MEDIA RELEASE: Markets are facing significant uncertainty as a number of macro-economic themes collide, and investors should be prepared to take steps to actively manage rising volatility and the likelihood of lower returns from equities, said Hamish Tadgell, portfolio manager at SG Hiscock & Company.
“Even before the escalation of events in Ukraine, there had already been an increase in volatility as markets grappled with the tug of war between rising inflation concerns, monetary tightening, and post COVID economic recovery,” Mr Tadgell said.
“The recent reporting season by Australian companies was, by and large, good from an earnings perspective. Cost inflation, supply chain disruption and labour shortages were issues universally cited by almost all management during reporting season. The burning question is: how much is event-driven and COVID related, and will therefore recede, versus structural?
“The other question for companies is: will they continue to be able to pass on rising cost pressures to consumers.? If inflation proves more persistent, and particularly food and energy prices remain higher, it could start to change consumer behaviour and weigh on economic growth.”
Mr Tadgell said whilst supply chain disruptions now seem to have peaked, they remain at elevated levels historically and will take some time to normalise – if indeed they do ever normalise completely.
“Looking back over history, rising inflation episodes have generally coincided with unexpected supply shocks. The COVID-19 pandemic has arguably resulted in the biggest supply shock in history with the effective lockdown of all economies.
“There is also growing evidence of structural changes driving inflation, including decarbonisation, rising popularist politics, greater government intervention and growing protectionism and geopolitical realignment. These are all inflationary and point to us entering a new higher inflation regime.
“Investors need to be aware higher inflation and interest rates will have an impact on asset prices and returns from equities will likely be lower going forward.
“The US Federal Reserve has confirmed it will increase interest rates this month which will lead to higher real yields and create further issues for equity valuations – which, in some major equity markets, have already fallen 20 per cent from their peak in August last year,” he said
Mr Tadgell said this has seen strong relative outperformance of more cyclical and value stocks leveraged to higher inflation and underperformance in growth. This has been most evident in the technology sector.
“The technology sector benefitted massively in the early stages of COVID when everyone was working from home but since then, with interest rate expectations rising, technology and particularly unprofitable technology companies have seen massive underperformance.
“The US unprofitable tech sector has fallen 50 per cent in the last year and the Australian tech sector is down 30 per cent on a rolling 12-month basis. So there has already been a massive correction in certain parts of the market – the question commentators are asking is, will this spread further? And will a rate shock cause a growth shock or a mid-cycle slowdown?
“Higher inflation concerns support calls for higher rates. However, if it results in lower economic growth it could also see the recent sharp rise in interest rate expectations revised down, and central banks delay or reduce the number of hikes as they seek to cushion their respective economies.
“The Ukrainian conflict, and sharp rise in commodity prices, also raises the question whether we are currently seeing peak inflation, and potential for the inflation narrative to take a breather.
“Any near-term fade in inflation expectations would likely be positive for growth stocks given their sharp sell-off, whilst reopening will continue to provide tailwinds for cyclicals such as travel and energy stocks. Both scenarios are plausible, and support the argument for maintaining a diversified portfolio and need to actively manage risks,” Mr Tadgell said.
