Whilst many have called the market strength in July and early August the start of a new bull market, we disagree and believe this has simply been a relief rally, and the market weakness at month end is evidence of this.
We have experienced many bear markets since 1987, here in Australia as well as in London, New York and the Asia Crisis in Hong Kong.
Relief rallies are a central part of a bear market. August is holiday month in the northern hemisphere, and yes, we have seen equities rally from their June lows, but we believe investors need to be prepared for more volatility ahead.
The reality of inflation now seems to have been accepted by markets and it will eventually settle at lower levels, albeit higher levels than originally expected (3-4 per cent range), but the market still has to absorb two factors…
The first is the lack of growth in economies as a flow on from lower corporate earnings. If we look at history, we see an average decrease in corporate earnings of 10-15% after peak inflation.
The second is the factors that have driven the slowdown in growth. The main cause of inflation has been supply side issues, causing higher food and energy prices to name two. Central banks are trying to solve this supply side issue with monetary policy, by increasing interest rates, a very blunt instrument which will have a negative impact on economic growth.
THE AUSTRALIAN ECONOMY AND THE TREASURER’S CHALLENGE
Despite this, we believe Australia will avoid a recession due to record low unemployment, and a lot of excess cash still in the system.
Australian workers are hurting, wage increases of 2-3 per cent are not enough to keep up with 7 per cent inflation. Any wage increases above 3 per cent will underpin inflation without productivity improvements.
The government needs to reduce spending, at a time when the new government is under pressure to increase expenditure on Medicare, Family payments and to the States. What do they cut?
We also expect the new government to stand by all that they promised at the election. For that reason, they will see the chance to increase revenue in areas such as Superannuation, by looking at balances above $5Mln as an easy target, as the political fallout will be minimal.
INFLATION AND INTEREST RATE POLICY – WHERE TO NEXT?
In August, there were growing signs that we are reaching a turning point in global inflation. Commodity prices and shipping costs are now down year on year, and product shortages are alleviating with fewer bottlenecks.
Despite this, central banks are intent on raising official cash rates and aggressively so. This will cause growth to slow but our asset allocation consultant, Heuristic Investment Services believes that any talk of possible rate cuts in the United States in late 2023 are optimistic. Whilst inflation will continue to fall, it will not fall below the upper target band of 3% for quite some time yet. Employment is still strong and wages strength will grow, limiting the pace of the fall in inflation.
Capital Economics in London believes that “central banks will continue to focus on taming inflation, meaning that policy rates will probably rise a bit further – and by more than markets expect”. They see the outcome of this as being rising bond yields and a resumption of the fall in equity values.
Capital Economics describes the rapid increase in official interest rates as “front loading”, in an effort to tackle inflation.
This front loading is bold action to reduce the risk of a drawn-out tightening cycle. The challenge is to increase rates to contain inflation expectations but at the same time to ensure that households and financial markets can cope with the pace and degree of these increases. This is a very delicate balancing act.
Capital Economics believes that the “RBA and RBNZ will cut interest rates next year and most others should follow in 2024” consistent with Heuristic.
WHERE DO EQUITY MARKETS GO FROM HERE?
Tighter monetary policy or higher interest rates resulted in the selloff at the beginning of this year. We don’t see a reversal of this tightening; we believe we are in the middle of a more sustained selloff.
Capital Economics has a calendar year end target of 3,600 on the US S&P500 against its previous low of 3,660 and its current level of approx. of 4,030 We expect the relief rally that equity markets have experienced will unwind further, given that interest rates will trend higher and the market will start to focus on the declining growth in our developed market economies.
PORTFOLIO CONSTRUCTION – WHERE ARE THE OPPORTUNITIES?
We have taken a constructive approach to the market volatility.
We are monitoring for an entry point to add duration into our portfolios through government bonds. If we see weakness in the Australian dollar, we will adjust our approach to hedging offshore assets. Finally, at some point a great opportunity will exist to buy equities and set a portfolio up for terrific long-term gains.
We are focussed on a clear strategy for our client portfolios to take advantage of this environment. We will never pick a market bottom as timing markets is difficult, the bottom in equity markets will likely come before the low point in the economic cycle. We will be looking for indication of this to increase exposure to risk assets.
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