January 25, 2024

Market & Economic Update - January 2024

AUTHOR

Financial Keys

POST SUMMARY

The Australian equity market (as measured by the S&P/ASX 200) started the December quarter the same way the September quarter ended, with a sea of red as stubbornly high inflation and rising bond yields placed pressure on current and forward-looking company earnings. November and December came roaring back as positive inflation data (i.e. lower inflation numbers) and sudden falls in bond yields created an air of optimism and the potential end of central bank tightening. The share market closed at near record highs.

Australian equities

The Australian equity market (as measured by the S&P/ASX 200) started the December quarter the same way the September quarter ended, with a sea of red as stubbornly high inflation and rising bond yields placed pressure on current and forward-looking company earnings. November and December came roaring back as positive inflation data (i.e. lower inflation numbers) and sudden falls in bond yields created an air of optimism and the potential end of central bank tightening. The share market closed at near record highs.

The Australian market returned +8.4% for the quarter to finish off the year with a healthy +12.4%. At the sector level, movements mirrored broader investor sentiment with all sectors finishing the year off strongly. Real Estate +15.8% as falling bond yields supported valuations, Materials +13.4% with surging iron ore and copper prices, and Healthcare +13.1% with the beaten-up sector mean reverting. These three sectors dominated the quarter with Energy posting -9.1%, as a result of falling oil prices, and Utilities -2.1% and Consumer Staples +0.2% struggled as we saw a rotation out of defensives. All sectors however finished in the black in what proved to be a fruitful year for Australian equities.

All parts of the market spectrum ended the year strongly and with signs of moderating inflation, the smaller end of the market, which struggled throughout 2023, was given a lifeline and an opportunity for a reversal of fortune. The large caps still outperformed their smaller rivals with the S&P/ASX 100 rising +8.4% and +12.7% for the quarter and year, respectively. In contrast, the S&P/ASX Small Ordinaries, helped by a bounce back in resources (small miners), gained +8.5% for the quarter to lift the year end return to +7.8%. Smaller capitalised companies remain in good shape to continue their rebound as conditions improve and policies become less restrictive in 2024.

International equities

International equity markets followed the same route during the quarter as the Australian market but not with the same vigour as returns were subdued by a pullback in the “Magnificent Seven” and poor returns from the world’s second biggest economy, China. Much like Australia, central banks around the world, and in particular the U.S. Federal Reserve, began to soften their approach to further tightening (interest rate rises) which meant by the end of the quarter, markets were implying the Fed funds rate would be cut as early as March 2024, with the prospect of six 0.25% reductions in 2024.

In USD terms, the S&P 500 ended the quarter up +11.6% and returned an impressive +25.7% for the calendar year, whilst also reaching its highest level since January 2022 in mid-December. Off the back of thematic forces, thanks in large to that “Magnificent Seven”, the tech heavy Nasdaq recorded +13.8% for the quarter and a magnificent +44.6% for the year.

At the sector level, the quarter ended with no great surprises as the best performers were led by Information Technology +17.2%, +57.8% for the year and Communication Services +10.9% and 55.8% for the quarter and year, respectively. Energy -6.9% and -1.3% was the only sector to post negative returns for 2023 however it was the only positive performer in 2022, returning circa +60%.

For one of the very few times over the past 12-24 months, the Australian dollar gained ground on the USD rising approximately (+5.8%) for the quarter, providing a kicker in returns for hedged strategies.

In Australian dollar terms, for the quarter and calendar year respectively, the broader global equity market (MSCI All Countries World NR AUD), gained +5.0% and +21.5%; Eurozone equities (STOXX Europe 600 NR) rose +5.3% and +19.1%; UK equities, FTSE 100 TR, continued to drag itself off lows and show some resilience, rising +1.1% and +13.7%. In Japan, rising sentiment and corporate earnings helped the Nikkei 225 Average TR report a strong return of +5.4% and +21.8% for the quarter and year.

Emerging Markets (MSCI EM Index) continue to lag developed markets as the Chinese equity market continued to struggle. The benchmark returned +2.0% for the quarter and +9.2% for 2023; The MSCI China TR index fell a disappointing -9.4% for the quarter and -11.6% for the year.

Outside of China, EM Latin America +11.2% and +31.9% and EM Europe +6.8% and +29.0%, both performed well led by Brazil, Peru, Hungry and Poland.

Although broader EM provided a solid enough absolute return, relative performance continues to lag that of developed markets. This remains frustrating for even the most patient of investors. Emerging markets however remain relatively cheap to developed markets. Some EM central banks have already started to loosen monetary policy (Brazil, Hungary, Poland) which may be the catalyst required, as is recent U.S. dollar weakness.

Property & Infrastructure

Real Estate felt the full brunt of the September quarter and October sell-off as the ongoing lift in real yields hurt the sector harder than broader equities. Although property valuations were already at sizeable discounts, the surge in real yields since August saw the sector decline a further -5.8% in October after dropping -8.6% in September.

The substantial bond rally in November & December could not have come at a better time for the sector with the S&P/ASX 200 A-REIT TR Index recovering to post a healthy return of +16.6% for the quarter and end the year up +17.6%.

Global listed property also suffered at the hands of rising global real bond yields. Headwinds are in line with the domestic market as well as ongoing concerns regarding China’s overall property market and lingering Covid headaches. Bad debts, delinquencies, and potentially higher finance costs will be key issues/headwinds. Balance sheet strength, attractive valuations and relatively high-quality income yields continue to provide a counterbalance.

The benchmark FTSE EPRA Nareit Global REITs TR index rose +9.3% for the quarter and ended the year up +10.2%. The hedged quarterly return assisted by the appreciating Australian dollar gained +12.2%.

The infrastructure sector also fell victim to rising real bond yields. Increased earnings and fundamentals unfortunately were not enough to save the sector in 2023 with the sell-off in yields during the quarter helping save the sector from posting a negative annual return.

The FTSE Global Core Infra 50/50 index rose +5.1% for the quarter, +2.5% for the year whilst the hedged equivalent posted a currency enhanced quarterly return of 8.8%.

2023 performance was driven by Transportation (post pandemic recovery), with Utilities being the unfortunate disappointment, due mainly to rising inflation, rates, climate event restoration costs and energy transition capital expenditure.  

Bonds and Cash

The December quarter started off in horrendous fashion for bond markets as US Treasury prices hit their lowest level since 2007, with yields hitting 5% for the first time in 16 years. That all changed in the early parts of November as cooler than expected inflation data buoyed financial markets with bonds making a strong comeback after several months of poor performance. The broad asset class marked its best quarterly performance in over 20 years.

The major driver of this performance was a perceived shift in monetary policy direction, from a “higher-for-longer” stance to prospective rate cuts as early as Q1 of 2024.

Bond yields proceeded to fall sharply as the yield on the U.S. 10-year Treasury fell approximately 0.60% in November, reaching a low of 3.76% in December before closing the year at 3.89%. Major economies such as the UK and those in Europe were also receiving positive inflation data whilst Australia’s recent inflation reading in November, 4.3%/year, continued the downward trend which had begun in Q1. The 10-Year Australian Treasury yield started the quarter at 4.47% and after hitting a 12-year high of 4.95% in late-October, followed a similar path to many developed countries, falling away sharply to finish the year at 3.94%. Central banks seemed to be winning the war on inflation however warning higher rates will remain in place for extended periods should inflation remain “sticky”.

During the quarter, the US Fed left rates unchanged (5.25%-5.5%), whilst the RBA, with the introduction of a new governor, made one change in November, raising rates to their current level of 4.35%.

The final two months of the quarter saved the year for the sector. Australian treasury bonds (Bloomberg AusBond Govn 0+Yr) rose +3.99% for the quarter, +4.83% for the year, underperforming Global Treasury bonds (Bloomberg Global Treasury TR Hedged) +4.93% and +4.96% for the year.

Regional credit markets also appreciated the positive news as recession concerns subsided and confidence of a soft-landing increased.  Global credit (Bloomberg Global Agg Corp TR) returned a very healthy +5.43% for the quarter, +5.43% for the year in AUD whilst the Australian corporate market, Bloomberg AusBond Credit 0+Y TR AUD, rose +3.18% for the quarter, +6.82% for the year. Investment grade credit outperformed higher yielding credit.

Most currencies appreciated against the US dollar during the quarter for the first time in many quarters. The DXY, which measures the strength of the USD against a basket of major currencies, fell -2.1%. The AUD recovered late to end the quarter at 64.34cents. As recession fears subside, and confidence increases going into 2024, we could possibly see the AUD continue to appreciate against the USD.

Quarter In Review – December 2023

A bumper quarter for markets following an exceptional November and December. Incredibly, this followed on from a very poor October and a weak August and September, as investors tried to get their head around the ever-changing inflation and central bank outlook whilst almost cheering on the “soft landing” path.

Inflation data was mixed for the quarter both within and across countries and regions. Inflation continued to fall quickly in the Eurozone, whilst US inflationary pressures seemed to get stuck before again making more in-roads downwards toward target. A combination of a smaller fall in Australian inflation and continued economic resiliency (wages, retail sales) forced the new RBA governor’s hands in pushing through a rate increase that caught many by surprise.

That change in sentiment and expectations, along with concerns regarding US government debt levels (and hence bond issuance volumes) pushed government bond yields significantly higher to levels not seen for more than 15 years! That sort of sudden move saw bond prices take another leg down along with yield sensitive / proxy assets like property and infrastructure also hit hard. Equities weren’t immune from the downturn with many investors concerned that central banks may have to maintain higher rates for longer and/or until something breaks. That saw the Australian dollar fall sharply thus buffeting unhedged global equity returns, outperforming the local market.

That all changed, almost on a dime, with bargain hunting investors coming back into the market to pick up higher yields on bonds and value in equities, property, and infrastructure which looked oversold following a poor showing in the September quarter. Fuel was added to the fire in early November when the US spuriously printed October inflation at 0%, which investors interpreted as the taming of the inflation beast. This along with weaker economic data saw US and European central banks (potentially prematurely) call the end of their rate hiking cycles in early December giving investors added optimism to keep calm and carry on with the same exuberance.

This resulted in an incredibly strong finish to the December quarter with bonds and equities alike clocking returns usually befitting of an annual return over the last two months of the year. Australian equities were very ably assisted by a falling Australian dollar as investors began to anticipate an early start to the US rate cutting cycle and expectations of more rate cuts in 2024 also rose. Property returns soared as investors flocked back to one of the most unloved asset classes of the prior 12-24 months, with the sharp cut in rate expectations providing much needed relief for the asset class.

The Chinese economy remained in a weakened state, but it became clear in the December quarter that a potential floor had been found (i.e. data stopped getting worse), providing some optimism that the significant volume of small stimulus packages out of Beijing were starting to provide some cushion to the economy without patching over the ills of past stimulus campaigns. Still a long way to go for an economy that received no stimulus during Covid (unlike the West), that carries way too much debt, and is trying to shift its economic growth potential away from old China to new dynamic growth industries. Also, a good reminder that trade relations are critically important, and the health of your key trading partners is integral to your own economic growth prospects.

The quarter ended with improved risk rhetoric out of economists, with continuing economic resiliency and falling inflation, increasing their odds of a potential soft-landing scenario whereby the economy slows to bring inflation under control but doesn’t slow enough to cause a severe and/or protracted recession, helped by central banks threading the finest of needles to bring about an environment not achieved too many times throughout history.

The quarter wouldn’t be complete without conflict, geopolitical developments, and surprise political results. Early in October, we saw Middle East tensions rise following an attack on Israel by Hamas militants, which threatened to bring other actors into the conflict, namely the US and Iran. The folly that has become the US government averted two government shut-downs whilst the House went speaker-less for three weeks, effectively paralysing one branch of US government. There was a shock in Chinese President Xi’s visit to the US where he was welcomed with open arms by the Biden administration, State governors, and US corporates with key Chinese manufacturing operations. The trip provided some clarity of the critical nature of US-Sino interdependence and that both countries may need each other more than ever before. Lastly, there was new political leadership in Argentina (a libertarian in Javier Milei) whilst the Netherlands also look likely to get new leadership given their election results.

Outlook

The strong positive swing in investor sentiment is likely to continue until a roadblock stands in the way, likely to be a flurry of realism – i.e. central banks talking down the prospects of early and significant rate cuts; a poor company reporting season; and/or signs of that economic resiliency waning. In light of this, some caution whilst remaining vigilant appears to be a suitable mantra for 2024.

Given the heightened risk-adjusted returns on cash and bonds remain, we believe some level of portfolio de-risking has been and may continue to be prudent, particularly after the strong returns in 2023. Portfolio de-risking can take many a form, and whilst history is usually a great guide, the last three years have clearly shown that we live in unusual times. Flexibility and pragmatic decision-making will be key as the year unfolds.

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