By Craig Turnbull, Active Super Chief Investment Officer
November 2021

Despite growing inflationary fears and a sell-off in the bond market, Australian shares made some positive headway in the past month, spurred by a stronger performance on Wall Street and the reopening of major Australian cities after a prolonged lockdown.

Financial markets were unnerved by concerns of higher inflation and expectations that the Reserve Bank of Australia (RBA) may bring forward a hike in the official cash rate, highlighting the challenge posed by increased price pressures.

Offshore, all three major US indices – the Dow Jones Industrial Average, the S&P 500 and the Nasdaq –struck record highs, setting a positive tone for the local market. This helped the S&P /ASX 200 regain lost ground to rise by around 1.0 percent over the month, despite global supply chain disruptions and a significant sell-off of three-year bonds.

Inflationary pressures

The RBA recently upgraded its growth and inflation outlook, adding it was “prepared to be patient” on rates due to modest wage pressures.

Inflation has picked up, but in underlying terms is still low at 2.1 percent. The headline consumer price index inflation rate is 3 percent and is being affected by higher petrol prices, higher prices for newly constructed homes and the disruptions in global supply chains. 

A further, but only gradual, pick-up in underlying inflation is expected. The central forecast is for underlying inflation of around 2.25 percent over 2021 and 2022 and 2.5 percent over 2023. 

The RBA has said its first increase in the official cash rate may now occur in 2023 rather than 2024 if conditions change. Any increase in 2022 has been dismissed based on the most recent data and RBA forecast which is for the economy to grow by 3 percent in 2021, 5.5 percent in 2022 and around 2.5 percent in 2023.

Wages growth is expected to pick up gradually as the labour market tightens, with the Wage Price Index forecast to increase by 2.5 percent over 2022 and 3 percent over 2023. 

"Wages growth should continue to pick up in the near term, as the remaining wage freezes and cuts implemented in 2020 are unwound and labour market conditions tighten," the RBA said.

The main uncertainties relate to the persistence of the current disruptions to global supply chains and the behaviour of wages due to the lowest unemployment rate in decades. 

Bond yields soar

Growing inflationary pressures drove yields on short-term bonds much higher as expectations grew that the central bank would abandon its policy of keeping a lid on three-year bond yields which works to lower borrowing rates. At the start of November, the RBA formally dropped the 0.1 percent target on the April 2024 bond as that bond’s yield rose significantly to 1.26 percent.

While higher bond rates will increase fixed mortgage rates, they’re likely to be welcomed by the big banks as the low interest rate environment has squeezed bank income. This may also be good news for superannuation as most funds invest heavily in bank stocks.

Rising bond yields can be negative for existing bondholders, but they are an attractive entry point for new investors as the income earned on bonds begins to rise from very low levels that are close to zero. 

Yields on Australian three-year bonds have since eased back to be trading around 1.0 percent.