Read Peter Warnes' Forecast 2021–2022: Brace for volatility as tightening cycle looms

Emma Rapaport: Hello and welcome to Morningstar. I am Emma Rapaport. Today joining me is Peter Warnes, he is our Head of Equity Research for Australia and New Zealand.

Peter, thank you very much for joining us.

Peter Warnes: Pleasure, Emma.

Rapaport: Peter, before we dive into the forecast that you published last week, I know that we're both in Sydney, so I can't help but ask your take on the COVID situation in Australia right now, the spread of the Delta variant. And whether or not you think this will have any impact on the Australia stock market?

Warnes: Well, it hasn't so far. And we're three weeks into a lockdown in Sydney, which is the largest population base in the country. It hasn't seemed to worry the market; overseas influencers are dominating there. But certainly, it will take the edge off economic growth in the third quarter. But only just marginally or I would say, maybe if it went another month, it would probably take 0.5% of the GDP for the third quarter.

Rapaport: So, we won't see any of that sort of those numbers come through in the August reporting season?

Warnes: Yeah, well, we probably won't see any impact at all in the reporting season, we didn't start locking down here until the last week of June, and the numbers would have been already, kind of, almost signed-off.

The forward statements are going to be the ones that you're going to have to watch for the reporting season, any brave CEO that's going to take the jump, if you like, and give some direction. But I think that'll be fairly, fairly conservative and play their cards very close to their chest.

Rapaport: So, I had a read of the forecast in last week's YMW. And I'll admit that I felt like reaching for a drink afterwards. I found that some of your commentary to be quite concerning and a little bit depressing. You were speaking there that you think that there will likely be a market correction? Can you talk through what your thinking is behind that?

Warnes: Well, Emma, I just think that some of these valuations are very extreme at the moment. The cash flows are still a little bit all over the place. There is not a lot of transparency going forward as to how this recovery is going. It seems to be very robust at the moment, but what's sustainability like. And if you look at the Fed's latest forecasts, despite the fact that they say they don't take any notice of forecasts, they are looking at a 7% growth in U.S. GDP for 2021. But in 2022, it's 3.3%; and for 2023, it's 2.4%.

Now, they are very, very significant, kind of, slowing in the GDP, in other words, economic activity of the country. And similarly, what will happen is that that will be replicated globally. I think what's happening is that China is the lead here. It was the first country to get the virus, the first country to control the virus, led the economic recovery out and was more robust than any developed or developing nation. And now it's starting to slow and the inflation rate in China, which has properly passed and peaked late 2020 is now starting to come be a little bit transitory, if you like.

And so, China is leading this charge, and I suspect the other developed nations, which are so interlinked with supply chains, interlinked very closely with China, those economies in 2022 will also slow and slows significantly, and that's what the Fed is saying.

Now, corporate earnings will track GDP growth, which is economic activity, so that you shouldn't be extrapolating or getting too excited about what you're going to see from the reporting season. The US reporting season is just about the start for the second quarter, they are looking for a 65% plus increase in corporate earnings over the second quarter of 2020. Now that shouldn't be surprising because that was the quarter where the U.S. GDP shrank by 31.4%. And similarly, in our situation, the six months from the 1st of January to the 30th of June 2021 will be probably the peak of our earnings. In terms of recovery over a six-month period as well, we'll start seeing that the economic growth rate will start to slow up as we progress through 2021. And so, you're just going to see corporate earnings also slow in 2022.

Rapaport: Do you have a view on the debate raging around inflation, whether or not it is a transitory phenomenon? Or we will continue to see inflation rising at a quite a steady or an extreme rate?

Warnes: No. Well, I think, look inflationary pressure is very, very evident across the board in the sensitive metrics. And commodity prices are leading the charge. And that shouldn't surprise anyone, when you've had so much stimulus, both fiscal and monetary thrown at this situation and that's trying to drive demand and you've got demand pulling inflation. We haven't had demand pulling inflation for 10 years, which is a traditional kind of inflationary push. And so, this inflation that's going on now, due to supply chain blockages and shortages, both in labor, and manufacturing, et cetera they will be transitory if you like. But I think when they do settle, and come back, they will settle at a higher level than the pre-pandemic levels. And so, the spike is transitory, but I suspect the level will be higher and that will be enduring. And that's where I think the bond yields will ultimately settle and settle higher than they are now, probably meaningfully over the next couple of years.

Rapaport: And you've said that the words and actions of central bankers are likely to meet the main driving influence – driving the direction of global markets. How did we get to this point where central banks – the words of central bankers was so influential, and that they hold so much significance for both local and global markets?

Warnes: Well, Emma. Just to take a quick look back. Before the GFC, the US fed, its balance sheet was just a touch under $1 trillion in assets. It peaked in 2017 at about $4.4 trillion and then they started tapering from there and pulled back to about $3.76 trillion in 2019, mid-2019. Since then, they've thrown over $3 trillion at this pandemic. And the balance sheet is now $8.1 trillion. It cannot possibly continue. And I believe that if you want to get labor productivity, you want to get more inflation, which people – that's what the central banks want, they want sustainable inflation between 2% and 3% will get the central banks out of the bloody – the equation. They are the reason why you have had low inflation and low labor productivity. If you swamp the financial markets with liquidity, that's what you'll get. Now, if you want that to turn around, they've got to stop and they've got to start easing – sorry, they've got to start tightening and they will have to start tightening I believe sometime in 2022, not 2023.

Rapaport: Yeah, so you're not betting on 2024 as was (first said), I see you're paying very close attention to the wording that is used by the RBA and by the Fed.

Warnes: Well, look, they've painted themselves into a corner, I believe. And if you do that, you better make sure the door is in the corner that you've painted yourself into. And I think they're not – they are in the wrong corner. And so, I think you'll find that they'll start using softer, more conservative vocabulary in their statements going forward to give them some flexibility to get themselves closer to the corner that they've painted themselves into where the door should be.

Rapaport: So, I guess, the big question, and obviously, all investors are different, and everyone has got a different time horizon. But if you take the totality of what you've been saying...do you think at this point, investors should be looking at de-risking their portfolios, maybe putting a little bit of cash aside to wait for opportunities? Now, what would you tell the average investor to do with all the information that you've put in your forecast?

Warnes: Well, given where valuations and markets are, and given that I think that a lot of the tailwinds, they are laughing now, they're not really right behind you. The fiscal and monetary stimuli, and support programs are behind you, they're not going to help you going forward. And so, if that's the case, and if you've got slowing GDP growth, coming at you, I think that you should be – the margin of safety in the market at the moment is absolutely wafer thin. I do think there will be a correction sometime over the next six months. It might not be a big correction, but I think the markets could easily come back 10% or 15%, and you'd still be – they'd still be – then maybe of some reasonable value. We think that the markets are – our market is about 15% overvalued at this point in time. There will be opportunities. You have to have some cash. As I said, in the overview, or in the forecast, that the Chief Investment Officer of Aussie Super was saying, ABC, Jackson 5 jingle, anything but cash. Well, he can say that, he can say anything but cash because he has got 2.3 million members, 90% of which are in accumulation phase, and 80% of which are under 50. And he has got $225 billion worth of funds. He can say anything but cash. But self-managed retirees they can't say that.

I wouldn't be dancing to ABC. I think, as I said, that can probably end up with broken hips and broken dreams, I'd be much preferred to be kind of doing a waltz rather than a jig to ABC. And I do think you'll get the opportunity later this year or early next year to put some money to work. You don't have to sell all your stocks because you never should do that, you've got to have a diversified portfolio with cash as not a balancing item as an item in there and just accept that you will get no return on it, it's an insurance policy. And I think that while I'm optimistic long-term, I think, we've got to get over this tightening period, which could be a little bit difficult and you are going to see very volatile markets.

Rapaport: Right. Well, we will look forward to talking to you at the end of the August reporting season as per usual. Peter, thank you very much for joining us today.

Warnes: It's a pleasure, Emma.