse of Lehman Brothers this trust disappeared and now the short term interbank debt market requires collateral (primarily US treasuries) to transact. We mention this because there is a global shortage of collateral that is causing tighter liquidity positions which is flowing through to all markets.

Stagflation leads to Recession

In addition, to the slow down in discretionary spending, the Ukraine/Russian war is causing a dislocation of supply chains particularly in the energy and food sectors. This is exacerbated with China continuing with its Covid lock downs that are disrupting supply lines out of Shanghai. Time will tell whether the Chinese regime will have a change in heart with its zero tolerance policy to Covid. The result of the above is greater mortgage payments along with higher petrol, gas and electricity, food and consumer good prices which are all placing pressure on family budgets.

Companies globally are saying there are staff shortages. Recently, I saw that the CEO of Sydney Airports on television say there was 5,000 vacancies at the airport and supporting services after 15,000 staff had been laid off because of Covid. This surprises me because Job Keeper was meant to ensure staff were not laid off because of the Government shutdowns. Where did the money go?

For over 2 years we have predicted that the world would move into a period of stagflation (high levels of debt and low economic growth). We are here, and it is likely the US with USD 30 trillion of national debt will fall into a recession as all the Covid assistance packages have ended, interest rates are on the way up and US property prices are falling. Mass layoffs have started in the US mortgage and technology industries which will flow through into other sectors. If the US falters, so will the rest of the world when the factors above are combined into the global economic outlook.

Equity Markets

Since 1 January 2022, the S&P 500 index is down around 25%. When will it end you may ask? We will only know 6-12 months after the bottom is reached. That’s why at sometime soon (1-9 months) it will be time to be fearless while others are fearful. Markets tend to over-shoot on both the up and down side. This we need to watch.

Crypto-currencies

The crypto-currency market is being smashed. The total market value of all coins has fallen from USD3 trillion to under USD1 trillion. Falls of this magnitude mean that many folks across the globe have suffered significant losses. These investors mainly younger people will need time to absorb their losses before they recover financially, particularly if they borrowed (leveraged). The loss of wealth has a significant impact on people’s psychology, i.e., negative wealth effect, and it takes time for folks to feel confident again. They generally need to feel financially secure and perceive the economy is in good shape before they take risks again.

Global Debt Markets

Based on the above global debt market yield curves are starting to indicate that the US Federal Reserve may limit the interest rate increases proposed for later this calendar year. We will watch this space closely because it could trigger a surge in equity markets. It is important to remember that equity markets tend to trade on future company earnings, i.e., they look 12 months forward, not at the current economic environment.

Diversification and Paying Down Debt

Sound diversification continues to be the strategy. We see opportunities arising in mining, agriculture and energy in the shorter term. In the medium term, financial services and residential property (after the shakeout that will take at least 12months) will arise. Paying down non-tax-deductible debt continues to be a sound tax effective strategy, so is holding cash.

As usual if you have any questions, please feel free to reach out to the team.