October Review

A further spike in global bond yields sent equity markets lower in October for the third consecutive month. The Australian market fell by 3.8% as higher bond yields impacted valuations particularly for growth stocks. The only bright spot was the gold sector which rose as geopolitical uncertainty in the Middle East saw the gold price spike by 7%.

Elsewhere in the world, global markets suffered similar declines with the US down 2.3%, Europe 3.3% the UK 3.6% and China 4.2%. Commodity markets were a mixed bag with the oil price falling 8% giving back last month’s gains, while iron ore was only marginally lower.

Bond yields were higher across the board with the Australian ten-year bond yield up 44 basis points to 4.92% while the US 10-year treasury note rose by 33bps to 4.77% as the burgeoning US deficit saw Moody’s downgrade the credit outlook from stable to negative.

In Australia, the new RBA governor Michele Bullock demonstrated a strong commitment to fighting inflation by staring down political pressure and raising cash rates by a further 0.25% to 4.35%. A stronger greenback saw the AUD decline by 2% to finish just over US 63 cents.

Middle East conflict adds another layer of complexity

Geopolitical risk is very hard to factor into any investment strategy and can result in investors seeking safe-haven assets such as gold, cash, the US dollar and in more recent times even cryptocurrency. While financial markets appear to have become somewhat complacent with the ongoing Russian invasion of Ukraine, the recent flare-up in the Middle East adds another layer of complexity. Disruptions to oil supplies following conflicts in the Middle East in 1973 and 1979 resulted in a spike in the oil price and global recessions.

While the major oil producers in the region are not directly involved in the current conflict, any escalation could quickly spread to key players such as Iran and Saudi Arabia. While the world is not as dependent on oil supply from OPEC countries as it was in the 1970s, any disruption from the region either through sanctions or via military strikes against oil facilities, could lead to an inflationary spike as higher oil prices feed directly through to transportation costs. While it is very difficult to place a probability on whether this will eventuate, it is a further risk to the inflation outlook that Central Banks are battling to get under control.

Strategy and Outlook

Equity investors are naturally optimistic and over time are usually rewarded by returns that compensate for the higher risk that shares carry. Shares are attractive when the risk premium they offer provides an adequate buffer against uncertainty. Sometimes however, optimism can be based on unrealistic expectations which can provide a false buying signal.

A good example of this can be found currently in the US equity market where despite aggregate S&P 500 companies barely recording positive earnings growth so far in 2023, the expectation for 2024 is for this to accelerate to almost 12% providing an acceptable risk premium. In a macro environment where policy is designed to slow the growth in aggregate demand, it is very hard to see how this will be achieved. While it is reasonable to assume interest rates are close to their peak, expectations of rate cuts by mid-2024 are also unlikely given how stubborn inflation is proving to be. In multi-asset portfolios, downside risk management becomes paramount when there is an insufficient premium offered by equities to compensate for their greater risk.

As shown above, the current equity risk premium is at a 20-year low and now in negative territory, as the 4% rise in bond rates since 2020 has not been compensated by higher earnings growth. While this does not preclude share prices from rising, it does mean that on a risk-adjusted return basis, equities are not as attractive as lower risk assets such as government bonds and other interest-bearing securities. For this reason, we have reduced the target allocation to both Australian and international shares in favour of a combination of lower risk assets such as corporate credit securities, US Treasury bills and cash as a means of managing downside risk and protecting capital.

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
AFSL 469081
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