A UNIQUE collision of global challenges is clouding the outlook for equities in the near term, but Australia remains well-positioned to outperform, says Pendal’s head of equities Crispin Murray.
Four major challenges are hitting markets simultaneously, says Murray: the crisis triggered by Russia’s invasion of Ukraine, impending interest rate rises, the pandemic and the re-emergence of inflationary pressures (though Australia doesn’t face the same inflation challenges as other parts of the world).
“It’s not a great short-term message — we think markets are going to continue to struggle,” says Murray, speaking to investment professionals this week in his bi-annual Beyond the Numbers webinar.
“There are however, two silver linings,” he says.
“The first one is that Australia is perhaps the most defensive market in the environment we’re in.
“And the second one is that when you see this sort of drawdown in financial markets, there tends to be an indiscriminate nature to those sell offs and they often lay the foundations for some of the best investment opportunities that we will be able to take advantage of over the next few years.”
Russia’s unprovoked invasion of Ukraine has first and foremost led to a terrible humanitarian disaster.
But it has also exposed the West’s reliance on Russia’s commodity exports and demonstrated that while Russia may be a mid-sized economy, it plays an outsized role in the global economy due to its commodity exports, says Murray.
Europe’s oil and gas purchases from Russia are in the order of 1 billion euros a day.
But government sanctions over the invasion are only part of the story of the global economy’s reaction.
Instead, widespread self-sanctioning is seeing companies avoiding trading with their Russian counterparts for fear of being seen to support the invasion.
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“What the Western governments were thinking would be minimal disruptions to these key commodities is turning into major disruptions,” says Murray. Estimates are that half of Russia’s 5 million barrels a day of oil exports is failing to find its way to market.
The result is a commodity price melt-up — prices are soaring.
This leads to the second big pressure point for markets in inflation.
Recent spikes in inflation have been driven by short term issues like COVID-related supply chain disruption, a tightening labour supply driving real wages higher and commodity capacity constraints, says Murray.
But now longer-term issues are taking over as the core inflation drivers, including rebuilding supply chains, declining working age populations, the investment required to build a clean energy economy and China’s shift away from exports to a domestic self-sustaining economy.
“The challenge we’ve see over the last few months is that a lot of these inflationary pressures are becoming self-reinforcing,” says Murray.
“History will look back and judge policy decisions in 2021 as some of the worst that we’ve seen in many decades.
“The reason is that we had a supply shock brought about by the pandemic and the policy response was to continue to stimulate demand and that’s led to this inevitable inflationary pressure.”
Murray says it’s important to remember that inflation can choke itself off: “Prices of goods go up high enough, chokes off demand, people don’t have the spending power, economy slows and inflation goes away.”
But inflation can become sustained if it is underpinned by rising wages.
“We’re at effectively full employment in the US, and that’s leading to higher wages.”
The question of how far interest rates will need to rise to combat inflation is key to the outlook for markets.
Murray says there are two schools of thought for how rates will play out.
One school believes rates will not need to be lifted as much as the market fears, due to deflationary forces and excess debt.
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That would lead to markets briefly correcting before rotating back quickly to long duration growth stocks, he says.
The second school of thought is that rates will need to rise and stay higher for a sustained period of time, similar to the period pre-GFC when the economy ran strong for years before slowing.
“If that is the model we’re looking at, then interest rates will have to go up materially more perhaps than the markets are thinking,” says Murray.
“This is the key debate from a macro point of view that we need to track,” he says.
Ironically, in the past, policymakers would likely respond to a geopolitical crisis by easing monetary policy, but that is highly unlikely this time.
“So, this is why near term we’ve got this irreconcilable conflict between these conflicting goals for policymakers.”
So, where does Australia fit in all this?
Surprisingly well, says Murray.
“Australia is as good a place as you’re going to be in this tough environment,” he says.
Partly this is because of the old-world make-up of the Australian stock market, dominated by finance, mining and energy companies.
But also, Australian companies are performing quite well.
Murray says Australian equity markets are declining despite improved earnings as a de-rating of prices due to higher interest rates and rising risk aversion is outweighing a good underlying earnings performance.
“So, what we’re seeing in markets so far is a reduction in the valuations rather than any earnings effect — if that remains the case, that would suggest that this is a correction within a longer term bull market, rather than the beginnings of a bear market.”
Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.
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