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In the first half of 1982, Japanese institutional investors made a surprising move. They came into the Australian bond market in scale and quickly acquired 5% of Australian government bonds. At a meeting of investors in Sydney at that time, I suggested we call the sudden surge in demand in Japan for Australian bonds as the Factor X in our investment markets.
Forty years on, keeping a watch out for Factor X (in 2007 re-named as the X-Factor) has become an obsession of mine, even an addiction.
The X-Factor is the major influence on investment markets that had not been generally predicted or allowed for, but which came out of the woodwork with a powerful effect. My list of all 40 years of the X-Factors is set out below.
To be a fan of the X-Factor does not preclude taking a view on where the economy, inflation, shares, property, interest rates and exchange rates seem to be headed. Instead, it’s a reminder that investors always need to allow for the surprises and over-reactions that drive returns up or down often at short notice. Risk-management - including a sensible diversification - is always important to successful investing.
The effects on investors from the X-Factor can be negative or positive. Examples of the former are the near melt-down of global banking in 2008, the initial effects from the outbreak of Covid-19 in 2020, and the disruptions caused by the terrorist attacks in 2001. By contrast, Factor-X resulted in better-than-expected returns in 1991 when Australia’s trend inflation collapsed, and in 1998 and 2008 when our economy showed unexpected resilience during, respectively, the Asian financial crisis and the GFC.
The last 12 months provide a bounteous harvest of X-Factors, from which I’ve selected these finalists for the awards this year, presented in no particular order.
It’s in the nature of pandemics to quickly change their shape and impact, making it difficult to take a view on what the future will hold. In 2021 there have been many surprises from Covid-19 as mass vaccinations took place, variants (notably Delta and Omicron) emerged, and lockdowns came, went and returned. However, the changing shape of the pandemic and the uncertainties it generated were, for most investors, less of a worry than was experienced in 2020.
The massive easings in budget and monetary policies announced by mid-2020 and maintained through 2021 have boosted the global economy, average share prices and many parts of property markets. The world-wide impact of the Covid-19 pandemic on global GDP and on most asset prices didn’t follow the L-shaped or U-shaped paths that were widely predicted. Instead, economic conditions and share prices tracked along the deepest and sharpest V-shapes ever seen.
Around the world, budget deficits are huge and will be for a long time. So far, the rapid increases in government bonds on issue have been funded relatively easily. Bond yields have moved up from their all-time lows but remain well below long-term averages, and many real interest rates are negative.
Looking ahead, the Reserve Bank’s forecast of 5.5% growth in Australian GDP in 2022 seems a big ask. But I share the thinking of Ausbil’s Paul Xiradis on the world economy, where he says:
“ ... expect forward estimates for the next two years will be upgraded, driven by an under-appreciated pick-up in activity beyond Covid lockdowns ... the economic environment is favourable for shares and will be for the next year or so.”
I would add as someone already a little over-weight in shares, I’m happy to wait for periods of market weakness before topping up further on shares and I expect average return on shares in single digits in 2022.
In rich countries, share market indexes have made strong gains over 2021, thanks to the combination of fiscal boosts, highly accommodative monetary policies, and negative real interest rates. There was also support from the good recovery in average profits and dividends after they collapsed in mid-2020. To quote Paul Xiradis again:
“I do not believe Australian equities are too expensive on average when you consider them in relative terms against where long-term interest rates are sitting, and their forward earnings growth outlook.”
Over much of the last two years, the dominant expectation in financial markets was monetary policy settings would remain highly expansionary for a very long time, particularly in the US and Australia where central banks have re-stated that higher interest rates were unlikely until 2024 at least and would await a pick-up in the pace of increase in nominal wages.
Recently, this near-unanimity of view of the outlook has fractured and the gap between the two camps could widen further. Many investors and commentators now expect higher interest rates in the US and Australia from 2022 or 2023. In the US, headline inflation jumped to 6.2% in the 12 months to September 2021, the highest rate of increase for 30 years. Canada, Korea and New Zealand have already raised their cash rates.
It seems to me that the majority of investors still view that recent increases in inflation as transitory. They’re focused on the short-run effects of supply disruptions, the temporary nature of high energy prices, and the boost in consumer spending as lockdowns were eased. The current bump in inflation is seen as disappearing as global growth slows, energy prices drop, globalisation picks up; and as unions have less power to raise wages than in earlier decades.
A growing minority of investors now expect inflation will be a lasting problem in the medium-term and longer. They emphasise: a continuation of supply disruptions; a quickening in wage increases led from businesses finding it hard to recruit or retain staff; perhaps, the return of expectations of higher inflation in coming rounds of wage negotiations; and they expect energy prices to increase as countries switch from coal, oil and gas to renewables.
In my view, inflation isn’t transitory. Inflation could be 3-5% in a year’s time and then move up another notch or two. Thus, the widening split in expectations for inflation is my selection of the X-Factor for 2021.
See the full list below.
To all who read this article on the X-Factor, I wish for you good health, good humour and good investing in the years to come.
2021 The fracturing of the long-dominant view low inflation is here to stay
2019 Strong share markets despite repeated predictions of global recession
2018 The impact from the royal commission on financial services
2017 The positive macro influences that, globally, restrained volatility, boosted shares and kept bond yields low
2016 Election of Donald Trump as US president
2015 Widespread experience of negative nominal interest rates
2014 Collapse in oil price during severe tensions in middle east
2013 Confusion on US central bank’s “taper” of bond purchases
2012 The extent of investors’ hunt for yield
2011 The government debt crises in Europe
2010 The government debt crises in Europe
2009 The resilience of our economy despite the GFC
2008 The near-meltdown in banking systems
2007 RBA raises interest rates 17 days pre-election
2006 Big changes to superannuation
2005 Modest impact on economies from high oil prices
2004 Sustained hike in oil prices
2003 Marked fall in US dollar
2002 Extent of US corporate fraud in Enron etc
2001 September 11 terrorist attacks
2000 Overshooting of exchange rates
1999 Powerful cyclical recovery across Asia
1998 Resilience of our economy despite Asian crisis
1997 Asian financial crisis
1996 Global liquidity boom created in Japan
1995 Powerful rally in US markets
1994 Sharp rise in bond yields
1993 Big improvement in Australian competitiveness
1992 Souring of the vision of “Europe 1992”
1991 Sustainable collapse of inflation
1990 Iraq invasion of Kuwait
1989 Collapse of communism
1988 Boom in world economy despite Black Monday
1987 Black Monday collapse in shares
1986 “Banana Republic” comment by Paul Keating
1985 Collapse of A$ after MX missile crisis
1984 Measured inflation falls sharply
1983 Free float of Australian dollar
1982 Substantial Japanese buying of Australian bonds
First published on the Firstlinks Newsletter. A free subscription for nabtrade clients is available here.
Analysis as at 15 December 2021. This information has been provided by Firstlinks, a publication of Morningstar Australasia (ABN: 95 090 665 544, AFSL 240892), for WealthHub Securities Ltd ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities, we), a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Whilst all reasonable care has been taken by WealthHub Securities in reviewing this material, this content does not represent the view or opinions of WealthHub Securities. Any statements as to past performance do not represent future performance. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, we recommend that you consider whether it is appropriate for your circumstances.