Welcome to the Summer edition of On the Marc. In this edition, we will review markets for the tail end of the 2022 calendar year and consider the outlook for the foreseeable future.

Market update 

There was no Santa rally this year as cautious investors had to contend with the faster-than-expected re-opening of the Chinese economy, central banks that continued to tighten monetary policy and a surprise from the Bank of Japan (BoJ). The result was developed market equities which were 5% lower over the month and the Australian share market down 3.3%.

The hawkishness of the U.S. Federal Reserve has its December meeting set the tone for markets, even as there is clear evidence that inflationary pressures are easing across large swaths of the developed world. At this point, there are no signs of a pivot from any of the world’s major central banks.

There has been one meaningful pivot by Central Banks in the past year going from injecting money into the economy to withdrawing it. The following graph illustrates the extent of their withdrawal of money from the system in order to tame inflation.

The Bank of Japan (BoJ) delivered a market shock in December by expanding the target band for its yield curve control policy. The move was small as the band increased by 25 basis points but the interpretation from the market was that even the BoJ was preparing to normalise its long-standing and extremely accommodative monetary policy settings.

China engineered a pivot of its own as the country undertook a series of swift policy changes towards re-opening, downgrading the status of the COVID virus and easing many of the restrictions on the local population, as well as international arrivals.

On the domestic front Australian households spent more across every consumer category except household goods in the 12 months to November, in the latest indication that retailers focused on furniture and appliances find themselves in a tough spot ahead of a broader spending slowdown.

The Australian Bureau of Statistics’ monthly household spending indicator, released this week, showed spending jumped 11.4% in the year to November 2022, a less significant rise than in previous months. However, spending on furnishings and household equipment declined by 7% (on the back of record spending in previous years during lockdowns).

In Australia, variable-rate mortgages account for about 65% of outstanding housing credit, according to the RBA. Only about 35% of mortgage debt is on a fixed rate, compared to about 55% in New Zealand. Some 90% of mortgages in the United States (USA) are fixed for 30 years. The dominance of variable rate mortgages is positive for Australia because monetary policy will have faster traction. In the USA increasing interest rates only impact new loans so the impact is less.

RBA research shows that if the cash rate reaches 3.6%, 15% of borrowers will experience negative spare cash flow. That is, their loan repayments will exceed their essential living expenses. This will be largely concentrated among low-income households and recent borrowers. Some of these borrowers will have savings or prepayments to draw on, but some will struggle to meet their commitments and will be at risk of default.

Market returns for major indices

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

The outlook for the year ahead 

Economists have varying views on how the competing forces will play out and events in the last year have shown how crystal ball gazing is fraught with difficulty.

Positively, unemployment is at a 48-year low of 3.4%, wages are picking up and the household savings stockpile is high. On the other hand, high inflation and soaring energy prices, rising interest rates and falling house prices will drag on people’s purchasing power. The fallout from these colliding forces will have a large bearing on what the Reserve Bank of Australia does with interest rates and ultimately determine the path of the economy in 2023.

NAB and AMP Bank are forecasting only one more rate rise while other banks and economists are expecting a few more. As noted above, given that 15% of households will experience a negative household cash flow with only two more rate rises, it is hard to see how several more increases can take place without crippling the economy and causing a moderate recession. Irrespective of what happens with rates in the first quarter of 2023 there is a general consensus that rates will be cut towards the end of this calendar year.

Goldman Sachs forecasts a 15% to 20% peak-to-trough decline in national house prices but expects the adjustment to be relatively orderly with few mortgagees falling into negative equity or default. Based on this forecast 2023 will see a smaller reduction in the residential property process as the bulk of the drop has already occurred.

Most market commentators are forecasting a further sharp sell-off in equity markets in the first half of 2023 and then a recovery to see prices around where they are today. The good news is the herd is normally wrong!

The Australian Dollar is in an upward trend and this is likely to continue over the medium term as commodity prices ultimately remain in a super cycle bull market.

Did you know?

The US has witnessed the steepest increase in interest rates ever. The following graph shows the record pace of interest rate increases in the US compared to the previous rapid tightening of monetary policy cycles. The 2022 rate changes occurred in only 8 months as shown in the orange line below.

Final reMarc

As evidenced in the index returns above, the Australian share market has held up relatively well when compared to most other nations. This is due to our economy’s large energy and material exposure. Our client portfolios generally have performed relatively well in the past year due to reduced or no exposure to the riskier shares that have fallen greatly. Portfolios are positioned to take advantage of sectors that are expected to perform well while our focus remains on managing volatility. This is achieved through utilising several leading fund managers with differing and specialised investment philosophies. When looked at as a whole, this results in less correlated strategies providing a lower level of volatility than traditional/index investments in growth assets.

The following chart illustrates the rotation away from growth companies (after an astronomical record low-interest rate fulled rally) is likely to have further to play out. Equally, industrials and mining stocks (value investing) are expected to have further upside.

As always, the key to long-term investment prosperity is keeping a long-term perspective and not getting caught up in the noise the media confronts us with on a short-term basis.

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Key Facts & Figures

1. Australian Cash Rate has increased by 3% in three months to 3.10%.

2. The RBA Cash Rate is may increase (66% probability) a further 0.25% in February when the RBA next meet.

3. Our annualised inflation rate is 7.3%. This is well above the upper end of the RBA’s target band of 2 - 3%.

4. Australia’s unemployment rate is 3.4%.

5. The Federal Reserve cash rate has risen from the record low and currently is between 4.25% and 4.50% in the US.