Themes For May

Following a solid run so far this calendar year, equity markets took a breather during May with the Australian market declining by 2.6%, dragged lower by consumer discretionary stocks impacted by signs of a slowdown in consumer spending. The US market fared a bit better, improving by 0.7% buoyed by a resolution to the US debt limit standoff where, as expected, both parties reached an 11th hour compromise agreement. Europe was down 2.1% however the major underperformer for the second month in a row was China which fell by 8.2% on concerns that the economy has failed to recover as anticipated following the lifting of COVID restrictions. This impacted negatively on commodity prices with iron ore down 9.2% and oil 9.6% lower which pushed the Australian dollar 2% lower against the greenback, finishing at US 65 cents. Bond yields crept higher over the month in anticipation of further increases in interest rates with Australian 10-year government bond yields increasing by 26 basis points while US 10-year treasuries were 19 basis points higher.

The RBA in Australia surprised the market by increasing cash rates by 25bp to 4.1% early in June citing nascent wages pressures highlighted by the 5.8% increase in the minimum wage approved by the Fair Work Commission. This sets the stage for a potential wage inflation spiral through collective bargaining agreements as employees attempt to restore the value of their real wages.

Markets have been resilient so far this year

Despite a series of bad news stories this year such as inflation proving frustratingly stubborn, interest rates continuing to rise, the war in Ukraine showing no signs of abatement, power prices on the rise and concerns that the global economy will enter a recession by the end of the year, equity markets have been remarkably stable in 2023. The following chart demonstrates that so far this calendar year there have been only two days when the US market has moved by more than 2% whereas at the same stage last year there had been 19 days that exceeded this threshold.

As a consequence of this, the volatility index (or VIX) sometimes referred to as the “fear index” has fallen substantially over the past six months which indicates the market is much less concerned about the outlook than it was towards the end of last year.

The reasons for this are somewhat puzzling given the likelihood that economic growth will continue to decline prompting negative revisions to corporate earnings, generally not a positive sign for share markets. Pricing in the interest rate futures market is reflecting an expectation that rates will be cut by the end of this year. This seems very unlikely based on current economic signals, particularly strength in the labour market where wages pressure is pushing rates higher. In addition to this, there are expectations that corporate profits will begin to rebound in the fourth quarter this year which is at odds with the economic outlook.

 

Our conclusion is that the market has run ahead of its fundamentals by adopting the most optimistic investment scenario in an environment where there is considerable uncertainty. In many ways this is not surprising given the unprecedented period we have just experienced where the global economy was fundamentally disconnected and policy makers created an inflationary outbreak by excessively stimulating demand which now must be corrected by restrictive policy. After a dozen cash rate increases in Australia and similar moves elsewhere in the world, it is unclear to what extent the economy will slow given the long and variable lags that apply to monetary policy. Expectations of a recession are certainly not unreasonable and in many ways is almost a necessary precondition for inflation to return to acceptable levels in the near term.

Strategy and Outlook

 We continue to adopt a “steady as you go” approach to investment strategy given the high level of uncertainty that is likely to persist for the balance of 2023. In this kind of environment, investors are unlikely to be rewarded in the near term for taking undue investment risks. The good news is that as we look further out towards 2024, the imbalances that we currently see are likely to normalise and a more positive picture will emerge for equity markets. While we are certainly past the peak of inflation, the task of returning it back to target levels will be an arduous process and will involve further tightening of monetary policy. There is a risk that policy error will result in a recession later this year.  Paradoxically, the equity market is most optimistic in this environment as it looks forward to the inevitable rebound in activity as lower interest rates and rising corporate profits provide a potent combination for equity returns.

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Boag Asset Management Pty Ltd
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