Monthly Investment Update — February 2023
In our first newsletter for 2023, we look at some of the key issues facing investors and how they may impact financial markets this year.
The main points are as follows:
Rising interest rates and elevated inflation caused plenty of headaches for equity and bond market investors in 2022.
With inflation now easing, we should shortly see a peak in US interest rates.
The focus in 2023 will likely shift to the impact that higher interest rates are having on the economy and company earnings.
There is still much uncertainty about how bad economic conditions can get as interest rates are maintained at elevated levels.
In our view, current US profit expectations are too optimistic and do not reflect the reality of an economic slowdown.
We think a level of patience and caution is warranted as equity markets are not being priced for this outcome.
At current equity market levels, we believe bonds and cash provide a better risk/return payoff.
2022 was a challenging year for investors. A rapid and significant rise in interest rates in response to elevated inflation drove negative returns across most asset classes.
For equity markets, higher interest rates and slowing economic growth meant investors were willing to pay less for a dollar’s worth of earnings (ie. pay a lower earnings multiple). This revaluation was felt greatest in high growth markets such as the US shown as the orange line below.
Bond prices also adjusted lower as interest rates rose from a low base (grey line).
The New Year has brought good news for investors on two fronts.
Firstly, US inflation fears have eased. US CPI inflation has decelerated from a high of 9.1% in June 2022 to 6.5% in December 2022. Investors are becoming more comfortable that inflation is under control and a peak in US interest rates is in sight. This should support equity market valuations (earnings multiples).
Secondly, the global growth outlook has improved somewhat. China accelerating its long-awaited economic re-opening is positive. Warmer weather means Europe’s energy crisis should avoid worst case scenarios. Other economies are also proving to be more resilient than expected. The economically sensitive Australian equity market is outperforming.
We believe markets have now entered a phase where the focus will shift to the impact of higher interest rates on the economy, company earnings and the potential for a policy mistake in too many rate hikes. The source of slowing inflation is indeed slowing economic growth!
In the US, we are seeing the most interest rate sensitive sectors such as housing impacted first. It will take more time to fully play out in the broader economy. We expect this to become increasingly visible as 2023 progresses. Important to this is how long the US Fed maintains interest rates at restrictive levels. This will be largely guided by what inflation does.
In our view profit expectations have not re-based to the reality of an economic slowdown. Analysts expect US S&P 500 earnings to increase by +12% over calendar year 2023. We believe such optimism is misplaced. At current levels equity markets appear to be fully priced under a soft-landing scenario (no recession) and not pricing in any possibility for a hard landing.
With such an asymmetrical risk/reward payoff we suggest a level of patience and caution is warranted whilst we wait to see how economic conditions and earnings play out.
Bonds remain investable offering sound income and better downside protection than equities.
Cash remains attractive, generating improved returns and adding defence and flexibility to fund future investment opportunities.
GROWTH TO OVERTAKE INFLATION CONCERNS
It is hard to believe that US interest rates were at 0-0.25% in March last year.
Fast forward 11 months and the US Fed Reserve has increased rates 8 times by a cumulative 4.50%.
This is the Fed’s most aggressive tightening cycle in the past 40 years.
Encouraging is that this step-change in interest rates has only seen growth slow and nothing break yet.
The challenge in 2023 will be dealing with the repercussions of higher interest rates and the impact on economic growth and corporate earnings.
GROWTH WILL SLOW BUT BY HOW MUCH?
Recent US economic indicators point to a weaker growth and inflation outlook.
Partially offsetting this is a slight improvement in the global economy, most importantly the sooner-than-expected Chinese economic re-opening.
The recovery in equity markets over the past few months has largely been driven by investors focusing on the inflation part of the equation. The implication is the Fed has less work to do in 2023.
We believe markets will now enter a new phase where growth (and its impact on earnings) will become the dominant market driver.
The difficulty facing investors is that there is much uncertainty about how bad economic conditions can get as interest rates are maintained at elevated levels.
The services sector accounts for about two-thirds of US personal consumption expenditure so provides a good barometer of current economic conditions.
S&P’s December US services survey highlights the impact that past rate hikes are having and the growth challenges ahead.
“Contractions in output and new business were broad-based and gathered pace in December as customer unease led to dwindling demand and order postponements”.
“A notable development through the month was a stark easing in inflationary pressures across the private sector…companies also saw a slower increase in selling prices in a bid to entice customers and boost sales”.
COULD CHINA'S RE-OPENING THROW A SPANNER IN THE WORKS?
In an environment where weaker growth and cooler inflation is being welcomed, the prospect of the world’s second largest economy re-opening may not be all good news.
Late last year Chinese authorities started making noises that it was preparing to pivot on its Covid-zero policy. Top medical adviser, Zhong Nanshan announcing that the fatality rate from the omicron variant of the virus is in line with influenza.
A re-opening would set the stage for economic recovery. Consumption could come back online supported by excess savings that Chinese households have accumulated in the past three years.
A manufacturing sector back at full capacity would see the demand for commodities lift.
Oil is a wildcard. Higher Chinese oil demand, sanctions on Russian oil and OPEC production falling short of quotas is set to keep the oil market relatively tight in 2023.
Materially higher oil prices would see inflationary concerns return, negating the recent progress made with lowering inflation.
Important for Australia is iron ore. China buys about 70% of global seaborne iron ore volumes. Most of this comes from Australia. Iron ore prices have gained 50%+ since bottoming in early November as sentiment towards China has improved.
Ultimately, the pace and timing of a China recovery is key for the global economy.
A near-term surge in demand from China could add to inflation pressures again, risking downside in equity markets.
A more gradual pathway out of zero-Covid would slow the pace of demand recovery and limit the potential for supply chain disruptions lessening inflationary pressures. This could be the better outcome for equity markets.
SOURCE: Australian Equities: S&P/ASX 200 Accumulation Index. International Equities: MSCI World Index(USD). Australian Property: S&P/ASX 200 A-REIT Index. International Property: S&P Global REIT (USD). International Infrastructure: S&P Global Infrastructure Index (USD). Australian Fixed Interest: Bloomberg AusBond Composite 0+Yr Index. Commodities: S&P GSCI Index(USD).
AUSTRALIAN EQUITIES
The S&P/ASX200 Index gained +6.23% in January reversing December’s -3.21% decline. Australian Equities continue to outperform International Equities over a 12-month timeframe.
10 out of 11 ASX sectors ended the month in the green. Best performing were the economically sensitive Consumer Discretionary sector gaining +9.82% and Materials sector adding +8.88%.
The strength in the Consumer Discretionary sector was driven by large caps Wesfarmers (+8.15%) and Aristocrat Leisure (+11.27%) and supported by hopes that Australian interest rates would soon peak.
The strength in the Materials sector came on the back of improving sentiment toward China growth and the easing of zero-Covid policies.
INTERNATIONAL EQUITIES
The MSCI All World Index ended the month +7.08% higher seeing the 12-month drawdown at -7.45%.
US equity market returns varied considerably. The interest rate sensitive Nasdaq technology Index benefitted most from a further easing of US inflation, surging +10.68%. The S&P 500 Index gained +6.18% and the Dow Jones Industrial Average added +2.83%.
On regional markets, the S&P Europe 350 Index gained +8.46% buoyed by improving business and consumer sentiment. Warmer weather adding to the optimism that the region may avoid a winter recession. The S&P Japan500 Index gained +6.23%.
Emerging markets continued their strong performance. The DJ Emerging Market Index ended the month +6.66% higher. The S&P China500 index added +11.44%.
PROPERTY AND INFRASTRUCTURE
The Australian Property Index gained +8.12% in January marginally underperforming Global Listed Property (Hedged) which gained +8.31%.
The Australian and Global property indices offer investors income yields of +4.4% and +3.9% which become increasing attractive as interest rate expectations decline.
Global Listed Infrastructure (Hedged) still gained a healthy +4.15% despite investors bidding up riskier investments amid a softening inflation outlook.
FIXED INCOME
The Bloomberg Australian Bond Index gained +2.76% over the month. Better news on the US inflation front and talk about slowing interest rate hikes is positive for fixed rate bonds.
The 10-year Australian government bond yield closed the month at +3.52%. In our view Government bonds still appear attractive around these yields.
GENERAL ADVICE WARNING
The advice contained within this document does not consider any person’s particular objectives, needs or financial situation. Before making a decision regarding the acquisition or disposal of a Financial Product, persons should assess whether the advice is appropriate to their objectives, needs or financial situation. Persons may wish to make their assessment themselves or seek the help of an adviser. No responsibility is taken for persons acting on the information within this document. Persons doing so, do so at their own risk. Before acquiring a financial product, a person should obtain a Product Disclosure Statement (PDS) relating to that product and consider the contents of the PDS before making a decision about whether to acquire the product.