AFR: Why equities could fall sharply ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌ ‌

No images? Click here   AFR: Why equities could fall sharply With the Fed behind the inflation curve, expect 6-7 interest rate hikes this year and a torrid time for stocks… Christopher Joye, portfolio manager, Coolabah Capital Investments In the AFR I write that for the first time in a long time, we agree with Jeremy Grantham: equities likely need to correct quite significantly. Here are some simple mental models. The cyclically-adjusted Shiller price-earnings (p/e) ratio is currently sitting at 37 times compared to its long-run mean of 17 times and median of 16 times. The only time in the last 150 years it has been higher was just prior to the 50 per cent drop in US equities during the “tech wreck”, which resulted in the Shiller p/e falling from 44 to 21 times.   If we suppose that it is reasonable for US shares to normalise back to their pre-pandemic peak on the basis that investors incorrectly extrapolated ultra-low inflation and 10 year bond yields in perpetuity, stocks would need to adjust downwards by 28 per cent from current levels.   If we consider a more serious downside scenario whereby equities mean-revert to their December 2018 level, which is when the Fed last had its cash rate at a “neutral” level of 2.5 per cent, shares would have to drop 48 per cent. There are many shortcomings with this analysis. One of the biggest is that this time is different to the recent past in so many ways. Unfortunately, that point of difference implies even greater downside risk.  When was the last time you can remember a US President egging on the Fed to crush inflation and raise interest rates? When do you last recall inflation being a major US political issue? The post-GFC period has been defined by politicians trying to strong-arm central banks into easier, not tighter, policy settings.  Of course, President Xi is begging the Fed not to hike interest rates given his currency is pegged to the US dollar. Furthermore, China is, like the US, home to hordes of “zombie” companies. In the US, zombies represent roughly 15-20 per cent of all listed firms. These are entities that do not have enough money to service the interest repayments on their debt using their existing earnings. Heaven help them if rates rise sharply, as they are now doing. In China, the state has been the primary backer of many of these entities, which can only survive with access to this artificially cheap public sector funding.  Since we started warning about the spectre of a savage fall in global equities (and correlated crypto) on 23 December, the S&P500 has corrected 5.1 per cent. The tech-focussed Nasdaq index has slumped 10 per cent. And Bitcoin has dropped 19 per cent.  The key driver has been rates. Since 23 December, the US 10-year government bond yield has jumped from 1.49 per cent to as high as 1.90 per cent. In Australia, 10-year government bond yields have leapt from 1.65 per cent to over 2.0 per cent.  The catalyst for the move has been a raft of data confirming the US likely has a persistent, rather than transitory, inflation problem. Core inflation is running at 4.7 per cent, miles above the Fed’s 2 per cent target. This might be okay if it was all explained by temporary supply-side factors.  But US wages growth is also expanding at a very high 4.7 per cent annual rate, which is feeding into a nascent wage/price spiral. This is being powered by an exceptionally tight US labour market where the jobless rate is just 3.9 per cent, in line with the Fed’s estimate of full employment.  To make matters worse, inflation expectations are decoupling from the Fed’s 2 per cent target, with US households now forecasting inflation of 6 per cent in the next 12 months and 4 per cent over the following 3 years.  Turning back to the supply-side, many of the cost-push pressures could be somewhat persistent. Reshoring of supply-chains away from China is likely to be an inflationary process for years to come. Starving fossil fuel industries of cheap money means they underinvest in capacity, which makes it harder for supply to sate rising demand. The greenification of energy industries could also become a prolonged inflationary pulse.  We have not seen this combination of high core inflation, strong wages growth, super low unemployment, and soaring consumer inflation expectations in decades. The concern is this is becoming secular: similar conditions are evident in many developed economies. And Australia may be heading down a comparable, if not identical, road.  This week the official statistician reported that Australia’s unemployment rate declined to just 4.2 per cent. In November my colleague Kieran Davies presented analysis showing that “underlying inflation in Australia would have been around the mid-point of the Reserve Bank of Australia’s target 2-3 per cent band had it not been for the government’s housing subsidies”.  “Constructing a version of the trimmed mean CPI that uses home prices excluding subsidies and reweighting the CPI basket accordingly, annual underlying inflation was 1.3 per cent in the fourth quarter of 2020, increasing to 1.8 per cent in the second quarter of 2021 and to 2.6 per cent in the third quarter,” Davies says. “This is much higher than the published—including subsidies—series, which showed annual inflation of 1.1 per cent, 1.6 per cent and 2.1 per cent, respectively.”  Assuming core inflation does push-into the mid-point of the RBA’s target band in January, and the wages data in February similarly portends a normalising trend, Australia’s very dovish central bank could be on track for its first cash rate increase in the second half of this year.  Martin Place will, however, want emphatic empirical poof that it is converging on what we call the “magic triumvirate”: 3-point-something per cent unemployment; 3 per cent plus wages growth; and sustainable underlying inflation heading towards the 3 per cent end of its target band.   And the RBA’s hikes are likely to be slower and steadier than its overseas counterparts because there are many important differences in the Australian economic story, including much higher skilled migration, which has offered a more elastic pool of labour supply that has kept a lid on wages growth.  Coming back to equities, rates and the Fed, which are the tails that wag the global financial market dog, we have been looking for a key regime change revolving around the speed with which the Fed hikes in 2022.   Market pricing for only three Fed hikes in 2022 late last year seemed extremely optimistic. The truth is that the Fed should be at a 2.5 per cent cash rate right now, and looking to shift into more restrictive settings, implying a cash rate at or above 3 per cent.   Some of this depends on where the neutral rate is in the US, and there are credible reasons to believe it might be lower than the Fed’s estimate of 2.5 per cent. But the Fed is ultimately in the driver’s seat, and taking its neutral estimate at face value, that is where we should be.  Another tell that policy in the US needs to tighten materially is that the financial conditions index (FCI) the Fed relies on has been signalling that monetary settings are currently near the most stimulatory levels in history.   An FCI index is an overall measure of how restrictive or loose policy is and captures a range of variables, including the Fed’s cash rate, 10-year government bond yields, credit spreads, equity valuations, and the trade-weighted exchange rate.  On 14 January, Goldman Sachs wrote that its widely watched FCI is “about 2¼ standard deviations easier than its historical average and 153 basis points easier than at the start of 2020”. While the Fed declaring that it is ready to lift rates in 2022 had increased 10-year bond yields, this effect was being more than overwhelmed by rising equity valuations. Having said that, the recent equity correction combined with even higher bond yields and wider credit spreads should have tightened the FCI somewhat.  Surprisingly, markets are still only pricing in four Fed hikes in 2022, which would put its cash rate around 1 per cent, or less than half the neutral estimate of 2.5 per cent. It seems that a more prudent policymaking path would involve the Fed lifting its cash rate to between 1.5-2.0 per cent this year, especially if future wages and inflation data validate the presence of a persistent wage/price spiral.  This change in the expected Fed funds rate profile could be one catalyst for a material equities correction in the order of 10-15 per cent, or more, in the short-term. A much larger correction would loom once the Fed pushed its cash rate into genuinely restrictive territory north of 2.5 per cent.            For further information please contact us on 1300 901 711 info@coolabahcapital.com | www.coolabahcapital.com Disclaimer: Past performance does not assure future returns. All investments carry risks, including that the value of investments may vary, future returns may differ from past returns, and that your capital is not guaranteed. This information has been prepared by Coolabah Capital Investments (Retail) Pty Limited, a wholly owned subsidiary of Coolabah Capital Investments Pty Ltd. It is general information only and is not intended to provide you with financial advice. You should not rely on any information herein in making any investment decisions. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The Product Disclosure Statement (PDS) for the funds should be considered before deciding whether to acquire or hold units in it. A PDS for these products can be obtained by visiting www.coolabahcapital.com. Neither Coolabah Capital Investments Pty Ltd, Coolabah Capital Investments (Retail) Pty Limited, Equity Trustees Limited nor its respective shareholders, directors and associated businesses assume any liability to investors in connection with any investment in the funds, or guarantees the performance of any obligations to investors, the performance of the funds or any particular rate of return. The repayment of capital is not guaranteed. Investments in the funds are not deposits or liabilities of any of the above-mentioned parties, nor of any Authorised Deposit-taking Institution. The funds are subject to investment risks, which could include delays in repayment and/or loss of income and capital invested. Past performance is not an indicator of nor assures any future returns or risks. Coolabah Capital Investments (Retail) Pty Limited (ACN 153 555 867) is an authorised representative (#000414337) of Coolabah Capital Institutional Investments Pty Ltd (AFSL 482238). Equity Trustees Ltd (AFSL 240975) is the Responsible Entity for these funds. Equity Trustees Ltd is a subsidiary of EQT Holdings Limited (ACN 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).     Preferences  |  Unsubscribe

---

Archr LLP is Authorised and regulated by the Financial Conduct Authority (FCA reference 617163).
Archr LLP is not covered by the Financial Services Compensation Scheme (FSCS).
Archr is registered in England and Wales No. OC371018. Registered office 115B Drysdale Street, Hoxton, London, United Kingdom, N1 6ND

This message may contain confidential or privileged information. If you are not the intended recipient, please advise us immediately and delete this message. The unauthorised use, disclosure, distribution and/or copying of this email or any information it contains is prohibited.

This information is not, and should not be construed as, a recommendation, solicitation or offer to buy and sell any securities or related financial products. This information does not constitute investment advice, does not constitute a personal recommendation and has been prepared without regard to the individual financial circumstances, needs or objectives of persons who receive it.

You are receiving this email because you are a valued client of Archr.