Our February Insight focused on interest rates, how much further official cash rates may rise globally and when will central banks consider they have done enough?
Markets began the year on a positive note, with both equities and bonds rallying in January and into the start of February, on the view that inflation was coming under control and that most economies were looking more likely to achieve soft landings. Central banks unanimously met this optimism with a brick bat and clear messaging that a lot more needs to be done yet and that more, rather than less, interest rate rises were likely required to tame the inflation beast.
The bond market reacted accordingly and sold off, but the equity market chose to ignore the central banks, viewing strong employment, retail sales and other activity data as a sign that the US economy will be able to avoid recession.
We are concerned with the level of complacency that has entered markets again.
Every cycle is different. In 2022 the MSCI World Equity Index was down 19 per cent, a significant fall but well short of the larger falls in previous cycles. The difference this time is that the unemployment levels have not yet risen.
Whilst many financial services and technology companies have begun reducing headcount, Australia’s January 2023 unemployment rate was just 3.7 per cent and in the US was 3.4 per cent. This is a long way from the high single digit levels seen at the same time in previous cycles.
Wages data is a reminder of the strength in employment.
Capital Economics in London point out that, “central banks need wage growth to slow significantly before they can judge that inflation is firmly under control”. They go on to point out that the “mismatch between workers and vacancies” needs to reverse, and “there will need to be some rise in unemployment, albeit less than would normally be required to bring about such a big drop in wage growth”.
Central Banks have a lot on the line, especially the Reserve Bank of Australia (RBA) and the US Federal Reserve. Both are stating that they are prepared to risk raising interest rates too far, to ensure that inflation is brought under control, but at the same time state that they can do this without breaking the economy and bringing on a recession. We believe the RBA is now in the process of “jawboning” and talking consumer spending down to ensure that inflation continues to fall.
The impact of monetary policy tightening takes six to nine months to flow through to economic activity and this time lag highlights the risks of overstepping on interest rate rises.
The issue for Australia is wages. Relative to other developed markets, our government has not got wages under control, indeed they seem determined to keep talking them up.
We believe this will hamper the rate easing process in Australia and that during 2024 we will see Australian rates above US rates, as US rates ease more aggressively (US Fed Funds futures are looking at US rate cuts from late 2023). The AUD should strengthen against the USD as a result.
US CPI for January rose 0.5 per cent to 6.4 per cent and core inflation by 0.4 per cent to 5.6 per cent. The downward trend in inflation is slowing, further declines in US inflation appear to be priced in and any interest rate pause by central banks is being pushed further out. The current complacency towards equity markets is therefore not justified and equities will come under downward pressure in the next few months.
As previously discussed, we have a small position in government bonds and if we were to see bond yields approach 4 per cent, we would increase this position. Capital Economics are sticking with their call on interest rate cuts later in 2023 and a US 10 Year Treasury Bond target of 3.25 per cent against the current yield of circa 3.8 per cent.
Australian credit markets have performed strongly, credit spreads have narrowed, and prices have rebounded after a difficult 2022. We do not have issues with Australian credit due to the quality of the market.
We have however avoided US credit, which has also seen strong gains and a narrowing in credit spreads. The overall quality is what concerns us there. Capital Economics point out that “there is limited scope for corporate bonds to outperform government bonds over the next couple of years, even if the global economy holds up relatively well”. They believe that “corporate bonds could underperform in the near term”.
Given the “higher for longer” interest rate outlook, the likelihood of recessions in Europe and the US is growing but the recession(s) may well be mild. The market’s focus will shift from interest rates to earnings, and this will push equity markets lower in the short term.
We do however expect gains for equity markets in the second half of the year. We often talk about the fact that equity markets always look forward and eventually they will look through the slowing economy and towards the next phase of the cycle.
Whilst Australian equities outperformed Developed Market equities in 2022, we don’t believe this will continue throughout 2023. Our neutral position in Australian equities versus an underweight in Developed Markets has produced results, with relative outperformance of 20 per cent. The Australian market benefited by being relatively overweight Materials by 20 per cent, Financials by 15 per cent and underweight technology by 20 per cent against the MSCI World index.
The last time we saw this level of outperformance was 2009-2010 and we are now moving to a small underweight position in Australia equities.
The materials sector should however be supported in the near term as China continues to reopen. Capital Economics point out that “prices of industrial metals, such as aluminium, copper and iron ore, will rise later this year as demand picks up, even though they have already made decent gains”, based on the China reopening trade.
China’s reopening saw an initial rebound in equity markets, higher bond yields and a stronger renminbi. Some of these positions have softened since but strong domestic demand will remain for some time yet.
The speed and surprise of the reopening removed the extreme pessimism that had prevailed there overnight, revealing as Capital Economics put it a “neutral position” without “stretched valuations or excessive optimism”. We expect Emerging Markets to resume outperformance later in 2023, supported by the large weighting China has in this index as more positive news on China and its economy becomes apparent.
The bigger picture though is that globally earnings will fall over the next twelve months as high interest rates continue to bite. US earnings have already fallen circa 5 per cent and at least another 5 per cent is very easy to see.
Some are still calling the US S&P500 down to 3,200 from its current level of approximately 4,000. We are not so pessimistic but do believe a further fall towards at least 3800 is likely.
We will be looking at periods of weakness or drawdowns to unemotionally increase risk-based exposure.
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