Key takeaways
There is a possibility that the next couple of years might be a bumpy ride in terms of the economy, financial markets, interest rates, and so forth.
It has been well documented that the cost of living has been rising in Australia and around the world.
It is likely that the neutral interest rate is probably a lot lower than it used to be.
The best time to buy property is when it's unpopular to do so.
It is entirely possible that inflation and interest rates will cause economic pain.
I think we need to be prepared for the possibility that the next couple of years might be a bumpy ride in terms of the economy, financial markets, interest rates, and so forth.
The media thrives on higher levels of uncertainty, so be prepared for plenty of doomsday predictions and lots of negativity.
The silver lining is that negative sentiment almost always creates attractive long-term investment opportunities, but you must be on the lookout for them.
Inflation is not demand-driven
It has been well documented that the cost of living has been rising in Australia and around the world.
Australia’s inflation rate is currently 5.1% p.a. (as measured by CPI), but anyone that’s been to the supermarket lately knows that prices of many products have risen by a lot more than this.
Inflation is a problem in many other countries too – NZ inflation is 6.9%, the UK is 9.0% and the US is 8.3%.
Inflation occurs because demand for goods and services exceeds supply.
Inflation can be demand-driven (i.e., when demand is above normal, but supply remains at normal levels) or supply-driven (i.e., supply is below normal).
I certainly acknowledge that some sectors have experienced levels of consumer demand that are well above normal levels, particularly during lockdowns.
However, at this stage, I think inflation is mainly driven by supply chain shortages.
Therefore, to cool inflation, demand must be reduced to below normal levels.
Unfortunately, that means financial pain for some people because household budgets need to be strained to the point that people buy fewer goods and services than they would otherwise need to buy.
That will be achieved either by higher prices (market forces) or higher interest rates (RBA), or both.
Cooling supply-driven inflation is generally painful, especially when wages aren’t rising nearly as fast as prices.
We should call the ‘cost of living’ crisis what it is - the cost of lockdown crisis.
— Laura Dodsworth (@BareReality) May 18, 2022
But interest rates must return to normal ASAP almost regardless of inflation
One year ago, I wrote that interest rate expectations can change very quickly, and we shouldn’t get seduced into thinking they won’t rise.
Last year many commentators were suggesting that interest rates might not rise for many, many years.
Today, the same commentators are predicting multiple increases in the coming months.
The reality is that interest rates were at emergency settings (zero) for a very good reason – Australia was in lockdown!
But that is no longer the case and interest rates must return to more normal levels as soon as the economy can afford it.
If interest rates were left at zero for too long, there would be severe negative long-term consequences.
The big question that economists are currently wrestling with is what do normal interest rates look like?
It is likely that the neutral interest rate is probably a lot lower than it used to be.
The RBA thinks it’s around 3.5% but most respected commentators think it’s likely to be less than this, maybe closer to 2%.
The upshot is that interest rates need to rise by 2% or more as soon as it's economically affordable.
Over the past few years, I have written a lot about irrational share market valuations, particularly in the technology sector.
Of course, I wasn’t the only one that suggested these market valuations made no sense and had to eventually be corrected.
That correction is well and truly underway.
The technology-heavy NASDAQ index is down 30% this year.
The NASDAQ index includes over 3,600 stocks and almost half of these companies have fallen by 50% or more from their pandemic highs.
A share market valuation rerating like this is always a bit messy because even fundamentally sound companies also get caught up in the negative sentiment.
That is, their stock prices fall too, albeit to a much lesser extent.
It certainly seems like share market fundamentals (e.g., profitability, strong cash flows, proven business models, strong balance sheets, etc.) once again matter to the market and that is good news for evidence-based investors.
It just might be a bit of a bumpy road in the short term but in the longer-term, sound stocks/indexes/strategies will emerge victoriously.
Property market sentiment has soured very quickly
The property market was going gangbusters throughout most of 2020 and 2021.
The popular theme was that property prices were set to rise sharply for many years and you’d better get in quick!
There was a lot of FOMO.
This led me to write a blog in mid-2021 advising readers to not buy property in such a buoyant market (at least not if you have to overpay, which was the case in most circumstances).
The property market has changed a lot since the beginning of this year.
The FOMO has evaporated, and the constant talk of inflation and higher interest rates has cooled demand for property.
Frankly, this is wonderful news for any would-be property buyers.
The best time to buy property is when it's unpopular to do so.
But the hardest time to buy property is when it's unpopular to do so (because it feels risky).
I expect that the negative sentiment surrounding the property market (including predictions of price falls) will become louder over the coming months.
If that’s true, it will be an excellent market to buy an investment-grade property.
The best time for investing
It is entirely possible that rising prices (inflation) and interest rates will cause economic pain, particularly for lower-income earners.
In fact, it could cause a temporary recession.
If that happens, there will be pressure on the RBA to cut rates again.
The extent of economic pain is highly dependent on how long it takes for supply chains to return to normal.
This is dependent on many factors outside of Australia’s control including China relaxing Covid lockdowns, the Ukraine war ending and the normalisation of commodity prices.
Often, the best time to invest is when it's unpopular to do so.
Therefore, please do three things
I invite you to do three things over the next 1 to 2 years.
Firstly, expect more bad news than good.
Expect volatility.
Expect negative predictions.
Expect to feel uncertain.
Secondly, focus on maximising medium to long-term investment returns.
I expect the market over the next 1 to 2 years will offer some excellent medium to long-term investment opportunities.
At the same time, it is entirely possible that your investments may not generate investment returns over the next 24 months.
Your ability to generate attractive medium-term returns will depend on whether you have the discipline to execute your investment strategy over the next 24 months.
Finally, don’t get spooked by volatility and negative sentiment and make wholesale changes to your strategy/investments.
The economy is in relatively good condition and if supply chains were normal, we wouldn’t be in this position.
These are temporary issues and remember to always focus on the long term.
