Themes For March

Despite concerns about a possible banking crisis in the US, equity markets performed quite well during March with the US market advancing a healthy 3.6%. Firmer bond yields gave some valuation relief to the technology sector which rallied 9.5%, outperforming the other major US indices. The Australian market was more subdued improving by just 0.2%. The ASX gold sector was a standout advancing by 19% on the back of an 8% rise in the physical gold price, reinforcing its value in times of financial stress. European markets were 1% higher while China bounced back from its decline last month to improve 4.3%.

Both the RBA and US Fed increased cash rates by 25 basis points as expected, reinforcing their determination to break the back of inflation. This prompted a rally in bond markets with Australian 10-year government bond yields declining by 56 basis points and US 10-year treasuries falling by 42 basis points. At their meeting in early April, the RBA decided to pause their tightening schedule to assess the impact of rate rises thus far on the economy, however they are likely continue hiking rates in coming months. While inflation has fallen it remains stubbornly high, and pipeline wage pressures from a tight labour market will keep inflation higher for longer.

Amongst the bulk commodities, iron ore was flat while fossil fuel commodities were weaker with coal down 8% and oil 4.3% lower. The AUD was slightly weaker against the greenback closing at just over US 67 cents.


Banks failures reflect financial stress

The collapse of the Silicon Valley Bank (SVB) and Signature Bank in the US and the forced merger of the 167-year-old Credit Suisse bank with its bitter rival UBS in Switzerland, sent shock waves through the financial system raising concerns of a 2008 style liquidity contagion. Fortunately, the combination of swift action by the US Treasury to guarantee all deposits at SVB, the Federal Reserve providing emergency liquidity lines to banks and the private sector buying assets, has been successful in restoring confidence to the banking system.

While there were special circumstances surrounding the banks that experienced difficulties, the stress in the financial system from higher interest rates and tighter liquidity always impacts the weakest banks first. In these circumstances, the risk to the banking system is that a lack of confidence by customers in the security of their deposits can quickly spread to other healthier banks. While there was some evidence of deposits being withdrawn from smaller US regional banks in favour of both money market funds (investing in Treasury Bills) and larger banks, liquidity lines provided by the US Fed were sufficient for banks to meet withdrawals and maintain confidence.

Fortunately, in Australia there were no such problems with our banking system which remains one of the best capitalised and regulated in the world.

Strategy and Outlook

In the short run, market behaviour is difficult to predict which is why the focus of our investment strategy is over longer time periods ideally 3 to 5 years plus. With the impact of tighter monetary policy and liquidity over the past 12 months yet to be felt, there is every reason to believe that economic activity and profit growth will decelerate over the course of this calendar year.

In anticipation of this, we have seen persistent negative revisions to earnings in global equity markets which has led to valuation measures such as PE ratios approaching 20 times which is not cheap compared to historic norms. Other value measures such as the equity risk premium (earnings yield less the bond yield) reinforced this conclusion, although valuations are better in Australia largely on the back of our resource sector which continues to benefit from strong commodity prices.

While it is fair to conclude that the peak in the inflation cycle is now behind us, there is no doubt there will be a long grind ahead to reduce inflation to the target levels of 2 to 3% per annum. While the initial cause of inflation was excessive demand against the backdrop of broken supply chains during the pandemic, we are now seeing tight labour markets and wage increases potentially having second round inflationary effects which will make the task of central banks more difficult.