Time to announce the X-factor for 2022

Don Stammer | FIrstlinks

Forty-one years ago - coincidentally when I was forty-one years old - I developed an obsession. It’s a compulsive need, as each year ends, to list the main X-factors affecting investment returns in the twelve months - and to pick the X-factor for that year.

In investment markets, X-factors are the largely unexpected influences that weren’t thought about when the year began but came from left field (we used to say came out of the woodwork) to have powerful effects on investment returns over the short, medium or long-terms.

To be a fan of the X-factor, as I am, doesn’t preclude one taking a view on where the economy, shares, interest rates, property and exchange rates seem to be headed. Rather, it’s a reminder that investors need to allow for uncertainties and surprises – because these are inevitable. That is why diversification and awareness of risk are important to successful investing.

Sometimes, the X-factor was favourable for investors. In chronological order, examples of positive X-factors include: the float of the Australian dollar in 1983; the collapse of inflation here in 1991; our economy being little affected during the global financial crisis of 2008; the surge in share prices that began in March 2009; the boost to most commodity prices in each of 2016, 2018 and 2020 as China avoided the hard landings so often forecast for it; and the sharp recoveries in the global economy and share prices soon after the Covid pandemic had hit hard.

Other times, the X-factor was unfavourable. For example (and again in chronological order), there’s been the sharp rise in bond yields in the fake crisis of 1994; the Asian financial crises in 1997 and 1998; the terrorist attacks in the US in 2001; the Enron fraud in US markets in 2002; the near meltdown in the global banking system in 2008; and the disruptions caused by Covid in 2020.

My year-by-year selections of the X-factor have usually been uncontroversial – but last year my phone and email ran hot with people disagreeing with my selection, when I selected the fracturing of the long-dominant view in markets that near-zero inflation would continue for many more years with the result that interest rates, too, would be “lower for longer”.

The finalists for the X-factor in 2022

A couple of times in the past 41 years, I included a silly and puerile comment in my report on the X-factor. It was on the lines “if ever a twelve-month period comes along without an X-factor, that would be that year’s X-factor”.

That flippant remark certainly has no relevance to 2022, which may well have generated a record number of contenders for the X-factor award.

In no particular order, this year’s finalists include:

• The sudden return of high rates of inflation.
• Many central banks raised their cash rates, quickly and often in big bites; ‘yield curve control’ was dropped; and ‘quantitative easing’ switched to ‘quantitative tightening’.
• Some central banks, and notably the Reserve Bank of Australia, gave up offering ‘forward advice’ on changes in their cash rates - and apologised for being so wrong in the messages they’d put out in the last two years.
• Energy prices, notably for steaming coal and gas, traded at very high levels
• The Russian invasion of Ukraine in February inflicted a big human cost, disrupted the global economy, and underlined the risk of nuclear war.
• Until recent weeks, China kept its hard line on eliminating Covid. It has also maintained a tight clamp-down on dissent in Hong Kong, and its military threat to Taiwan.
• In Australia, employment increased strongly; unemployment rates here (and in the US) fell to their lowest levels in almost fifty years.
• Rates of wage increases have started to accelerate in many countries.
• For a while in September-October markets were in turmoil after the then UK prime minister announced a further, and large, fiscal boost. There were also a few days of unexpected rapture, such as 10 November when bond yields declined on thoughts inflation might have peaked and US share prices jumped 6%.
• In May, Labor won a small but workable majority in the House of Representatives, minor parties and crossbenchers made big gains in both houses, and the Coalition parties polled extremely badly.
• Investors’ enthusiasm for ESG guidelines seems have reduced during the year, as fossil fuels rose in price and investors worried renewables might not be able to keep the lights working.
• Gold and particularly cryptocurrencies failed to protect investors after the return of inflation.

And the X-factor for 2022 is …

In my view, the X-factor for 2022 is the surge in inflation experienced early in the year and the sharp increases in interest rates that quickly resulted – and all this at a time when many investors and most central banks had expected inflation and interest rates to be ‘lower for longer’.

So, what will be next year’s X-factor?

The search for next year’s X-factor always makes for a lively debate at the Sunday barbeque. Remember, though, that X-factors must be unexpected; anything that’s widely anticipated, doesn’t qualify.

The X-factor in 2023 could well be something that happens to inflation or to the resolve of central banks to bring inflation down to their target rates as economic growth slows and unemployment increases.

In my view, inflation should slow a little in coming months, as energy prices come off the boil and as China relaxes its zero-Covid strictures allowing supply disruptions to lessen. Nonetheless, inflation could remain a problem in 2023 (with inflation running at perhaps four to five per cent in the US and Australia). The yield on 10-year government bonds, which in both countries was close to 3.5% at time of writing, may need to rise further. Also, there currently appears to be only limited scope for official cash rates (currently 4% in the US and 3.1% here) to be cut in 2023. But if cash rates are raised, Australia should see smaller moves than the US, because of the predominance here of variable rate debt.

Many investors and commentors had predicted a global recession would start in 2022; it hasn’t. Warnings of a severe economic slump in the world economy in 2023 are likely soon to proliferate, with many investors and commentators saying they’ll stay away from shares until the next recession stares them in the face.

My prediction for the X-factor next year is that share markets will bottom before the next global recession is underway.

My colleague at Stanford Brown Private Wealth, Ashley Owen, wrote a fascinating and apposite report called “Recessions are usually good for sharemarkets”; and Firstlinks published it on 12 October 2022. Ashley looked in detail at the 21 recessions Australia has experienced since the 1860s. He considered the timing of turning points in the economy, average share prices, profits and dividends and concluded: “Nothing scares investors more than talk of a recession. However, history shows that economic contractions have mostly been good for share prices and the Australian share market has actually increased during the majority of economic recessions in Australia. The same is true for the US share market during US recessions.”

41 years of the X-factor files

2022 The surge in inflation, tighter monetary policies, and sharp rises in interest rates

2021 The fracturing of the long-dominant view low inflation is here to stay

2020 Covid-19

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.

^{Dr Don Stammer has been involved in investments for many decades as an academic, a senior official at the Reserve Bank, an investment banker, chairman of eight companies listed on the ASX, and columnist for The Australian and Business Review Weekly. These days, Don is on the investment committee at Stanford Brown Private Wealth, is enjoying his octogenarian years, and is working hard - with reasonable success - to contain his Parkinson’s Disease diagnosed seven years ago.}

^{The article is general information only and does not consider the circumstances of any investor.}

^{Analysis as at 15 December 2022. 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.}