Charles Jamieson, Chief Investment Officer

Originally featured in The Australian, published 4 July 2022.

As the second quarter ends, investors are licking their wounds from negative asset returns as policy withdrawal corrodes asset values around the world.

Investor sentiment has swung wildly throughout the year but now seems firmly entrenched in Kubler-Ross’s famed five stages of grief – denial, anger, bargaining, depression and acceptance.

Make no mistake, things do not look good in the near term for economies as central banks raise rates the world over, lifting interest servicing costs and reducing discretionary spending. Bond markets have already priced in the most substantial and violent rate hiking cycle in generations – far beyond the 2.5 per cent US Federal Reserve rate hiking cycle peak of 2018 that crashed the corporate credit markets (and ultimately the equity market). As investors are entering the bargaining phase of grief, perhaps there is some glimmer of hope emerging, as inflation data and the inventory cycle (the bullwhip effect) can help ease the pathways into 2023.

It is very likely there will be some depression as the markets continue to adjust (illiquid assets need to play rapid catch-up to listed assets) and finally an acceptance that our new geopolitical world order requires a vast recalibration of energy and labour markets that will have far-reaching effects, add risk premia to asset classes in higher volatilities and crimp the lofty growth valuations seen in the last cycle.

Government bonds led asset underperformance, correctly signalling tougher times ahead for the economy as reopening inflation was turbocharged by the Russia-Ukraine conflict and further China lockdowns.

Early in the year, many investors seemed in ‘‘denial’’ that markets could fall abruptly, despite the early warning signs from the bond market that funding interest rates would be moving significantly higher, tightening the economy at significant pace despite the economy opening the year in great health.

No doubt significant ‘‘anger’’ has been experienced as many risk assets followed the lead of bonds over the second quarter, playing catch-up and slingshot in a spectacular fashion (the US Nasdaq is now down 29 per cent).

The cult of crypto has been forced to stare into the abyss and contemplate life without self-reinforcing feedback loops, amid nasty infighting among the tribal communities. Australian equities have thankfully been well insulated from larger global declines to date, thanks to heavy commodity exposures which have outperformed significantly so far in a supply constrained world. This requires some investor consideration should growth fall substantially, as commodities can flip from leader to laggard very quickly despite supply constraints – in the Global Financial Crisis of 2008, oil fell from $140 a barrel to $44 in a matter of months.

Are we somewhere around the ‘‘bargaining’’ phase currently – looking for pathways that can deliver a soft economic landing? There are certainly signs that goods inflation has significantly abated in the US – major retailers such and Walmart and Target have reported a surge in inventory accumulation and expect consequential goods discounting as a result. Supply lines are healing, and freight costs have fallen – this is known as the ‘‘bullwhip’’ effect, where inventory can flip from deficit to surplus almost instantaneously.

Many businesses perhaps over-order inventory, knowing their order may be scaled back, but as supply lines heal one day the entire order arrives and they find themselves overstocked, leading to poor inventory turnaround times. This may also be the result of changing consumer demand, but either way discounting occurs and inflation pressures ease as a result until the excess inventory is cleared to restore equilibrium.

This should help inflation begin to moderate, along with a more stable energy complex (oil peaked at $US130 after the outbreak of the Russia-Ukraine conflict; now $US106).

However, services inflation is still expected to rise in the near term, leading to an ongoing, volatile series of outcomes in the inflation data. We expect that inflation will moderate over the balance of the year which will help central bankers find a change of narrative towards a ‘‘pause’’ of policy from the highly restrictive settings they are currently embarking upon.

Sadly, while this improvement in inflation will help lift the angle of decay, we still have some difficult times to navigate as interest rates rise over the balance of the year, as expected by the bond market which has fully priced these expected outcomes. And so the ‘‘depression’’ phase may remain ahead as a ‘‘pause’’ of policy may help alleviate the declines, they will not bring back the financial asset lunacy of 2021 (anyone for a digital ape drawing for a few hundred thousand?). Assets are finding new valuation ranges for a post-Covid geopolitical world.

This is probably a world where inflation can oscillate from inflationary (supply disruptions from war) to disinflationary (capitalism solves the problem) as secular forces clash and government policy stimulates or destroys demand, chasing inflation mandates.

Investors must finally find ‘‘acceptance’’ that the pandemic uprooted a rule-based system, led to the great resignation, accelerated working from home – essentially it threw the economic and social jigsaw puzzle into the air and pieces have landed all over the place. Incredible government policy saved economies from their stark realities at that time, but the entropy of that volatility has returned and will leave us with a more unstable world.

Part of that acceptance will be to realise that asset allocation is paramount for investors, who will be reminded that some equity is worthless, some dividend policies are best endeavours only, some credit will default, and many boring and and conservative assets play a critical role. In combination, strong and diverse asset allocation will generate good outcomes through the uncertainty we continue to face.

Contractually and legally binding bond coupons from highly rated governments are close to certain for income investors (unless you think the governments will not exist in time to repay you).

They might find growing acceptance in a world where the only certainties are death and taxes.

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