Monthly Investment Update — October 2022
It has been a volatile few months on financial markets as investors grapple with a range of issues including inflation, rising interest rates, Central Bank policy, slowing economic growth, corporate earnings forecasts, geopolitics and Europe’s energy crisis.
This month’s newsletter focuses on a number of these issues.
The main points are as follows:
The US Fed is continuing to aggressively hike interest rates and is likely to keep rates elevated well into 2023.
Other Central Banks have little choice but to follow as they too fight inflation and weakening currencies.
The impact of higher interest rates on the real economy is yet to be seen and is what investors are trying to establish today.
The European energy crisis presents an enormous challenge for Europe’s export-driven economic model.
This is one of many challenges facing the global economy and financial markets today.
High inflation is forcing the European Central Bank to raise rates into an already weak economy.
We continue to be wary about buying the dip. We think profit expectations are too optimistic and equity market risks are to the downside.
The bear market in equities continued in September. The US S&P500 Index declined -9.34%, its worst month since March 2020 when the index declined -12.51%. Turning our attention to the local market, the S&P ASX200 Index had it second worst month since March 2020 declining -6.17%, somewhat better than the -8.92% decline in June 2022.
Clearly there is something going on and investors are becoming increasingly concerned. In our view the challenges are not only because of inflation but also about how Central Banks and Governments are responding. Their goal is to slow demand enough to remove upward pressure on prices whilst at the same time not killing demand entirely. The margin for error is slim, very slim.
As Benjamin Graham said, “In the short term the stock market behaves like a voting machine”. In that context the market action this year and more specifically in September is clearly pointing to lost confidence. In Central Bank talk and finance jargon, hopes of a “soG landing” (low/no growth, no recession) are fading. In our view markets are not yet pricing a “hard landing” (sharp downturn/recession), but the market is concerned.
Jerome Powell, the Chairman of the US Federal Reserve Bank has warned us about things getting a little bumpy. The goal of the US Fed is to get inflation back to 2.0% from its current 8.2%. Achieving that goal may however cause “some pain on households and businesses”. Some jobs may be lost, and earnings may decline is what he means. The stock market tends to ignore statements like these, until it doesn’t. We were reminded of that in September.
October has brought some much-needed relief as equity markets rallied strongly. The market somehow thinks Central Banks are going to be less aggressive in raising interest rates to fight inflation. That is a big assumption as inflation data is still sticky/buoyant, especially in the services sectors.
We have been wary for some time, cautioning investors against buying the dip. We maintain that view. As mentioned before, there will be much more clarity as we move through the next month. What are we watching? US jobs data out on Friday night. A weak employment report should see the US Central Bank consider the impact of recent interest rate hikes on the economy. More clarity will be provided as we move through US profit reporting season with banks setting the scene late next week. Comments from Jerome Powell at the next Fed rate hike meeting on 2 Nov will provide further insight on how the US Central Bank is interpreting the data.
The high level of uncertainty around the above events are reflected in the recent weekly price action of equities. A new bull market will be built on more certainty and that will be reflected in the smaller weekly moves. Compounding these oGen smaller weekly returns is a more attractive and a lower risk environment for investing. The below chart highlights the big weekly moves in the US S&P500 Index in 2022 compared to a more calm 2021.
We remain focused on developments as they unfold. Our preference remains for well diversified, high quality and highly liquid investments. An allocation to cash adds defence and flexibility to fund future investment opportunities.
NO ESCAPING HIGHER INTEREST RATES
Investors know they need to keep a close eye on the US Fed. Their policy settings are often a path followed by other Central Banks.
This time has been no different. By November 2021 the US Fed acknowledged the US had an inflation problem. Today we are witnessing a co-ordinated interest rate hiking cycle globally.
What is different this time is we are seeing a very aggressive interest rate hiking cycle not seen in decades.
The once common 0.25% interest rate hike has been replaced by 0.50% and 0.75%. The impacts of these outsized interest rate hikes are yet to be felt in the real economy.
The challenge today is whether everyone can keep up with future US interest rate hike expectations.
As we saw earlier this week, the RBA surprised markets by only hiking interest rates 0.25% against expectations for a 0.50% interest rate hike.
This is material and probably reflects the RBA’s concerns of already significantly higher rates on the housing market and flow-on to the broader economy.
A STRONG USD IS HURTING GLOBAL ECONOMIES
As seen in the above chart expectations are for the US Fed to hike interest rates by another 0.75% in November, another 0.50% in December and end the “super-sized” rate hikes.
These expectations are already priced into the bond market and so too the currency market. Fixed income funds have sold off heavily and so too has the US$ strengthened against major currencies.
The US$ strength over the last 12-months has once again pushed us to levels not seen in decades. Japanese Yen at 1998 levels, Euro parity last seen in 2002, Pound weakness last seen in 1985.
Yes, high inflation calls for higher interest rates. The challenge however is inflation pressures in some global economies are due to strong demand AND weak supply (Europe).
Central Banks now need to hike interest rates to protect their currencies and avoid renewed inflation pressures as import prices continue to move higher.
A strong US$ does help in the US inflation battle. A strong US$ is however not 100% supportive of global economic growth.
EUROPEAN ENERGY CRISIS
Energy Prices have surged!
Europe is experiencing an unprecedented energy crisis.
After decades of largely stable low prices, European gas prices have increased by over 15-fold during the past 2 years.
Russia’s invasion of Ukraine in late February and the subsequent reduction of gas supply from Russia has had a big impact.
How did we get here?
For some time, Europe has prided itself on leading the world’s transition to cleaner energy sources.
Today renewables including wind, solar and hydro account for a significant and growing proportion of Europe’s energy mix. In Germany, this proportion reached 40% last year.
The European Union’s 2050 climate-neutral goal will require the investment of many trillions of euros in clean energy infrastructure over the next few decades.
In the interim fossil fuels, particularly gas will play an important role as a “transition” fuel.
Government policy has however gone the other way. Political opposition to new European fossil fuel developments and expansions has been fierce as the green movement gathered pace.
This has made Europe increasingly reliant on cheap Russian gas supply which has now been taken away.
Today Europe is paying the price for its energy security complacency.
Governments have responded
In the short-term European Governments are focused on securing energy supplies and making energy prices more manageable.
In the medium to longer-term a complete transition to clean energy is the goal.
Germany and many of its neighbours are reactivating coal-fired power plants as a “temporary” measure to conserve declining natural gas stocks.
France has announced its intention to restart all nuclear reactors by winter. These actions will buy more time for the energy transition.
In financial terms, European Governments have so far pledged a combined €300 billion to lower energy bills for consumers and business.
The German Government has been busy. In July, it spent €15 billion to bail out major energy utility Uniper. Possible nationalisation is now being talked about. More recently it announced a €65 billion relief package to help households and companies cope as energy costs soar.
The UK Government has announced that from October it would cap energy bills at £2,500 per household for two years at an estimated cost of £130-150 billion.
End of an era
Unless there is an unlikely truce with Russia, there is no quick fix.
European politicians, utilities and energy companies are warning that Europe faces a prolonged period of financial and economic fallout from the energy crisis.
In the words of French President Emmanuel Macron, the “era of abundance” that much of Europe has enjoyed for a couple of generations is coming to an end.
A more challenging future
Europe’s economic model of manufacturing and exporting quality goods to the world has created enormous prosperity in countries such as Germany.
This model is dependent on having access to cheap energy and other input costs.
Removing abundant low-cost energy changes the playing field.
In the real economy:
The output of manufactured goods will fall, and what’s produced will cost more.
Consumers will suffer from negative real wage growth (less demand) and corporates from weaker profitability.
On financial markets:
Higher energy costs drive higher inflation forcing the European Central Bank to raise interest rates (even when the economy is clearly weak).
After raising rates by +0.75% in September, ECB President Christine Lagarde stated “We have a goal, we have a mission. We have incredibly high inflation numbers, we are not on target in our forecast and we have to take action”
Financial assets such as shares and property which are priced on future earnings and interest rates will likely suffer from stagflation (low growth/high inflation).
AUSTRALIAN EQUITIES
The S&P/ASX200 Index declined -6.17% over the month of September. Australian Equities continue to outperform International Equities over a 12-month timeframe.
All sectors ended the month deep in the red as the market became more concerned about higher interest rates for longer.
Leading from the front were sectors whose stock prices are most sensitive to interest rates. The Utilities sector gave back -14.87%, Real Estate -13.75%, Technology -10.67%.
They were followed by economically sensitive sectors with Industrials declining -10.40%, Consumer discretionary -9.22%, and the Energy and Financial sectors coming in at -6.74% and -6.63% respectively.
The defensive Healthcare and Consumer Staples sectors came off the best, but still declined -5.05% and -5.81% respectively.
INTERNATIONAL EQUITIES
The MSCI All World Index ended the month -13.60% weaker seeing the 12-month drawdown now at
-19.60%.
There were no real regional bright spots as investors indiscriminately sold markets. The US S&P500 Index declined -9.21%, the S&P Europe350 Index declined -8.84%, and the S&P Japan500 Index declined -9.61%.
Even Emerging Markets had little interest declining -10.51% being led by China which declined -11.43%.
The mood was risk off and investors focused on absolute protection instead of relative performance.
PROPERTY AND INFRASTRUCTURE
Australian Property Index continues to be the worst-performing market over 12-months after declining -13.60% over the month.
Global Listed Property (Hedged) ended the month -12.59% lower, it too is a clear underperformer over a 12-month timeframe.
One reason for the underperformance of the Real Estate sector is due to the fast pace of the rate hikes. In previous cycles the hikes were much smaller/slower and offset by growing rental income.
Global Listed Infrastructure (Hedged) traded like stocks, down -9.72%. We have seen this happen many times before. Infrastructure remains the top performing asset class over a 12-month timeframe.
FIXED INCOME
The Bloomberg Australian Bond Index declined -1.36% over the month as investors price in higher interest rate expectations. The widely followed Australian bond index is down -11.36% over the past 12-months.
The monthly performance of equities and bonds remain highly correlated. Our view however is for Government bonds to be much more resilient going forward.
The 10-year Australian government bond yield closed the month at +3.97%. To us Government bonds certainly do 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.