Welcome to the Spring edition of On the Marc. In this edition, we will review markets for the first quarter of the 2024 financial year and consider the outlook for the foreseeable future.

Market update 

Global equity markets started off positively in July as constructive economic data reinforced investor expectations for a soft landing in the USA. GDP growth continued to surprise positively (versus consensus expectations), and inflation moderated further, with the main (PCE) price index slowing to year-on-year gains of 3.2% and 3.4% in June and July, respectively.

However, markets declined sharply in August and September to more than offset the positive early start to the quarter in July. The surge in long-term bond yields impacted investor sentiment.

Weaker Chinese economic data also weighed on markets, with credit growth, retail sales, industrial output and investment data all coming in below expectations and indicating a subdued post-COVID recovery.

The focus of markets over the quarter was the spike in long-term bond yields. Figure 1 below highlights the move in the U.S. ten-year bond yield, with yields increasing by 75 basis points (bps) to 4.57% at the end of September, a 16-year high. The Australian 10-year bond yield moved similarly, with yields up 47bps over the quarter to 4.49% at the end of September, the highest level since October 2011 (refer to Figure 2).

Consensus expectations at the short end of the curve have also shifted, with rate cuts in the USA expected to start in Q3 calendar year 2024 relative to expectations two months ago of cuts starting in early 2024. The shift in rates was driven by several factors, including a more resilient USA economy indicating that the Fed will likely have to maintain restrictive policy settings for longer, and an increase in bond supply with the US Treasury raising its quarter three preliminary borrowing plan by over 35%, to ~US$1 trillion.

There is also greater concern for the long-term health of the US economy, with the national fiscal deficit increasing alarmingly. Economists currently forecast that the surge in borrowing costs will mean that about 15% of US government revenues will be required to service the interest expense alone on its massive US$33 trillion debt.

The rate impacts have rippled through the broader economy with a spike in the US 30-year fixed mortgage rate to 7.5%, the highest in 23 years (Figure 3). US housing affordability is now at its lowest point ever, a substantial 13% below the worst level during the GFC (refer to Figure 4), and data from the Atlanta Fed indicates that the median housing repayment is ~44% of a household’s disposable income.

These factors will likely pressure economic growth and increase market volatility as investors continue to reassess their expectations for the economy, interest rates and corporate profits.

Australia’s GDP for the June quarter increased modestly by 0.4% quarter-on-quarter. Household consumption growth continued to slow as cost-of-living pressures weighed on real disposable incomes. The August monthly Consumer Price Index (CPI) indicator rose by 5.2% year-on-year, in line with market expectations.

The retail sector continues to be a major drag on confidence. Retail sales in Australia increased modestly in August and came in below market expectations as consumers cut back spending on food and clothing amid increasing cost of living pressures. Australia’s labour market remained steady in August, with the unemployment rate at 3.7%.

The Reserve Bank of Australia (RBA) continued to hold its cash rate steady at 4.10% as it took the time to assess the impact of the tightening it has already delivered. The board noted that although inflation in Australia has passed its peak, the focus is to return inflation to target levels within a reasonable timeframe and indicated that further tightening measures may be warranted.

Market returns for major indices

Below is a table showing the percentage returns of the major market indices to 30th September 2023.

The outlook for the year ahead 

Inflation and interest rates continue to dominate the narrative. In the USA, the Fed’s aggressive interest rate rises strengthen the US dollar, which has ripple effects worldwide. China is reopening its economy at a fast pace, while the conflict in Ukraine continues to have wider global implications. With interest rates expected to keep rising, the likelihood that the US and Europe will enter a recession is increasing. Still, it is less certain whether Australia will follow suit, given high energy costs and favourable conditions for commodities, although future rate rises could do some damage.

Immigration and population growth are likely to accelerate. These are key to underpinning Australia’s long-term structural growth and provide an additional cushion against recession. The businesses that tend to do well during inflationary periods are those linked to commodities (both soft and hard) and essential businesses with pricing power.

The opposite is true for companies with no pricing power or offering fixed-price contracts. Businesses such as contractors and building companies with fixed-price contracts and rising input costs see their margins significantly squeezed through inflationary periods. While sectors such as essentials (supermarkets, health care), materials, insurance and financials are likely to perform well, a more challenging environment should provide investors with an opportunity to invest in inexpensive, high-quality businesses with long-term structural growth.

Did you know?

Annualised net overseas migration declined from 247,620 in 2019 to minus 94,326 in quarter one of 2021 and has since risen to a record 454,361 in the first quarter of 2023. It averaged 218,131 in the ten years before the pandemic. This large increase has prevented Australia from entering a recession as more people consume goods and services. The below graph illustrates the record high level of immigration and the historically low level of permanent departures from Australia.

Final reMarc

We remain cautiously optimistic for the remainder of this year and into 2024. Share markets worldwide have pulled back in recent months, with the Australian market no different.

The key areas of interest to note include:

• Geopolitical tensions are at the highest level in years with the ongoing war in Ukraine and, in recent weeks, the Middle East turmoil.

• Interest rates appear to be approaching (or at their peak) as inflation heads in the desired direction.

• Pockets of low valuations in certain asset classes make for excellent buying opportunities among active managers.

• Central bank policy, inflation data and the outlook for China will drive fixed-interest markets.

• The risk of policy mistakes remains elevated.

For the above reasons, we believe active management remains the key to managing downside risk and providing consistent returns over time. This is expected to deliver more consistent returns over time than a passive approach.

"I don’t fear failure, I embrace it. It’s through adversity that we grow and learn."

Ang Postecoglou

Key Facts & Figures

1. The Australian Cash Rate was kept on hold in October at 4.10%.

2. The RBA Cash Rate is likely (77% chance) to remain on hold in November when the RBA next meet.

3. Our annualised inflation rate is 6.00%. This is well above the upper end of the RBA’s target band of 2 - 3%.

4. Australia’s unemployment rate is 3.7%.

5. The Federal Reserve cash rate is between 5.25% and 5.50% in the USA.