Investment update with John Pearce - February 2022

John Pearce: Hi, welcome to this investment update. I’m John Pearce, UniSuper’s Chief Investment Officer. For those of you who have followed share markets, you’d appreciate that the new year is not off to a particularly happy start. All those gains that we saw leading up to Christmas are being reversed in January. We’ve seen the Australian market, for example, down about 6%.

Today, I’d like to explain what is actually driving this volatility. I’d like to briefly discuss where the impacts are being mainly felt. But finally, I’d like to provide some reasons as to why my team and I are not particularly concerned about current developments. 

What’s behind all this volatility? Let’s start with what’s not driving it, in my view. This is not about Omicron. In fact, the world economy is handling Omicron very well. This is not about heightened geopolitical tensions, i.e. Russia aligning troops on the Ukrainian border. Yes, that has had some impact on oil prices but it’s not really driving what’s happening in markets. 

This is all about inflation and inflationary expectations. I want to refer you to a diagram that we’ve been using over the past few of these updates. I refer to the economic and financial markets cycle. You might recall back in about October last year, it was abundantly clear that the global economy was in rude health. Unemployment was declining, and there were signs of inflationary pressures emerging. In these respects, the cycle was playing out just as depicted. 

However, in some other respects, there were some question marks. Central banks were not getting overly concerned about inflation. In their views, it was transitory. And they were not foreshadowing a rate cycle anytime soon. 

Chart 1: Chart showing the economic / financial cycle. Typically, recession and higher unemployment is followed by: policy stimulus and market rallies; a recovery in growth and a fall in unemployment; inflation and market falls; policy tightening. Then the cycle repeats. Two question marks signify that in about October 2021, uncertainty existed in relation to inflation and market falls, and policy tightening.

This emboldened investors. They figured with rates staying around zero, they could still pile into risky assets, and hence the rally continued. 

But that has since changed. What has changed it? The US in early January announced an inflation number of 7%. This was the highest number in over four decades. And the Federal Reserve of the US—that’s the US Central Bank, the most powerful central bank in the world—its language changed pretty much overnight.

Chart 2: Chart showing the economic / financial cycle. Typically, recession and higher unemployment is followed by: policy stimulus and market rallies; a recovery in growth and a fall in unemployment; inflation and market falls; policy tightening. Then the cycle repeats. Two steps in the cycle are highlighted to signify that within the economic financial cycle, we’re currently in the stages of inflation and market falls, and policy tightening.

It was about six months ago, when the Federal Reserve was adamant that we weren’t going to see rate rises until about 2023. Now they’re saying the first rate rise is going to be in March this year, and by the way, we can’t rule out another four or five throughout the year. This is an incredible about face in a pretty short period of time. And this has rattled share markets.

What has been the impact? As you might expect, it has not been uniform. And the old adage applies—the harder they rise, the harder they fall. And that’s been the case. If you look at the US tech market, the NASDAQ is down about 17% from its highs that were experienced in around November. The Australian share market, which didn’t experience the same rise, is down about 8%. So, a slightly better result there. If you look at our investment options over January, as we speak, the Global Environmental Opportunities option—the high flyer over the last couple of years—is down around 10%. At the other end of the spectrum, we have the Conservative option, only down around 1%. Our Balanced option, where the bulk of our accumulation members have their superannuation, down around 3.7% for the month of January. 

Markets are volatile, losses are being incurred. Why aren’t we overly concerned? There are a few key reasons. The first one is that pullbacks like this are actually quite common. Have a look at this graph. Over the last decade, pretty much every year, we’ve seen a pullback of at least 6% in the Australian Stock Exchange. 

Chart 3: Chart showing the performance of the Australian Stock Exchange over the last decade. A pullback of at least 6% is depicted almost every year during this period.

Pullbacks like this, as I said, are very common.

In terms of superannuation returns, have a look at the Balanced option returns over the last 20 years on a calendar year basis. Our members have enjoyed a pretty stellar run, and even over the last few years in the midst of Omicron, no negative returns. It was pretty much a matter of time before we experienced flat returns in our Balanced option. Could this be the year? We don’t know. But clearly it hasn’t started particularly well.

Chart 4: Chart showing the performance of UniSuper’s Balanced investment option over the last 20 calendar years. The only years in which negative returns are depicted are 2002, 2008 and 2011. A question mark over the 2022 calendar year depicts uncertainty as to the returns for 2022 in light of current market conditions.

The more fundamental reason we’re not overly concerned, is that you’ve got to look as to why the Federal Reserve is indeed embarking on a rate hike cycle. And the fundamental reason is the US economy is doing really well. And yes, they have to dampen things down to make sure that inflation gets under control. But the economy does not need the emergency settings that currently apply. It does not require zero interest rates—they can run on their own steam. And quite frankly, as an old timer, zero interest rates don’t feel right to me. I’m very comfortable with 2% interest rates. But as I said, it’s the speed of the change in the Fed that is rattling markets.

With the global economy doing well, we expect that to feed into corporate profits, and rising corporate profits, as we’re seeing with companies reporting currently, will lead into higher share prices over the long term. We think about rising rate cycles leading to share market falls, but an interesting statistic—since 1950, when the Federal Reserve regained its independence after World War Two, there have been 13 rate rise cycles. In 11 of those cycles, share markets actually rallied. Now history may not repeat, but that’s a pretty comforting stat in my mind. 

What could go wrong? Once again, it all comes back to inflation. If inflation doesn’t get under control, central banks might find themselves in a situation where they have to hike rates to bring on a recession. We do not believe that that is going to eventuate, and neither does the market generally. If you look at 10-year bond yields, that is the best forecast of future inflation—still well below 2%. So, the bond market is basically saying yes, we think inflation is going to be a problem for the next year, maybe the next couple of years. But over the long term, we think those secular forces, technology, demography, etc., will bring inflation back under control. 

Let’s say we end up with a 2-2.5% interest rate. Is that an issue? I don’t think so. Have a look at the dividend yield on the Australian stock market at the moment. If you include franking credits, over 5%. We’re talking about a pretty healthy yield on share market relative to interest rates, even if we do see a rate rise cycle. 

That’s not to say that we’ve seen the end of this volatility. I expect we’re going to see a fair bit more of it. UniSuper, of course, is very well placed, as we always are, to handle these situations. We’ve got ample levels of liquidity, and we indeed take opportunities of these types of sell-offs. Of course, individual circumstances vary. And we have seen elevated levels of concern—we’re getting elevated levels of calls to our frontline, and we’re also seeing a lot of switching activity, as members move their money to safe havens of cash from risky assets. If this current bout of volatility is causing you concern, you should see one of our excellent financial advisers. 

Thank you to all of you who have referred family and friends to the fund since we’ve opened to the public. Our flows have exceeded our expectations. So, a big thank you for your support. Thanks very much for watching.