In 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 increase in demand in Japan for Australian bonds the X Factor in our investment markets.
Forty years later, monitoring the X-Factor (renamed the X-Factor in 2007) has become an obsession, even an addiction, for me.
What is an X factor?
The X-Factor is the major influence on the investment markets that had generally not been anticipated or allowed, but which has come out of the woodwork with powerful effect. My list of 40 years of the X-Factors is shown below.
Being a fan of the X-Factor doesn’t preclude looking at the direction the economy, inflation, stocks, real estate, interest rates and exchange rates seem to be taking. Instead, it serves as a reminder that investors should always be mindful of surprises and overreactions that drive yields up or down often in the short term. Risk management – including wise diversification – is always important for successful investing.
The effects on investors of the X-Factor can be negative or positive. Examples of the former are the near collapse of the global banking sector in 2008, the early effects of the Covid-19 epidemic in 2020, and the disruption caused by the terrorist attacks of 2001. In contrast, Factor-X resulted in better – Better-than-expected returns in 1991, when Australia’s core inflation crashed, and in 1998 and 2008, when our economy showed unexpected resilience during the Asian Financial Crisis and the GFC, respectively.
The last 12 months have provided 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 shape of the pandemic
It is in the nature of pandemics to change shape and impact rapidly, making it difficult to get an idea of what the future holds. In 2021, there were many surprises from Covid-19 as mass vaccinations took place, variants (notably Delta and Omicron) emerged and lockdowns came, went and came back. However, the changing shape of the pandemic and the uncertainties it generated were, for most investors, less of a concern than in 2020.
2. The global economy
The massive fiscal and monetary policy easing announced in mid-2020 and maintained through 2021 has boosted the global economy, average equity prices and many segments of the real estate markets. The global impact of the Covid-19 pandemic on global GDP and most asset prices has not followed the widely predicted L-shaped or U-shaped trajectories. Instead, economic conditions and stock prices followed the deepest and sharpest V-shapes ever seen.
All over the world, budget deficits are enormous and will remain so for a long time. So far, rapid increases in government bonds issued have been financed relatively easily. Bond yields have risen from 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% Australian GDP growth in 2022 looks like a big ask. But I share Paul Xiradis d’Ausbil’s thoughts on the global economy, where he says:
“ … expect forward estimates for the next two years to be updated, due to an underestimated recovery in activity beyond the Covid lockdowns … the economic environment is favorable for equities and will be for about next year.
I would add that as someone who is already somewhat overweight in equities, I am happy to wait for periods of market weakness before stocking up on equities and expect mid-single-digit equities returns in 2022 .
3. Stock market valuations
In rich countries, stock market indices have risen sharply in 2021, thanks to a 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 a support. To quote Paul Xiradis again:
“I don’t think Australian equities are overpriced on average if you look at them in relative terms to the long-term interest rate situation and their earnings growth outlook.”
4. Monetary policy… and inflation
For most of the past two years, the prevailing expectation in financial markets was that monetary policies would remain very expansionary for a very long time, particularly in the United States and Australia, where central banks reaffirmed that a Rising interest rates were unlikely until 2024 at least and would expect an acceleration in the pace of nominal wage growth.
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 jumped to 6.2% over the past 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 the 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 containment measures have been eased. The current surge in inflation is seen as on the way out as global growth slows, energy prices fall and globalization accelerates; and that unions have less power to raise wages than in previous decades.
A growing minority of investors now expect inflation to be a lasting medium to long-term problem. They emphasize: continued supply disruptions; an acceleration of wage increases due to companies’ difficulties in recruiting or retaining staff; perhaps, the return of higher inflation expectations in the next rounds of wage negotiations; and they expect energy prices to rise as countries switch from coal, oil and gas to renewables.
And the winner is …
In my view, inflation is not transitory. Inflation could be 3 to 5% in a year, then go up a notch or two. So, the rising split in inflation expectations is my pick 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 good investment in the 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 columnist for The Australian and Business Review Weekly. The article is general information only and does not take into account an investor’s situation.
40 years of X-Factor Files
2021 The fracture in the long-dominant view of low inflation is here to stay
2019 Solid equity markets despite repeated global recession predictions
2018 The impact of the royal commission on financial services
2017 The positive macroeconomic influences that, on a global scale, have limited volatility, boosted equities and kept bond yields low
2016 Election of Donald Trump as President of the United States
2015 Widespread experience of negative nominal interest rates
2014 Oil Price Collapse Amid Severe Middle East Tensions
2013 Confusion over US central bank’s ‘decline’ in bond purchases
2012 The magnitude of investors’ hunt for yield
2011 Public debt crises in Europe
2010 Public debt crises in Europe
2009 The resilience of our economy despite the GFC
2008 The near collapse of banking systems
2007 RBA hikes interest rates 17 days before election
2006 Big changes to the pension
2005 Modest impact on economies from high oil prices
2004 Sustained rise in oil prices
2003 Marked fall in the US dollar
2002 Extent of corporate fraud in the United States in Enron, etc.
2001 September 11 terrorist attacks
2000 Exchange rate overrun
1999 Powerful cyclical recovery in Asia
1998 Resilience of our economy despite the Asian crisis
1997 Asian financial crisis
1996 Global liquidity boom created in Japan
1995 Powerful US market rally
1994 Sharp rise in bond yields
1993 Strong improvement in Australian competitiveness
1992 Embitterment of the “Europe 1992” vision
1991 Lasting collapse in inflation
1990 Invasion of Kuwait by Iraq
1989 Collapse of Communism
1988 Global economy boom despite Black Monday
1987 Black Monday stock slump
1986 “Banana Republic” commentary by Paul Keating
1985 Collapse of the Australian dollar after the MX missile crisis
1984 Measured inflation falls sharply
1983 Australian dollar free float
1982 Substantial purchases of Australian bonds by Japan