As we enter 2022, Six Park’s Investment Advisory Committee (IAC) members share their thoughts on three key areas:
- Australia and its place in the world (Brian Watson AO);
- Bonds, inflation and interest rates (Mark Nicholson); and
- The view of global equities from the US (Lindsay Tanner).
Mark Nicholson joined Six Park’s Investment Advisory Committee (IAC) in January 2019, bringing exceptional experience and investment judgment. Mark has worked for some of the world’s biggest and most respected financial institutions, including the World Bank and Tudor Investment Corporation. As we enter 2022, he shares his observations on inflation, interest rates and bonds.
‘Transitory’ price pressures become more widespread
“Over the past six months, inflation has become the primary concern and focus of financial markets. In the US, the latest consumer price index reading rose 7.0% over the preceding year – the highest rate since 1982. Removing the volatile influences of food and energy, the core CPI inflation rate rose 5.5% year over year, the highest rate since 1991.
“Earlier last year, the Fed (the US central bank) and most economists believed price pressures were transitory, the result of COVID-created supply chain bottlenecks in areas such as semi-conductors and logistical issues causing substantial transport cost increases.
“Over the past six months these pressures have spread widely and measures of wage inflation have also increased significantly. Last December the Fed Chairman conceded it was time to retire the word ‘transitory’.
“Although inflation’s level, breadth and persistence are now of clear concern, the extent of interest rate hikes required to slow its course remains an open question.
“For now, the Fed believes a series of gradual rate hikes in the official short-term rate, starting with three this year and reaching just over 2% by the end of 2024, will be sufficient. Financial markets had been more sanguine but, over the past few weeks, market pricing has risen to price in a peak short rate just under 2%, close to the Fed’s view.
“It remains surprising, and the subject of much commentary, that the Fed and the markets believe a slow increase in interest rates to a level below the expected inflation rate will be sufficient.
“The US economy is rebounding strongly, with little if any spare labour capacity and emergent wage growth. A short-term rate of at least 2.5%, considered the ‘neutral’ rate by the Fed, would seem to be a more reasonable initial destination point.
Issues slower to emerge in Australia
“For all the attention given US inflation, it is as yet much less of a concern in the EU and Australia, each of which has more inertia in price and wage-setting processes.
“In Australia inflation has been slow to emerge, with the core (“trimmed”) CPI rate at 2.3% in Q3, just above the 2-3% range targeted by the Reserve Bank. It is unsurprising our price pressures trail the US, given our extended lockdowns relative to the rest of the world.
“Even as the economy accelerates over the next couple of quarters, prices may be slower to rise given the lags in our wage determination system. Ultimately, however, the US inflation experience is likely to flow through to Australia.
“Longer-term structural factors such as the declining size of the global labour force, western government tolerance of much higher deficit spending, constraints on investment in oil and gas production, higher trade barriers and the west’s de-linkage with China, are all influences for higher inflation relative to the past 20 years. The risk for investors is that inflation becomes entrenched.
Bonds likely to play a stabilising role
“It may well be, as financial markets imply, that consumer, corporate and government debt have risen globally to such high levels that modest rate hikes will succeed in quickly slowing growth and inflation. But, if not, central banks will quickly readjust plans for higher rates.
“Added pressure for higher rates will also come from low political tolerance for inflation, as seen in current US polling showing rising prices to be deeply unpopular.
“Unexpectedly higher rates would negatively affect all financial assets. Bond returns would not be immune, as longer-term, fixed rate bond prices will fall as yields rise. However, bonds should offer relative stability.
“Investors across the spectrum are under-invested in bonds and will be eager to switch out of cash or mid-risk assets back into bonds as soon as yields (on government bonds) rise to levels close to expectations for long-term inflation.
“Growth assets, particularly high growth but as yet unprofitable companies, are likely to fare much worse, and indeed there are many examples of these where prices have already fallen 30-50%.
“The next six months will reveal much about the nature of the current inflation upswing and whether the markets have correctly assessed it as not overly threatening to investment returns.”
Learn more about Mark Nicholson, his professional experience and his personal interests in this video interview with Six Park’s Ha-Dieu Ford.