Welcome to the Spring edition of On the Marc. In this edition, we will review markets for the first quarter of the 2023 financial year and consider the outlook for the foreseeable future.

Market update 

Share markets fell sharply over the last week in response to another round of hawkish rate hikes pushing up bond yields and adding to recession fears and a threatened intensification of the war in Ukraine adding to worries. While inflation is showing signs of peaking in the US, it’s not enough for the US Federal Reserve (Fed), which hiked by another 0.75% last week and remains very hawkish. High inflation also drove rate hikes from numerous central banks over the last week – with another 0.5% hike from the Bank of England (BoE) which also remains hawkish, a 1% hike from the Swedish central bank and a 0.75% hike from the Swiss central bank. There were also rate hikes in South Africa, Norway, the Philippines, Indonesia and Taiwan.

The UK announced a large stimulus package that risks adding to inflation.

The commitment of central banks to bringing inflation down is good news, as a sustained return to 1970s-style high inflation would be very bad for economies, living standards, jobs and investment markets. The danger is that the Fed and other central banks have become locked into supersized hikes based on backward-looking inflation and jobs data, amid a loss of confidence in their ability to forecast inflation (at a time when they should be giving more attention to monetary policy lags). This increases the risk of overtightening driving a deep recession. We know in hindsight they were too slow to start hiking rates and the stimulus spending throughout 2021 has led to the necessary drastic increase in rates today.

The bottom line is that while short-term inflation remains high, these considerations are consistent with the US have reached peak inflation and point to lower inflation ahead, which should enable central banks to slow down the pace of hiking by year-end, hopefully in time to avoid a severe recession (except perhaps in Europe). If this applies in the US, then Australia should follow, as it’s lagging the US by about six months with respect to inflation. For this reason, while shares are likely to remain volatile in the short-term, we remain optimistic about shares on a 12-month horizon.

Five reasons why the RBA should be less hawkish than the Fed.

1. Household debt to income ratios in Australia is almost double US levels – at 187% in Australia v 102% in the US.

2. Household debt interest costs in Australia are far more responsive to rising interest rates – as most borrowers are on variable rates tied to the Reserve Banks of Australia’s (RBA) cash rate and the rest are on relatively short-dated fixed terms many of which mature next year, in contrast to the US, where most mortgages are 30-year fixed, so only new borrowers are impacted by rising rates. Combined with the first point, this means that a given sized rate hike in Australia will be more potent in slowing consumer demand than in the US.

3. Inflation is lower in Australia and is likely to remain lower.

4. Wages growth – the biggest single driver of business costs – in Australia is around half that in the US.

5. The Fed risks overtightening and causing a serious recession in the US and there is no logical reason why the RBA should do the same. But taking the cash rate to 4.15% by mid-next year (currently 2.35%), as the money market is assuming, may knock home prices down by as much as 30% and put the economy into a recession we don’t have to have.

In summary, the combination of Australian households being far more vulnerable and hence responsive to rising rates than US households, lower inflation pressures in Australia and a desire to avoid overtightening means that the RBA should not raise rates as aggressively as the US Fed.

The main argument for following the Fed is that if the RBA doesn’t, the Australian Dollar will depreciate resulting in an increase in demand for Australian goods/services leading to increases in prices and in doing so further stoke inflation.

There is merit in the RBA scaling back the October meeting rate hike to 0.25%, but it’s looking like another 0.5% is on the way (77% chance at the time of writing).

The below chart shows the change in the RBA cash rate over the past 25 years illustrating the increases in rates since May.

The Australian Bureau of Statistics (ABS) has decided to bring forward the release of its monthly consumer price index (CPI) Indicator to this Thursday (29th), with data for July and August. This is a very important event. The below chart shows monthly and quarterly inflation over the past four years.

The Australian fuel excise cut ends today, adding 25 cents a litre to petrol prices. The fuel excise cut in March made political sense ahead of the election, but was of dubious merit economically – it would have been better to use the $3 billion it cost to provide direct help to low and middle-income earners and it doesn’t appear, until recently, to have led to fuel prices substantially lower than what otherwise would have been the case.

In the interest of the budget and sending a long-term message to motorists to switch away from using petrol, it makes sense that it ends on schedule. The reversal of the cut will push average petrol prices up to around $1.90 a litre. Some service stations look to have already started to anticipate this and fortunately, global oil prices have been falling and so this may offset some of the impact.

Russia is in the process of doubling down on Ukraine after its recent successes. The mobilisation of conscripted Russian’s mobilisation would see up to 300,000 reservists called up, “referenda” in occupied territory aimed at annexing them as part of Russia and a reiteration of Putin’s nuclear threat. The former would amount to a major escalation and annexing could see Russia claim that any attempt by Ukraine to regain such territory is an attack on Russia. Of course, conscription comes with more risk of a backlash, but at this stage short of a change in the Russian leadership, this conflict, unfortunately, has a long way to go.

Coronavirus update - new global COVID cases and deaths are continuing to trend down (refer to the below graph). This includes Australia. Cases in China are low and trending down, but the risk of more lockdowns is likely.

Good news was received in the past week with the 2021-22 budget deficit likely to be $50 billion better than expected.

Property prices across Australia have come well off from January highs while rental listings in Sydney and Melbourne have dropped sharply helping to increase rental incomes for landlords as demand remains strong.

Market returns for major indices

Below is a table showing the percentage returns of the major market indices to 31st August 2022.

The outlook for the year ahead 

Shares remain at risk of further falls in the months ahead as central banks continue to tighten, uncertainty about recession remains high and geopolitical risks continue. However, we see shares providing reasonable returns on a 12-month horizon as valuations have improved, global growth ultimately picks up again and inflationary pressures ease through next year allowing central banks to ease up on the monetary policy brakes.

With bond yields likely at or close to peaking, short-term bond returns should improve in the coming year.

Unlisted commercial property may see some weakness in retail and office returns (as online retail activity remains well above pre-covid levels and office occupancy remains well below). Unlisted infrastructure is expected to continue to see positive returns.

Australian home prices are expected to fall 15 to 20% from top to bottom with a low in around twelve months. This is when markets expect we will see interest rate cuts as the economy struggles due to the impact of higher interest rates. This assumes the cash rate tops out below 3% but if it rises above 4% as the money market is assuming at present then home prices will likely fall by around 30%. The market’s expectation of rates is dynamic as illustrated below graph where there is only one month difference in the outlook for Australian interest rates.

The Australian Dollar is likely to remain at risk of further falls in the short term as global uncertainties persist and as the RBA remains a bit less hawkish than the Fed. However, a rising trend in the Australian Dollar is likely over the medium term as commodity prices ultimately remain in a super cycle bull market.

Did you know?

Since 1980 the average growth in property prices across Australian capital cities and territories are very similar with 6.29% at the low end (Perth) up to 8.08% (Melbourne). The below chart shows after large year on year growth there tends to be sideways periods more so than any significant year on year declines.

Final reMarc

Increasing interest rates and the war in Eastern Europe are major events however these are shorter-term events when looking at the bigger picture. There is one mega tailwind behind the Australian economy. That is, the Australian population is forecast to grow to 36 million by 2050. This will occur through immigration instead of a natural increase in Australian birth rates. An increasing population is central to a prosperous economy as it leads to higher consumption of goods and services. It also helps to ensure strong demand for housing as more people need a roof over their heads.

Looking at the bigger picture it is fair to expect growth assets will continue to do well over time as they have in the past. There will be disasters and catastrophes along the way however we need to keep top of mind humans react much stronger to negatives than positives. The negatives are what the media tends to consume us with.

We continue to position client portfolios with managers that have the ability to reduce some of the downside exposure resulting in smoother returns over time. It is pleasing that most of these managers have achieved this throughout the 2022 calendar year.

"I will tell you the secret to getting rich on Wall Street. You try to be greedy when others are fearful. And you try to be fearful when others are greedy."

Warren Buffet

Key Facts & Figures

1. Australian Cash Rate has increased in five months from the record low of 0.1% to 2.35%.

2. The RBA Cash Rate is poised to increase (77% probability) a further 0.50% in October to 2.85%.

3. Our annualised inflation rate is 6.1%. This is above the upper end of the RBA’s target band of 2 - 3%.

4. Australia’s unemployment rate is 3.5%.

5. The Federal Reserve cash rate has risen from a record low and currently is between 3.0% and 3.25% in the US.