A Letter to Investors – Part Two

There is a lot we don’t know

The analysis in Part One of A Letter to Investors illustrated that markets are constantly speculating on the economic outlook. Market prices are either supported or hindered by the risk free rate of return and can be greatly upset by “black swan” or unpredictable events. Over time, speculation is dialled up or down (“risk on” or “risk off”) which magnifies the price moves of assets and increases volatility at turning points.

The chart below shows that equity markets deliver solidly positive returns over time. Those returns may be enhanced or hampered (short term) by moves in the risk free rate (ex GFC), black swan events (COVID) and excessive speculative exuberance (Internet bubble).

However, ultimately economic growth is reflected in the increased cashflow (dividends) from, and the value of, companies. The Australian market returns are greatly enhanced by the payment of franked dividends, with investors further rewarded by reinvestment. Australia remains a great place to invest.

The chart is interesting because it shows the following:


  1. Periods of excessive price speculation are followed by price corrections.
  2. There are periods when the Australian equity market outperforms the US equity market.
  3. The Australian equity market has outperformed world indices for 25 years; and
  4. The US market outperformance since the GFC has been overdone, more so during COVID, and it is now correcting as monetary policy is tightened.


The most important message from the above is that investors should maintain an allocation to equities to generate returns over the long term that benefit from economic growth, and which outperform inflation.

At times, the allocation to equities should be adjusted (raise cash) but it is generally a mistake to sell entirely out of the equity market. This is because the market constantly reprices itself based on the outlook. Importantly, equity prices correct before downturns and revalue before recoveries. When a downturn is “priced in”, it is the time to consider buying. Over time, equities perform better than other assets, and quality companies perform better than poor ones.

With the above points stated, it is true that the short term outlook is most uncertain. Whilst long term economic growth is assured, both across the world and particularly in Australia, there are short term headwinds.

These are:

  1. The spiking of inflation to levels not seen for 20 years and risk of stagflation.
  2. The onset of wage pressures that flow into cost inflation.
  3. A commitment of central banks to lift cash rates.
  4. A desire of central banks to reverse QE and reduce their balance sheet holdings of bonds.
  5. The contraction in PERs of equity markets that flow from the rise in risk free yields.
  6. The unpredictability of the war in Ukraine.
  7. The resultant dislocation of energy markets, now hampered by western sanctions on Russia and Russian export embargoes.
  8. The disruption of grain markets, creating food shortages in many developing countries, and increasing political unrest.
  9. The shutting down of Chinese cities and trade centres causing a slowing in Chinese growth and disturbing supply lines of goods to the developed world.


While these issues are significant, our judgement is that they are not as significant as the downturn presented by the GFC in 2008. At that time, the world teetered on financial collapse and potential depression but was able to pull through with a co-ordinated global response.

There should be no doubt that world leaders and central bankers will tread a cautious path as they deal with the numerous issues noted above. Will they be able deal with them? History suggests they will.


Some thoughts on what is likely to happen

My thoughts on the issues noted above follow. In doing so, I admit a level of speculative thought – but I do so from a rational and informed perspective based on earlier observations.

  1. Inflation will peak over the next 6 months in the US but remain an issue across Europe into 2023 due to the Ukraine war. The strength in the USD will push US inflation down, and a mild economic slowdown will take the heat out of the US economy. The outlook for Europe is not so clear and stagflation is a high risk that will see the maintenance of QE programs.
  2. Wage rises are difficult to forecast. For years, the US Fed and Treasury anguished about the lack of wages growth, but now that it has arrived, it is deemed too strong. Clearly US wages have begun a sharp upward trajectory as it normally does in tracking inflation. In Australia, with a change in government, there needs to be more a proactive fiscal strategy around wages policy that includes taxation adjustments for low-paid workers. A focus on take home pay (after tax) adjustments is essential to stop a wages surge that would make inflation difficult to manage.
  3. Cash rate adjustments will occur quite quickly (say 12 months) in the US (to 2.5%) and Australia (to 2%) and slow household consumption and demand for credit. The extent to which cash rates will rise are significantly overstated by markets at present. European and Japanese cash rate adjustment will be muted and limit the extent to which the Fed can push rates higher.
  4. The desire of central banks to reduce their balance sheets (QT) will be tempered by the bond market reaction to the increased supply of bonds. As the world economy slows, fiscal deficits will increase, and Government issuance of debt will increase. Central banks will adjust their QE/QT policies to ensure bond markets do not destabilise governments (e.g. central banks will move from selling bonds to holding them to maturity).
  5. The contraction of PERs has substantially occurred. The speculative overshoot (Nasdaq, IPOs, and the SPACs) is over, and the increase in risk free rates has begun. The next issue confronting markets will be the trajectory of earnings in the PER formula. On this point, Australian company earnings look superior to many of our Western peers.
  6. The war in Ukraine has developed into a quagmire with NATO supporting Ukraine, and Putin doubling down on his strategy. Sanctions imposed against Russia will take time to bite but will ultimately deplete Russia’s economy and perhaps one day force regime change. At that point, will Russia reset and re-engage with the West?
  7. The Ukraine war and Russian embargoes on energy exports will ensure a faster decarbonisation of energy markets – whilst maintaining elevated energy prices. The support required by governments to affect this conversion suggests that deficits endure with targeted expenditure that drives decarbonisation. Given this outlook, the support of central banks is essential so (once again) expect a pivot in monetary policy.
  8. The inflationary and supply pressures in grain markets is a critical issue for developing countries. Once again, this suggests that central banks must remain responsive to the needs of their governments which will need to support underdeveloped economies. Australian grain producers are in for a good period with sustained higher prices.
  9. China’s pandemic lockdowns are not sustainable. The closures have extended the supply chain issues flowing from COVID, but they will be rectified in due course. Once this occurs, inflationary pressures caused by lack of supply will be relieved.


We see the next year or so as a period where market reaction dominates economic policy, causes pivots by central banks that determine the trajectory of interest rates, and therefore equity market PERs.

The last twenty years has been a period of continuous and extensive economic policy support. The result is that today world government debt has never been higher and interest rates never been lower when measured against inflation.

It would be folly to expect that the world economy can simply transition to a benign growth and inflation period that was last seen in the 1960s. Central banks aggressively pushed interest rates too low. Their support for government deficit funding was unprecedented. Whilst they would like to adjust back to normal, they cannot without causing real pain.

As investors, we must continue to invest. Our protection is sticking to fundamentals and seeking out quality businesses (and properties) that have strong sustainable characteristics.

To this final point, I present a most persuasive chart. It shows that as interest rates lift in response to rising inflation, a reset of the equity market is occurring. The beneficiaries are quality companies that can endure through economic cycles because they have pricing power in the supply of their products or services. The temptation is to sell quality when markets are bullish and to liquidate them when sentiment is negative – like now.

However, the more logical and time-tested approach is to simply hold them as core investments. Quality equity investments clearly outperform all other assets and particularly low yielding bonds.


Based on the above analysis, this is our outlook for Australia in FY23 – noting that it looks far superior to Europe and mildly better than the US.

  1. No recession, but with low real GDP growth of about 2%. A solid rebound in FY24 as borders open and immigration returns.
  2. Reported inflation peaking at 6%, before retreating to 3.5%.
  3. Cash rates reaching 2% and stalling.
  4. Mortgage rates rise 2% and drag residential property down by 10%.
  5. Ten year bonds reaching 4% yield.
  6. AUD rises to its long term average of US75 cents.
  7. AUD export income buoyed by sustained commodity prices and agricultural exports.
  8. ASX All Ordinaries re-testing 7800 with an ASX Accumulation return of 8%.