January Review

Equity markets built on the strong finish to last year to post healthy returns in January. Driven by expectations of a more positive interest rate environment, the US market advanced by 1.7% while the Australian market improved 1.1%. The standout performer in the US market was the semiconductor manufacturer NVIDIA which advanced 24% on the back of heavy demand for its chips for artificial intelligence applications. This is one of the “Magnificent 7” stocks that accounted for some 71% of the US markets’ 24% gain last year.

Other global markets posted positive returns in January apart from China which fell 0.9%, sinking to a five year low after manufacturing activity fell for the 4th consecutive month. Bond markets were docile with yields on government paper ending a few points higher with both US and Australian 10-year bonds finishing at 4.1%.

In commodity markets, the oil price spiked by 8% closing at $84 a barrel due to instability in the Middle East affecting shipping channels through the Red Sea. The Australian dollar fell 4% against the US dollar to close at US 66c as the market tempered expectations about a further rate rise in Australia and the US dollar gained some strength due to geopolitical instability in the Middle East.

 

Interest rates, The Middle East & China

The strong market rally in the December quarter last year was driven exclusively by a sharp revision to interest rate expectations following positive comments from Fed chairman Jerome Powell following slightly better inflation data. The market sharply revised the likelihood of interest rate cuts this year with interest rate futures pricing in 150 basis points of cuts for the year beginning in March 2024. Subsequent data and commentary from other Fed voting members tempered this view somewhat which tended to be ignored by the market. If history is any guide however, the interest rate futures market is a rather poor indicator of likely monetary policy outcomes as shown in the following chart.

 

The conundrum for policy makers is that although inflation is moderating, economic data is still printing strongly.  In this circumstance, it would be a bold move to begin cutting interest rates with inflation still above target levels. For example, in Australia inflation is sitting at 4.1% well above the RBA’s 2-3% target range. During the month, the RBA forecast that inflation would only return to the target range in 2025, and to the midpoint in 2026. The Federal government’s recalibration of the stage 3 tax cuts to redistribute benefits more to lower income earners, is broadly neutral for the inflation outlook and remains more of a political issue than an economic concern.

The difficulty in setting monetary policy are the long and variable lags between changes in interest rates and the impact on the economy. Once policymakers are convinced that the trajectory for inflation is moving sustainably towards the target range, they will have the confidence to cut rates. While it is likely we will see rate cuts both in Australia and overseas this year, we think the more likely probability is that these will commence in the second half of the year and involve two or three cuts totaling between 0.5% and 0.75%. The re-pricing of interest rate expectations to more realistic levels may result in some market consolidation.

 

While the interest rate and inflation outlook is encouraging, there are some storm clouds on the horizon for financial markets. Most notably this revolves around the continuing uncertainty about the war between Israel and Hamas in the Middle East and the peripheral involvement of Iran and its other proxy forces Hezbollah in Lebanon and the Houthi rebels in Yemen. While the war between Israel and Hamas to date has been contained to Gaza, there is always a risk this could quickly escalate into a broader regional conflict involving Iran with implications for the oil price and the global economy. The Iran backed Houthi rebels are already disrupting shipping channels through the Suez Canal and Red Sea and have launched attacks on tankers prompting retaliation from US military forces. In addition to this, the Chinese economy continues to struggle with several large property developers under financial stress most notably Evergrande which has recently moved into liquidation with others likely to follow. Despite this, Chinese demand for bulk commodities remains reasonably strong with the iron ore price holding firm around $130/tonne.

Strategy and Outlook

 The new year has started well, and we look forward to the remainder of 2024 with confidence. The expectation of lower interest rates will continue to be the dominant theme for the next few months however the focus in the second half of the year will be much more driven by earnings expectations. Through either good luck or good judgement, it appears that central banks have been successful at avoiding a global recession while reducing inflation from 40-year highs in 2022. While geopolitical risks in both the Middle East and Ukraine/Russia together with the slowdown in China could provide some obstacles, on balance we believe that investors will be well rewarded in 2024. The combination of lower interest rates and earnings growth should provide the foundation for healthy returns in multi-asset portfolios.

Gary Burke

Chief Investment Officer

Level 6 / 360 Collins Street
Melbourne Victoria 3000
Phone 03 9959 9872
enquiries@boagfinancial.com.au

Boag Asset Management Pty Ltd
ABN 67 162 211 449
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