Themes For September

Concerns about persistently higher interest rates to combat inflation spooked markets once again in September, with all major exchanges suffering substantial declines. The US market fell 10% which set the trend for rest of the world with Europe down 6.8%, the UK 6.4%, Japan 8%, and China 6.3%.

UK markets experienced a bout of volatility when new Prime Minister Truss announced a raft of tax cuts to stimulate a supply side response from the British economy. With UK inflation close to 10% and the budget severely in deficit, this was interpreted as being negative for interest rates and inflation and caused a sharp sell-off in UK gilts as well as the pound. After holding up quite well last month, the Australian market declined by 6.2% but losses were contained by a resilient resource sector.

The hawkish tone from global central banks triggered a further sell-off in the bond market with US 10-year treasury yields 70 basis points higher to close at 3.83% while Australian 10-year bonds increased 22 basis points to finish at 3.89%.

Concerns about slowing world growth and a possible global recession pushed commodity prices lower with crude oil down 13.7% and iron ore 6.3% lower. As usual, the risk-off environment negatively impacted the Australian dollar which was sharply lower against a rampant US dollar finishing just under 64 US cents. This represents a decline of almost 16% from its peak 6 months ago mitigating losses sustained from offshore holdings which underlines the merits of holding foreign currency denominated assets in a multi-asset portfolio.

No quick fix for the global economy

As mentioned in last month’s report, financial markets are climbing a wall of worry in the face of persistently high inflation, prompting an increasingly hawkish stance by central banks that are hiking interest rates and reducing liquidity. There is a growing likelihood the US, Europe, the UK and possibly Australia will fall into recession. As expected, most central banks around the world increased interest rates during the month with the US Federal Reserve hiking rates by 75 basis points and the Australian Reserve Bank followed suit by tightening by 50 basis points in September, but surprised the market early in October by increasing rates by only 25 basis points which caused a brief rally. The US unemployment rate of just 3.5% does not bode well for pipeline wages pressure and hence it is very likely that the Fed will increase rates to 4.5% by years’ end, well above the expectations of the previous quarter.

Unfortunately, the quest to fight US inflation has not been helped by the profligate spending of the Federal government which continues to stimulate demand through a series of massive new spending bills. With the US mid-term elections coming up in November, the likelihood that the Republicans will take control of the House of Representatives (which must approve all new spending bills) will help impose greater fiscal discipline on the Democrat controlled executive branch of the US government.

The combination of higher bond yields and negative earnings revisions is toxic for equity markets. It has been our belief most of this year that earnings expectations have been too high and subject to revision. With the growing likelihood of economic decline in the US, we are now starting to see a raft of earnings downgrades such that the upcoming third quarter reporting season is now forecasting earnings per share growth of just 2.9% compared to 9.8% just a month ago.

Adding to the negative sentiment in markets are heightening geopolitical risks particularly as the Russian/Ukrainian war is entering a dangerous phase with the threatened use of tactical nuclear weapons by Russia to put down a stubborn Ukraine resistance heavily supported by sophisticated US weaponry. Poor energy management policies in Europe (particularly Germany) have left them very dependent on natural gas from Russia creating uncertainty about supply for the upcoming winter. Complicating matters further was the recent sabotage of the yet to be commissioned Nord Stream 2 gas pipeline that runs under the Baltic Sea between Russia and Germany. While oil prices have fallen in recent months in response to weakening global demand, the recent decision by OPEC to cut production by two million barrels a day is bad news for the oil price with potential inflationary consequences.

Investment  Outlook

For most of this year we have adopted a very cautious investment strategy largely anticipating the negative consequences flowing from higher inflation, slowing growth and negative earnings revisions. With such a high level of uncertainty and volatility in financial markets, there is simply no value in making aggressive changes to portfolio structures. The next few months are likely to be problematic for financial markets as they encounter the twin challenges of tightening monetary conditions and slowing economic growth. The good news is that if policy makers maintain their resolve and discipline, the outlook for 2023 will be much brighter.