During the first half of 1982, Japanese institutional investors made a surprising move. They entered the Australian bond market on a large scale and quickly acquired 5% of Australian government bonds. At an investor meeting in Sydney at the time, I suggested that we call the sudden surge in demand for Australian bonds in Japan the X factor in our investment markets.
Forty years later, monitoring Factor X (renamed Factor X in 2007) has become an obsession for me, even an addiction.
What is an X factor?
Factor X is the major influence in investment markets that was not generally predicted or authorized, but came out of nowhere with a powerful effect. My list of 40 years of the X-Factors is shown below.
Being a fan of the X-Factor does not preclude forming an opinion on the direction the economy, inflation, stocks, real estate, interest rates and exchange rates seem to be taking. Instead, it’s a reminder that investors should always consider surprises and overreactions that cause returns to rise or fall often in the short term. Managing risk – including sensible diversification – is always important to a successful investment.
The effects of factor X on investors can be negative or positive. The first examples are the virtual collapse of the global banking system in 2008, the first effects of the Covid-19 epidemic in 2020 and the disruptions caused by the terrorist attacks of 2001. In contrast, Factor-X has resulted in better outcomes. Higher than expected returns in 1991 when core inflation in Australia collapsed, and in 1998 and 2008 when our economy showed unexpected resilience during, respectively, the Asian financial crisis and the GFC.
The past 12 months provide a bountiful harvest of X-Factors, from which I have selected these finalists for this year’s awards, presented in no particular order.
1. The form of the pandemic
It is the nature of pandemics to change shape and impact quickly, making it difficult to get a sense of what the future holds. In 2021, there were many surprises from Covid-19 as mass vaccinations took place, variants (most notably Delta and Omicron) appeared and blockages came, went and returned. However, the changing form of the pandemic and the uncertainties it has generated have been of less concern to most investors than in 2020.
2. The world economy
Massive fiscal and monetary policy eases announced by mid-2020 and maintained through 2021 have boosted the global economy, average stock prices and many segments of the real estate markets. The global impact of the Covid-19 pandemic on global GDP and most asset prices did not follow the L- or U-shaped trajectories that were widely predicted. Instead, economic conditions and stock prices followed the deepest, sharpest V-shapes ever.
Budget deficits around the world are huge and will be for a long time to come. So far, the rapid increases in government bonds issued have been relatively easily financed. Bond yields have risen from historic 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% Australian GDP growth in 2022 looks like great demand. But I share the reflection of Paul Xiradis d’Ausbil on the global economy, where he says:
“ … expect forward estimates for the next two years to be revised upwards, due to an underestimated recovery in activity beyond Covid lockdowns … the economic environment is pro-equity and will be for the next year or so. ”
I would add, as someone who is already a bit overweight in equities, I am happy to wait for periods of market weakness before recharging equities further and expect an average single-digit equity return in 2022.
3. Stock market valuations
In rich countries, stock market indices rose sharply compared to 2021, thanks to the combination of fiscal stimulus, very accommodating monetary policies and negative real interest rates. The good recovery in average earnings and dividends after their collapse in mid-2020 was also supported. To quote Paul Xiradis again:
“I don’t think Australian stocks are too expensive on average when you look at them in relative terms to long-term interest rates and their outlook for earnings growth.”
4. Monetary policy … and inflation
For most of the past two years, the dominant expectation in financial markets was that monetary policy parameters would remain very expansionary for a very long time, especially in the United States and Australia, where central banks have reaffirmed that an interest rate hike was unlikely before 2024 unless and would wait for an acceleration in the pace of nominal wage increases.
Recently, this near-unanimity on 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 United States and Australia from 2022 or 2023. In the United States, headline inflation has jumped to 6.2% over the years. 12 months to September 2021, the highest rate of increase in 30 years. Canada, Korea and New Zealand have already raised their spot rates.
It seems to me that the majority of investors still consider recent increases in inflation to be transitory. They focus on the short-term effects of supply disruptions, the temporary nature of high energy prices, and increased consumer spending as closures have been eased. The current surge in inflation appears to be waning as global growth slows, energy prices fall, globalization accelerates; and as unions have less power to raise wages than in previous decades.
A growing minority of investors now expect inflation to be a sustainable problem in the medium to longer term. They focus on: continuing supply disruptions; an acceleration in wage increases induced by companies having difficulty recruiting or retaining staff; perhaps the return of higher inflation expectations in the next wage negotiations; and they expect energy prices to rise as countries move from coal, oil and gas to renewables.
And the winner is …
In my opinion, inflation is not transient. Inflation could reach 3 to 5% in a year, then go up a notch or two. So the increasing division of inflation expectations is my selection of the X factor for 2021.
See the full list below.
To everyone reading this article on the X-Factor, I wish you good health, good humor and a good investment for years to come.
Don Stammer has been involved in investing for many decades as an academic, senior Reserve Bank official, investment banker, chairman of nine ASX-listed companies and a columnist for The Australian and Business Review Weekly. The article is only general information and does not take into account the situation of an investor.
40 years of X-Factor files
2021 The long-term vision fracture of low inflation is here to stay
2019 Stock markets strong despite repeated predictions of global recession
2018 The impact of the royal commission on financial services
2017 Positive macroeconomic influences that globally have limited volatility, boosted stocks and kept bond yields low
2016 Election of Donald Trump as President of the United States
2015 Widespread experience with negative nominal interest rates
2014 Fall in oil prices during high tensions in the Middle East
2013 Confusion over the “tap” of bond purchases by the US central bank
2012 The extent of investor hunt for yield
2011 Public debt crises in Europe
2010 Public debt crises in Europe
2009 The resilience of our economy despite GFC
2008 The virtual collapse of banking systems
2007 RBA hikes interest rates 17 days ahead of election
2006 Big changes to the retirement pension
2005 Modest impact on economies of high oil prices
2004 Sustained increase in oil prices
2003 Sharp decline in the US dollar
2002 Extent of corporate fraud in the United States to Enron, etc.
2001 September 11 attacks
2000 Excess exchange rates
1999 Strong cyclical recovery in Asia
1998 Resilience of our economy despite the Asian crisis
1997 asian financial crisis
1996 A global liquidity boom created in Japan
1995 Powerful rally in US markets
1994 Strong rise in bond yields
1993 Great improvement in Australian competitiveness
1992 A sharpening of the vision of “Europe 1992”
1991 Lasting collapse of inflation
1990 Iraq invasion of Kuwait
1989 The collapse of communism
1988 Boom in the global economy despite Black Monday
1987 Black Monday crumbles into actions
1986 Commentary “Banana Republic” by Paul Keating
1985 Collapse of A $ after MX Missile Crisis
1984 Measured inflation falls sharply
1983 Floating Australian Dollar
1982 Large Japanese purchases of Australian bonds