September Review

Equity markets fell for the second consecutive month as higher bond yields placed pressure on market valuations. Despite a stronger energy sector, the Australian market fell by 2.8% while the US market declined by 4.8% weighed down by higher US Treasury yields and growing concern about the burgeoning US federal deficit. Other global markets fared similarly with European markets down 2.5% while China continued its recent decline losing a further 2.8%. The outlook for the Chinese economy continues to deteriorate as the critical property and infrastructure sectors struggle under the burden of excessive debt.

US 10-year bond yields rose by 48 basis points with the Australian equivalent rising by 46 basis points to both finish at 4.5%, a level not seen since 2008. While Central Banks have paused their interest rate tightening schedules for now, strong labour markets and catch-up wage claims to restore real wage levels are building pipeline inflation pressures, meaning that further interest rate rises will be necessary.

Commodity markets were generally stronger, particularly the oil price which was up 6.2%, gold advanced 5.1% and iron ore finished 10.4% higher for the month. This would normally be positive for the AUD however it was basically flat against a stronger USD to finish around 64 cents.

Warning signs in the bond market

As I have written before, the bond market is often the “canary in the coal mine” providing early warning of economic dangers ahead. This was certainly the case before the 1987 share market crash and also before the global financial crisis in 2008. While not suggesting that events of this magnitude are in prospect, the recent bond sell-off is telling us quite clearly that the fight against inflation is far from over.

The share market rally in the first half of 2023 was largely driven by the false expectation that the back of inflation had been broken and that interest rates would be reduced by the end of the year. While the headline rate of inflation has fallen substantially this year, the strength in the labour market and the desire for workers and unions to restore real wages is now producing second round inflationary effects. The best example of this is the current strike by US auto workers seeking wage gains of up to 40%.

Often overlooked in the financial media and by politicians is that inflation is the rate of change in prices, so even though inflation has fallen, prices are still rising, albeit at a slower pace. Aggregate prices have risen by around 20% in the past 3 years which have not yet been compensated by higher wages, leading to cost of living pressures for households. Contributing to this has been a spike in global oil prices as supply has been restricted through a combination of output cuts by OPEC, environmental restrictions on US drilling, coupled with sanctions on Russian oil exports as a consequence of the war with Ukraine. The bond market has drawn the conclusion that Central Banks will have to further increase interest rates before the end of the year to contain pipeline inflationary measures.

We also must not forget that Central Banks are no longer buyers of government debt as was the case for long periods following the GFC from 2008-2014 and more recently at the onset of the pandemic in 2020. In recent times, Central Banks have been allowing their balance sheet holdings of bonds to mature without reinvesting the proceeds, which has placed further upward pressure on the yield required to attract buyers to soak up the ever-increasing supply of government bonds.

One of the negative consequences of the artificial manipulation of bond yields from Central Bank buying (or QE) has been that governments have lost all fiscal discipline given that debt servicing costs were suppressed. Following the outbreak of inflation sparked by excessive government deficit spending in early 2021, the spike in bond yields has meant that maturing debt is now financed at much higher rates. For example, in Australia, maturing 3-year bonds issued at the start of the pandemic are now being refinanced at a 4% higher interest rate, which means the costs of servicing debt is becoming a much larger component of the Federal Budget, which places constraints on other areas of spending and possibly leads to higher taxes.

Strategy and Outlook

The next few months are likely to be problematic for equity markets. Higher bond rates will place pressure on equity valuations while the promise of earnings growth has yet to materialise this year. Higher bond yields are particularly punitive for the share price of companies that have a long-term growth profiles, as future earnings are discounted at higher rates. Not helping the market is that earnings growth has been disappointing, with every passing quarter the promise of growth is pushed out further into the investment time horizon. As mentioned last month, the higher yield environment has changed the investment arithmetic. There is now a high opportunity cost for investing in risk assets with attractive yields available on lower risk interest bearing securities. While we are still confident that earnings growth will drive solid market returns in 2024, in the near term the risk and return equation favours a more cautious approach for now.

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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