October saw investors increase cash holdings and continued market volatility as we entered US third quarter earnings season. In the US $140B has poured into money market funds according to The Financial Times, with 10 straight weeks of inflows.
US equities have re-entered bear market territory with the S&P500 at approximately 3,800. Capital Economics in London have reduced their downside target from 3,400 to 3,200.
The Hong Kong market is at a 13 year low, its lowest level since the GFC (Global Financial Crisis) as Chinese growth, lockdowns and regulatory change relating to Chinese tech companies led to a savage sell-off in listed equities.
The cause of this market volatility is well known, persistent inflation and the willingness of Central Banks to raise interest rates to restrictive levels.
Only twelve months ago commentators were justifying equity valuations on the basis of TINA, there is no alternative. Now, market pundits are calling out the differential in bond and equity market yield, highlighting the relative attractiveness of bonds, particularly if we continue to see lower earnings forecasts.
The sell-off experienced in bond markets through the 2022 calendar year with a positive correlation to the equity market has frightened investors. This increase in yields has impacted almost all asset classes with lower valuations on the basis of a higher ‘risk free rate’.
Investors now have an alternative, returns available on cash plus investment have been adjusting upward with central bank rate increases. These returns are enticing investors seeking stability in an uncertain economic environment.
We have built up cash levels in recent months and for investors with new money we have remained on the side-lines awaiting a more attractive opportunity to invest in risk assets.
Investors should expect bear market rallies. We saw one in the third quarter and given the volatility in October we believe another could be with us as we head into Christmas. Remember to focus on the economic data to identify where we are in the cycle and avoid being seduced by a short-term bounce.
Over the 2022 year a lot of excess and speculative behaviour has left the market with the collapse of crypto and the severe unwinding of unprofitable tech stocks and so-called ‘meme’ stocks. Sentiment has become increasingly negative as the pace of interest rises during this calendar has accelerated. Looking back to the beginning of 2022 the official cash rate was 0.10 per cent increasing on the 4th of May to 0.35 per cent. Today we are at 2.60 per cent with Capital Economics in London seeing the RBA (Reserve Bank of Australia) continuing to increase rates to a peak in April next year of 3.80 per cent.
The strong US dollar (USD) and relative weakness of the Australian dollar, despite strength against other major currencies, has increased the cost of imported goods. This has added to inflationary pressures. The third quarter Australian CPI (Consumer Price Index) figure showed inflation increasing from 6.1 per cent to 7.3 per cent. We expect Australia to avoid recession, the Australian GDP forecast for 2023 by Capital Economics is now growth of 1.2 per cent compared to Europe where they project the economy to contract by 1.80 per cent.
The pace and size of Federal Reserve interest rate increases will dictate equity market movements in the short term, which will in turn be dictated by the direction and level of inflation. We see defensive asset yields continuing to trend upward through to the end of 2022 and expect a brighter outlook for risk-based assets in 2023.
As retail investors become more bearish, one signal we look for and often talk about internally is the “point of capitulation,” which is difficult to predict but often signals a bottom.
We are not at the point yet, but we do believe investor behaviour has started to show signs that this process has commenced. Sentiment is negative and it is now about looking for a sign that the economic environment is becoming less negative. We are waiting for the signal that interest rates look to be near their peak, and we will start progressively increasing our exposure to risk based assets, based on a strong process and strategy, the big question is when? We simply do not know!
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