Themes For October

28 November 2022

Equity markets clawed back most of their losses from last month with major exchanges delivering solid returns for October. The US market advanced 8% however the NASDAQ did not fare as well, improving by 3.9% reflecting sharp declines in some of the major technology companies. Europe was up an impressive 9% and the Australian market recouped all its losses from last month improving by 6.0%. The exception was the Chinese mainland market which fell 4.3% following the five-year Communist Congress which re-elected President Xi as leader and reaffirmed its commitment to a zero COVID policy which threatens to constrain manufacturing activity. The UK appointed its second leader in 45 days with new Prime Minister Rishi Sunak largely unwinding the fiscal policies adopted by the previous regime that rattled UK markets.

Bond markets were mixed with the US selling off by 28 basis points to finish at 4.05% whereas in Australia, 10-year bond yields fell 13bp to close at 3.64%.

As expected, the RBA tightened interest rates by 25 basis points on Melbourne Cup Day, continuing its accretive approach to tightening compared to the more aggressive US Fed. The chart over the page shows that the Australian yield curve is normal (higher yields for longer maturities) indicating economic expansion, whereas the US yield curve is inverted for all maturities beyond one year, which indicates a possible recession. Following the Fed’s 75bp rate rise, Chairman Powell reiterated they were prepared to risk a recession in their quest to stamp out inflation.

In commodity markets, oil rebounded by 8.3% following news of OPEC supply cutbacks while gold was a little weaker falling by just under 2%.

The return of fiscal responsibility?

In Australia, the recently elected Albanese government delivered its first budget during the month which was both measured and responsible. While it contained no great surprises for the market, the best news was there were no plans for any major government spending initiatives which simply cannot be afforded given the budget deficit and the almost $1 trillion of debt being carried by the Federal government.

In early November, the US mid-term congressional elections will be held for the full 435 member House of Representatives and 35 of the 100 Senate seats. Opinion polls suggest that dissatisfaction with the Biden administration will almost certainly see the Republicans taking control of the House and quite possibly the Senate – although this is less certain given that Republicans are defending 21 seats to only 14 for the Democrats in a 50-50 tied chamber. A Republican congress would be positive for the market as it would act as a check and balance on government spending which has injected a staggering $6 trillion (30% of GDP!) into the US economy over the past two years. This has massively over stimulated demand in the world’s largest economy, producing 40-year high inflation.

Investment Outlook

There is a tough grind ahead for the global economy in the face of tightening monetary policy and the run-off of central bank liquidity. We continue to emphasise that it is going to take some time for the global economy to re-balance after being thoroughly dismantled over the past two years from restrictive COVID management policies. US third quarter earnings were lacklustre and showed growth of just over 2%, however, excluding the strong energy sector, earnings actually contracted by 5.1% for the quarter.

Looking forward, analysts now expect earnings to fall by 1% in Q4 compared to an expectation of 9% growth just four months ago. Until forward looking earnings revisions stabilise, we are unwilling to commit any further capital to equity markets. The bond market will be first to reflect the likely trajectory of inflation, at which time it will no longer provide a headwind for equity valuations. This highlights the importance of earnings per share growth as the primary driver of share market returns over the next 12 months.