October 30, 2023

Market & Economic Update - September 2023

AUTHOR

Financial Keys

POST SUMMARY

The Australian equity market (as measured by the S&P/ASX 200) started the September quarter with a flurry but ended up in the red as the global “higher-for-longer” narrative (interest rates) coupled with the ever-increasing cost of living concerns caused consumer confidence to wane.

Australian equities

The Australian equity market (as measured by the S&P/ASX 200) started the September quarter with a flurry but ended up in the red as the global “higher-for-longer” narrative (interest rates) coupled with the ever-increasing cost of living concerns caused consumer confidence to wane.

The Australian market in AUD terms returned -0.77%, for the quarter.

The August reporting season was wedged in mid-quarter with results being generally in line with very modest expectations. Overall, the S&P/ASX200 Index suffered modest negative earnings per share (EPS) revisions (circa: -1.4%) but remained significantly higher than pre-COVID-19 levels, despite large and dilutive capital raising during the early pandemic period. The FY24 consensus EPS growth outlook now stands at -3.1% however, consensus expects earnings to rebound by +5.2% in FY25.

At the sector level, only three out of the eleven S&P/ASX sectors produced a positive return. Energy (+11.2%), off the back of a surging oil price and supply cuts, Consumer Discretionary (+5.3%), following surprise positive earnings revisions and Financials (+2.4%), more so non-bank optimism although bank balance sheets remain strong. All other sectors lost ground, led by Health Care (-8.6%), Consumer Staples (-5.9%), with both sectors facing rising cost pressures, and Information Technology (-5.8%).

Across the market spectrum, large companies significantly outperformed small companies. Although a modest reporting season for smaller capitalised companies, consensuses has small company earnings to grow at 10.0% in FY 2024.

International equities

An eventful quarter across international equity markets as a bright first half of the year was met with a sea of red in the third quarter. The quarter started brightly as confidence of a soft landing grew. Celebrations ended in August as surging bond yields posed the real threat of a longer life with higher interest rates. It then all came to a head in September as bond yields rose to levels not seen since the GFC, supply concerns caused a surge in oil prices, the magnificent seven A.I. hype began to fizzle out and the VIX, the universal measure of equity price volatility spiked.

The S&P 500 fell almost -5% in September, ending the quarter down -3.4%, whilst the tech heavy Nasdaq fell in similar fashion, shedding -3.9% for the quarter, in local currency. Energy (+12.2%) and Communication Services (+3.1%) were the only two sectors to record positive movement during the quarter. Laggards were led by capital intensive, interest rate sensitive sectors, Utilities (-9.4%) and Real Estate (-8.9%).

In Australian dollar terms, the broader global equity market (MSCI All Countries World NR AUD), fell slightly (-0.4%) for the quarter; Eurozone equities (STOXX Europe 600 NR), fell -2%; UK equities, FTSE 100 TR, off a much lower base and buoyed by rising oil prices, was one of few developing markets to produce a positive return (+1.2%).

Emerging Markets (MSCI EM Index) returned a flat +0.1% for the quarter but did manage to outperform broader equity developed markets. China growth concerns remain problematic as confidence continues to wane, but other emerging markets propped up the region with Eastern Europe and parts of Asia, particular India, remaining strong.

Property & Infrastructure

Real Estate followed the path of broader equity markets, at least in July and August, as the S&P/ASX 200 A-REIT TR Index posted a healthy return of +6.18. By quarters end, the S&P/ASX 200 A-REIT TR Index had posted a loss of -2.93%. The end result was not surprising as the steep rise in real yields hit REITs harder than most equity sectors during September.

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 as a result of the semi-banking crisis in the U.S., China’s overall property market and lingering Covid headaches. The benchmark index, (FTSE EPRA Nareit Global REITs TR), fell -3.57% whilst the unhedged quarter return suffered additional currency loses, falling -4.75%.

The infrastructure sector also sold-off (late quarter) as the sharp rise in yields also took its toll. This was not unexpected taking the capital intensive and long duration nature of the sector into account.

Performance was diverse across region, country, and sector with more interest rate sensitive sub sectors once again faring worse. The heightened volatility also contributed to quarterly losses. North American and European defensive utilities were the worst performing as was the Communication Services sector. The FTSE Global Core Infra 50/50 index (unhedged) fell -4.91% for the quarter with the hedged equivalent falling further at -7.16%.

Bonds and Cash

The September quarter started quietly as markets rallied off the back of more encouraging economic data - which boded well for a “soft landing” and potential rate cuts, as early as late 2023 – but quickly turned ugly as good news was suddenly viewed as bad, resulting in real bond yields reaching levels not seen since the GFC.  

The volatile swings in the bond markets made conviction, in any form, difficult, however several central banks began increasing their official cash rates after some brief pauses as prices continued to rise. The U.S. Fed and ECB both raised by 0.25% in July. Volatility was further exacerbated by the Bank of Japan’s (BoJ) decision to adjust its yield curve control (YCC) policy; The BoJ introduced a 1% cap on the 10-year Japanese government bond yield, leading to Japanese government bonds selling off in response. The People's Bank of China (PBoC) however continues to cut interest rates in order to stimulate its spluttering economy. The PBoC slashed the one-year medium-term lending facility (MLF) rates by 0.15% to 2.50% in August.

August began with a major bang as Fitch Ratings downgraded US government debt from AAA to AA+. Bond yields started to rise almost instantly as did volatility. The RBA left rates unchanged in both July and August perhaps recognising the higher short-term interest rate sensitivity of the Australian household. Australian yields as a result fell slightly in August relative to global treasuries resulting in some slight relative outperformance for the Australian market. Credit spreads however for both investment grade and high yield remained relatively tight as recession fears abated.

The 10-Year Australian Treasury yield started the quarter at 3.99% and after a tumultuous quarter, ended at 4.47%. An overall increase of 0.47%. Its highest level since 2011. The Australian yield curve reverted to normal shape (i.e. longer term yields higher than shorter term) in the September quarter however the curve remains fairly flat.

The 10-Year US Treasury yield remains inverted. Starting at 3.85% and ending the quarter at 4.58%. The resilient U.S. consumer continues to underpin the economy and although slowing down to a degree, the risks of a deep recession look remote based on current data. Both economies continue to battle rising and persistent inflation.

Australian treasury bonds (Bloomberg AusBond Govn 0+Yr) fell slightly (-0.60%) outperforming Global treasury bonds (Bloomberg Global Treasury TR Hedged) (-2.19%). Both indices falling off the back of spread widening due to persistently higher inflation, and the re-examining of terminal rates which could potentially be higher than initially expected.

Regional credit markets continued to provide mixed results due to their respective economic and company outlooks. Global credit (Bloomberg Global Agg Corp TR) returned a moderate (+0.30%) in AUD whilst the Australian corporate market, Bloomberg AusBond Credit 0+Y TR AUD, rose (+1.30%). Higher yielding credit continued to outperform higher rated investment grade credit during the quarter however the yield premium has reduced.

Most currencies depreciated against the US dollar during the quarter. On a trade-weighted basis the USD appreciated approximately 2%. The AUD was hit hard in August falling close to the 64-cent level, a 4% drop in the month alone. Falling close to 63.49c in September, it recovered late to end the quarter at 64.34cents. Risk aversion will continue to see the USD appreciate should global conditions continue to come under pressure however the Australia vs U.S. 10-Year yield differential will play a role in determining the relative value of the AUD.

Quarter In Review

The September quarter seemed to solidify calendar year 2023 as one akin to a washing machine – wash, rinse, and repeat. Again, interest rates and inflation were front and centre of market movements with short-term macroeconomic signalling / consensus (noise) changing every 30-45 days, attempting to second guess where inflation, rates, and the economy might land in 2024 following the fastest period of rate hikes ever seen.

Whilst most market participants correctly called peak inflation and likely peak interest rates (maybe 1-2 more) early in the quarter, given most central banks either slowed the pace of rate hikes or began to pause, conjecture began to rise as the pace and size of falls in inflation began to slow. This meant that the market narrative began to continually shift its focus to different themes including: inflation falling at a rapid pace; leading indicators pointing to impending recession; meaningful rate cuts coming next year; concerns of inflation getting “stuck” above central bank targets (and potentially reaccelerating higher); economy being on potentially stronger footing than previously expected; interest rates higher for longer.

These varying narratives have quite distinct market backdrops and hence portfolio playbooks, resulting in volatility creeping up through the quarter as investors readjusted portfolio settings to account for the changing consensus.

The implications of higher rates for longer in light of inflation remaining stickier than expected is an interesting dynamic and hence dilemma for investors – is this time different in that economic resiliency can be maintained; or do higher rates for longer eventually lead to a more meaningful economic downturn? We finally started to see the impact of higher rates and higher inflation in the quarter with cost-of-living pressures seen in the data, including weaker retail sales growth, falling household savings, excess discretionary spending capacity almost all gone, and borrowing costs catching corporates by surprise in terms of impacts to their bottom line.

In other economic developments, employment conditions remained strong in most jurisdictions, maintaining upward pressure on inflation, particularly in services. Residential housing market sentiment and hence prices began to reaccelerate higher on continuing tight supply, increasing immigration (Australia), and full employment with reasonable wages growth still coming through. This was in contrast to leading indicators still pointing to likely recession in the period ahead, or significantly weaker conditions at the very least (i.e. recession-like).

Economists and investors became ever more impatient with China’s economic woes as the country’s economic data continued to worsen with slumping household and business confidence / sentiment, very high youth unemployment, a still deflating housing market bubble, concerns that Chinese government overregulation would remain, and both foreign demand and capital flows slowing. The government continues to provide very measured and specific stimulus, prioritising stimulus volume over size, which provides incremental stability to the economy over a longer period of time rather than fixing any malaise with a big bazooka approach to stimulus – a play book that China has used regularly and aggressively over the last 20-30 years. However, the more current measured approach from Chinese officials has seen investors favour developed markets and other emerging markets (e.g., India, Korea, Mexico).

In the US, rhetoric from the Federal Reserve was increasingly more hawkish, putting another rate rise on the table for this year and dousing expectations of significant rate cuts in 2024.

From a market perspective, we saw both ups and downs for most asset classes given the changing dynamics discussed above. The A.I. / technology sector received considerable positive attention, with surging prices for anything tagged as being “A.I.” broadening into support for technology names. Corporate reporting season was mixed at best, with results coming in a little better than fairly weak expectations, whilst the limited guidance provided was generally weak with rising costs and slowing demand expected in the period ahead. Those companies with very low debt levels or no debt are clearly in enviable positions.

Oil prices surged higher in the quarter as supply was further tightened by OPEC and Russia, first temporarily and then more permanently, whilst demand remained resilient. Conflicts in oil/gas rich regions also pushed prices higher as investors fretted over additional supply shortages, whilst investment in new oil/gas fields remains constrained by the global push to renewable energy sources.

There was also weakness in the AUD/USD in the period as concerns regarding the Chinese economic outlook rose (negative AUD) whilst expectations of narrower interest rate differentials between Australia and the US were dashed (positive USD) as the higher rates for longer mantra took hold.

Outlook

Given the constantly changing consensus on the path for 2024, and the stark contrast between lagging and leading economic indicators, we are adopting a cautious and watchful approach to asset allocation, investment selection, and portfolio construction, as we continually digest updating data.

There are significant impediments for central banks to bring inflation back to target, most of which are outside of their control. That means two paths – either they continue tightening policy to force the issue sooner (economic destruction); or they roughly maintain their current tight settings and attempt to bring about a more controlled landing over a longer period. We think the latter path is more likely, but patience can wear thin, and inflation can have bouts of reacceleration.

We expect choppy conditions to continue until the economic path becomes clearer. We also expect economic weakness in the period ahead which means both risk and opportunity. Remember, the share market is not a reflection of the current economic landscape. We don’t think significant changes to portfolio settings are warranted but sensible adjustments may be necessary. We think that looking back on the months ahead from a future point in time, will again remind us of the opportunity these unique environments create.

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