Themes For January

28 February 2023

Following a dismal year in 2022, equity markets started the New Year on a positive note posting healthy returns for the month of January. Expectations that inflation is past its peak, has given the market confidence that central banks will begin to moderate the pace of interest rate rises. While the market is expecting a slowdown in economic activity in 2023 because of tighter policy last year, there is growing confidence that a severe recession will be averted.

The US market set the tone for global exchanges advancing by 6.3% for January with the technology heavy NASDAQ recovered some of its 32% loss from last year, improving by 10.7%. The Australian market gained 6.2% on the back of firmer commodity prices which have been boosted by the post-COVID reopening of the Chinese economy led by iron ore which is up 50% over the past 3 months.

The Chinese market was up 11.7% on the reopening news, while lower gas prices in Europe saw its markets up 7.9%, the UK market also rose climbing 4.1%.

Expectations of lower inflation provided a boost to bond markets with the Australian 10-year bond yield falling 50bp and US 10-year Treasuries falling 35bp. While 10-year bond yields are now roughly equivalent at around 3.5% in both countries, the US yield curve remains negative signalling a possible recession whereas the Australian curve is positive indicating better economic prospects. The Australian dollar rallied 3.9% on the back of the improved terms of trade from higher commodity prices to finish at US 71 cents.

The State of Play in 2023

As we begin the New Year it’s worth reflecting on how we arrived this position. The economic consequences of policies designed to lessen the impact of the COVID 19 pandemic were vastly underestimated by policy makers. With manufacturing supply chains deliberately disrupted through a combination of lockdowns and border closures, demand was over-stimulated through extremely lax monetary policy and very generous government compensation measures funded by deficit spending. This proved to be a deadly combination for inflation, which rose sharply through the course of 2021 & 2022.

The now infamous comments from US Fed Chairman Jerome Powell and Treasury Secretary Janet Yellen in mid-2021 that inflation was merely “transitory” will go down as one of the biggest policy blunders of our time. History tells us that once the inflation genie is out of the bottle, it is very difficult to put it back in. Facing 40-year high inflation, global central banks have acted in unison to substantially raise interest rates and reduce liquidity in order to moderate demand. While the invasion of Ukraine by Russia in February 2022 did give rise to higher energy prices, you can see from the chart above the root cause was much earlier in March 2021 sparked in the US by the $US1.9 trillion (9% of GDP) “American Rescue Plan” which handed out cheques to US consumers igniting the inflation fire by over stimulating demand.

Investment Outlook

When designing the asset allocation for multi-asset portfolios, it is critical to assess whether you will be compensated for taking additional risk. In the current environment, markets are still readjusting from a state of extreme disequilibrium. There are conflicting signals regarding the major factors that drive long-term financial market returns – most notably inflation and company earnings. While it is likely we have seen the peak of inflation and that the pace of interest rate rises will decline, interest rates will remain at elevated levels for at least the rest of this year. While the headwind to equity markets from higher interest rates has begun to abate, it is still a factor working against equities albeit to a lesser degree. Given that higher interest rates affect demand with a lag of up to 12 months, it is unclear just how much the global economy will slow and therefore to what extent company profits be negatively affected. In the US, Q4 2022 earnings have declined 5% and expectations for both Q1 and Q2 this year have been wound back.

The combination of strong returns in January and negative earnings revisions has seen the forward-looking market P/E rise from around 16 times at the beginning of the year to over 18 times at the end of January. While the second half of 2023 looks brighter for equity markets, negative profit revisions temper our appetite for more equity risk at the moment. Geopolitical factors also provide potential risks with the war in Ukraine about to pass its 12-month mark with no obvious resolution and China continuing to make provocative moves toward Taiwan. Following a poor year in 2022, the prospects for government bonds look better as deflationary trends will likely see nominal and real bond yields fall in coming months.