Themes For November

Equity markets continued their recent strong rally to post impressive gains for the month of November. Expectations that global inflation is approaching its peak has given a boost to markets in recent times. The Australian share market improved by 6.6% for the month driven by a strong mining sector which was up 17% on optimism that the China would remove its COVID restrictions. Our market is now up an impressive 14% from its mid-October lows. Healthy gains were also recorded around the world with the US up 5.4 %, Europe and the UK both up 7% and China roared back to life by advancing 22%.

Both the RBA and the US Fed continued to tighten cash rates and run-off balance sheets which can be expected to continue until real rates are at least positive. The more optimistic inflation outlook saw bond markets rally with US 10-year treasury yields falling 38 bp and the Australian 10-year government bond responded similarly by falling 23 bp. The USD weakened sharply over the month reflecting the market’s risk-on mood benefiting the Australian dollar which rallied off its recent lows to approach $US 0.67 by months’ end. Commodity prices were mixed as oil fell 6.3%, gold improved 7.3% while iron ore pushed through $US100 per tonne for the first time since September.

Is FTX the “canary in the coal mine” for Crypto?

In our June report we cast a spotlight on cryptocurrency highlighting the risks inherent in this fledgling industry. The spectacular collapse of FTX, the world’s second largest crypto exchange, raises doubts about the long-term future of the industry. In an amazing set of circumstances, the Bahamian based FTX appears to have illegally confiscated up to $US 2 billion of client’s assets to fund a failing related party crypto trading company, Alameda Research. Malfeasance of this magnitude is a stark reminder that cryptocurrency is effectively the “wild west” of the financial world operating in an unregulated environment with no investor safeguards, attracting some of the weirdest individuals and bizarre business practices that one could imagine.

While FTX is a private exchange (quasi brokerage firm) rather than a cryptocurrency itself, trust in the crypto ecosystem has taken a huge hit. Given that cryptocurrencies have no utility value, produce no income, carry no explicit guarantee, and have no tangible assets, the mutual trust and acceptance of investors is critical to their survival. Fortunately, there aren’t significant linkages between conventional financial markets and cryptocurrency so there is little risk of this becoming a contagion event for the global financial system. Crypto players tend to borrow from within their own industry, from hedge funds and private equity operators often using their own self-created crypto tokens as collateral for counter party loans creating a “foundation built on highly leveraged sand”. The FTX experience will no doubt result in long overdue government regulation of the cryptocurrency industry which will shake out the more dubious fringe dwellers and entrench the position of longer-term players such as Bitcoin and Ethereum.

Investment Outlook

In determining the appropriate strategy for multi-asset portfolios, we take a strategic rather than tactical approach. By adopting a longer time horizon, we ignore the noise in markets and focus on the factors that drive long-term returns. Our investment approach relies on taking calculated risks that are likely to be rewarded by superior returns. We believe there is very little value in trying to time and trade markets that move sharply in response to short-term variables that can’t easily be predicted.

While hedge funds and other investors claim to be able to benefit from this sort of market behaviour, we believe it is very difficult to do so consistently overtime and which incurs high transaction costs and tax consequences due to excessive portfolio turnover. In recent times, markets have experienced the headwind of higher inflation and rising interest rates and while this is abating it will continue to be a factor restraining market returns over the first half of 2023. The other major consideration is the direction of corporate earnings which are still in the process of being negatively revised in the wake of the expected slowdown in economic growth engineered by tighter monetary policy. The chart below underlines this point by depicting earnings revisions and aggregate earnings per share for the Australian share market.

Australian market earnings outlook

As we look out to the second half of 2023, it’s likely these factors will move more positively in favour of equities as monetary policy becomes less restrictive and where corporate earnings begin to anticipate an economic upswing. In this scenario, the investment return equation is much more positive for share markets which would prompt us to increase equity risk in multi-asset portfolios.

As we begin to close out 2022, we can reflect on a volatile and tumultuous period where financial markets struggled with the effects of the economic imbalances created by COVID management policies. The good news is that we can look forward to 2023 with optimism as markets will inevitably reflect a more favourable outlook and reward patient long term investors.

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Boag Asset Management Pty Ltd
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