This month’s newsletter looks at the latest market and economic developments and what they mean for investors.

The key points are as follows:

Equity markets rebounded in October on hopes that the US Fed would soon soften its aggressive interest rate stance.
Any such hope for a Fed “pause” or “pivot” was quickly quashed in early November.
As expected, the Fed raised rates by 0.75% for a fourth consecutive meeting and flagged an even higher peak interest rate.
Inflation is still too high and the jobs market too strong for the Fed to stop raising rates or to consider cutting them.
There are sounds of things breaking as high interest rates challenge the stability of the financial system.
Whilst the interest rate debate will undoubtably resurface, we believe the next phase of equity market direction will be driven by corporate earnings.
At this stage we do not have a bullish outlook for corporate earnings and therefore remain cautious.
We favour the risk reward payoff in high quality bonds as we enter a higher for longer interest rate world.
The AUD have once again reached levels where active investors could consider hedging global exposures.

As we approached October the mood amongst investors was one of caution. October is notoriously known to be a bad month for share markets. Not encouraging given the market weakness over the first 9 months of the year.

Whilst the US S&P500 Index did reach a new bear market low on 12 October, it managed to end the month strongly, gaining +8.10% for the month.

What changed on 13 October? The minutes from the 20-21 September US Central Bank meeting was released. What in the minutes could have sparked the +2.60% rally on the day? We think the below statement had a big part to play.

“Participants observed that, as the stance of monetary policy tightened further, it would become appropriate at some point to slow the pace of policy rate increases while assessing the effects of cumulative policy adjustments on economic activity and inflation.”

Before these minutes were released the Reserve Bank of Australia surprised investors with a smaller rate hike than expected. Now investors are hearing similar debates within the US Federal Reserve Bank. Further adding fuel to an already “slower rate hikes” fire was Nick Timereos from the Wall Street Journal. On 22 October he released an article titled “Fed Set to Raise Rates by 0.75 Point, Debate Size of Hikes”.

The potential slowing in the pace of US interest rate hikes was welcome news for investors. Nothing to get too excited about in our view as Central Banks would not be stopping interest rate hikes, nor will they be cutting interest rates. This was clear in the remainder of the paragraph in the minutes which the market happily ignored.

“Many participants indicated that, once the policy rate had reached a sufficiently restrictive level, it likely would be appropriate to maintain that level for some time until there was compelling evidence that inflation was on course to return to the 2 percent objective.”

On Wednesday all eyes were squarely fixed on Fed Chair Powell. The market was looking for leadership and he did not disappoint. He emphasised at his press conference that “Restoring price stability will likely require maintaining a restrictive stance of policy for some time” and “The historical record cautions strongly against prematurely loosening policy”.

The Fed effectively views the cost of doing too little and risking “unanchored” inflation (requiring much higher interest rates) as being greater than doing too much now, having a recession but being able to respond with measured policy support (eg. rate cuts).

With US interest rates 3.75% higher than March, it is fair to say that most of the interest rate hikes are now behind us. Keeping interest rates at elevated levels is what is to be expected in 2023. Whilst this makes the Fed nervous about potential asset price destruction, they also know this is needed to slow demand and bring inflation closer to 2% from the current 7-8%.

Keeping interest rates elevated “for some time” is likely to be challenging for US corporate earnings in 2023. How challenging is the unknown.

We believe the direction of corporate earnings will determine the direction of share markets and whether we have already seen the bottom in this bear market.

Not Easy Being A Central Banker in 2022.

WHY WE ENDED UP IN THIS MESS

We all know why we find ourselves in this mess of continued high prices, etc.
Covid stimulus programs. US Money Supply exploded by 40% (M2 Money Supply).
Yes, there was US$15.3T in circulation in Dec19 and that increased to US$21.4T in Dec21.
If money supply increases by 40%, we should not be surprised to see prices skip much higher.
Today we see higher prices in consumer goods/services, hard assets (property) and financial assets (stocks).
It all started because Central Banks increased money supply like never before.

CENTRAL BANKS THOUGHT THEY COULD MANAGE IT

Central Banks always knew there were risks, but perhaps underestimated the risks.
Since the 2008 Global Financial Crisis Central Banks often intervened to manage economic outcomes.
Keeping interest rates low for prolonged periods of time. Printing money via Quantitative Easing programs.
Despite pushback from some economists, inflation remained low allowing interest rates to remain low.
Expecting a similar outcome was a mistake given the volume of money being injected into the economy.

CENTRAL BANKS MISREAD INFLATION

Central Banks thought consumer price inflation was due to supply challenges, therefore only temporary.
Little was said about the much-enjoyed asset price inflation. Only a few comments of rising inequality.
In hindsight, stimulus should have been removed much sooner.
But Central Banks remained committed to supporting the economy until all lost jobs (from the pandemic) were recovered.
Unfortunately, that arrived together with an asset bubble, and the highest inflation since the 1980’s.
Deflating this asset bubble without an economic or financial accident is what their goal is today.

ARE CENTRAL BANKERS ABOUT TO MAKE ANOTHER MISTAKE?

With credibility lost, we have very little confidence the US Fed will deliver a “soft landing”.
Expecting inflation to fall back to 2% with only limited economic damage and a few job losses is a fairy tale.
Are they now mistakenly remaining committed to their “inflation back at 2% target”?
Being steadfast in hiking interest rates and draining money supply to achieve this.
Setting future policy on past economic data has the market divided.
- Some say keep hiking interest rates, possibly deliver a big blow and get it over with.
- Other say pause, let already higher interest rates feed into the economy.
We are not convinced the US Fed knows which path is needed.
It does feel like the US Fed have backed themselves into the “keep hiking” corner.
We need to expect some damage with 4 x 0.75% interest rate hikes behind us and more to follow.

THE SOUNDS OF THINGS BREAKING

We have previously highlighted the strength of the US$, and its negative impact on global economies.

The AUD has also fallen victim to the US$. The catalyst, a modest 0.25% rate hike in October by the RBA vs 0.50% expected.

Can the RBA be more aggressive?
Not easily. Such a move would be positive for the AUD, it may however sacrifice the property market.
The Bank of Japan has moved to protect the Japanese Yen, one of the first US$ victims.
The Bank of Japan is now buying bonds to keep rates low and selling foreign reserves to protect the Yen.
Reports are the Bank of Japan in September bought $20B worth of Yen and $42B in October to support the local currency.
Policy mistakes in the UK has placed the pension funds under significant pressure recently.
This is one of the most financialised industries in the world, not surprising to see their near collapse.
The Bank of England intervened with a promise to buy up to £65bn of UK Government bonds.
For some perspective, the NY Fed provided US$29B assistance for the rescue/sale of Bear Sterns in 2008.
The noise out of the UK is significant. By no means are the problems solved.

WHAT NEXT FOR THE US FED?

The US Fed has learned from their 2018 rate hike disaster which was created by their “auto pilot” view.
Today, in their view they are decisive, with some flexibility:
- “a need to be restrictive for some time, to have confidence that inflation is moving back to target.”
- “the Fed will proceed in a data-dependent manner.”
At this stage, the data is not in the Fed’s favour. US Inflation still above 8%. Unemployment at 3.5%.
Whilst being data dependent is good, the data has them trapped in the “be restrictive for some time” camp.

MAYBE THE FED KEEPS GOING TILL SOMETHING BREAKS?

The US Fed will certainly try to avoid this outcome.
The reality is interest rates are already at restrictive levels, each additional hike gets us closer to something breaking.
We are clearly seeing challenged parts of equity, bond and currency markets showing their fragility.
In our view, this needs to at least be acknowledged by the US Fed.
Fed officials can no longer keep telling the market they like what they see when markets are convulsing.
All of this whilst the all-important inflation and employment data is not swinging in their favour.

DIVERGING CENTRAL BANK PATHS

Smaller-than-expected rate hikes by the Reserve Bank of Australia and the Bank of Canada are showing us that some Central Banks are turning more cautious.
These Central Banks are likely concerned about the level of debt in their property markets and the broader economic impact from a weakening property market.
The US housing market however is less sensitive to short-term interest rate movements (fixed-rate mortgages). The US economy is therefore more resilient.
This makes the Fed’s job much tougher. Powell this week re-iterating the Fed’s commitment to lower inflation to its 2% target even if this means job losses and a weaker economy (which it will).

AUSTRALIAN EQUITIES

The S&P/ASX200 Index gained +6.04% over the month of October. Australian Equities continue to outperform International Equities over a 12-month timeframe.
9 of the 11 ASX sectors ended the month in the green as the local market followed global markets higher.
Leading from the front were economically sensitive sectors that were heavily sold off in September. The Financial sector gained +12.16% lifted by positive earnings reports. The Real Estate sector gained +9.91%, Energy +9.34%, and Consumer Discretionary +8.80%.
One economically sensitive sector that did not participate in the strong October rally was the Materials sector (-0.11%) as Iron Ore prices softened -16.3% over the month.
The defensive Consumer Staples and Healthcare sectors were largely flat returning -0.19% and +0.56% respectively.

INTERNATIONAL EQUITIES

The MSCI All World Index ended the month +7.74% higher seeing the 12-month drawdown at -18.06%.
The regional bright spots were in the US and Europe. The catalyst for the positive moves for US equities was better than expected earnings (at the margin) and potential easing in rate hikes and for Europe the decline in energy prices.
The US S&P500 Index gained +8.10%, the S&P Europe350 Index gained +7.21%, and the S&P Japan500 Index gained +2.85%.
The catalysts for the rally in Developed Markets had little impact on Emerging Markets. The DJ Emerging Market Index declined -3.61% being weighed down by China which declined -12.16%.

PROPERTY AND INFRASTRUCTURE

Australian Property Index continues to be one of the most volatile asset classes. After declining -13.60% in September, the asset class gained +9.91% in October.
Global Listed Property (Hedged) ended the month +4.11% higher, whilst positive, it has taken over from Australian Property to be the worst performing asset class over a 12-month timeframe.
Global Listed Infrastructure (Hedged) gained +4.83%. In September we saw Infrastructure follow Global Equities lower (-9.72%) but now failing to match the strong rally in October.

FIXED INCOME

The Bloomberg Australian Bond Index gained +0.93% over the month. News flow about slowing interest rate hikes is positive for bond and could signal a turning point for this asset class.
The 10-year Australian government bond yield closed the month at +3.76%. To us 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.

Monthly Investment Update — November 2022