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

Market update 

Investors will likely remember 2023 as a great year. The S&P 500 rose nearly 25%, all but erasing 2022’s bear market, as bonds also turned positive by year-end—a gift of the Fed’s policy pivot. But for economists, strategists and financial advisors, 2023 will be studied for years to come. On one level, history will perhaps record a simple narrative: “Inflation fell faster than expected, and forecasts for an earnings recession were defied, so stocks rose.” That, however, massively oversimplifies reality.

Many well-worn paradigms broke in 2023. Consider that it was the first time in decades that rapidly rising interest rates neither destroyed aggregate demand nor dented corporate profits. The US economy was essentially rendered rate-insensitive due to roughly 15 years of balance sheet repair and negative real rates (when inflation is higher than cash rate). Excess cash, turbocharged by fiscal stimulus, provided a much bigger cushion than anticipated. While punitive mortgage rates dampened homebuilding, structural imbalances supported house price appreciation.

In this environment, traditional recession indicators all failed, as models premised on variables like leading economic indicators, manufacturing surveys, bank credit growth, and yield curve inversion obscured economic strength based on vast excess liquidity. When, for instance, did bank failures not have a systemic impact? When in modern memory did a 550-basis-point rise in fed funds produce easier financial conditions? And when did doubling real rates not affect equity valuations? We point these out because current euphoria may be premised on no longer prevailing correlations. If rising rates were of limited consequence and only prompted the Fed to add net liquidity, could lower rates prove equally impotent?

The US 10-year bond peaked at a rate of 4.99% in mid-October, 2 ½ months ago, and since then, it has been one way, with the rate ending the year at 3.86%, a huge fall in rates, and a commensurate rise in bond prices.

Australia’s inflation rate is likely to be harder to bring under control, and the new RBA Governor is determined to make people understand that she will not let inflation stay high.

Nevertheless, the Australian 10-year bond has followed a similar path to many other countries, falling from a peak of 4.95% at the end of October to trading at a yield of 3.96% at year-end.

December was a strong month for local equities, with the S&P/ASX 200 rising 7% to end the month at 7590.8, effectively reaching an all-time high.

Part of this was definitely a catch-up in the context of stronger overseas equity markets, but also a big part of it was the strength in bond prices, with the Australian 10-year bond yield falling from 4.48% to 3.96% in just one month.

Market returns for major indices

Below is a table showing the percentage returns of the major market indices to 31st December 2023.

The outlook for the year ahead 

The macro-environment has been a key driver of Australian equities over the past year. The inflation outlook, interest rates and bond yields influence the varying performance of sectors during the year. With inflation continuing to slow, there is a plausible scenario that central banks could cut rates in 2024. The market is pricing this in, which has been a key driver of the strong performance of equities.

During the recent high inflation environment, companies have generally been successful in passing on price increases, which has helped protect margins. However, maintaining margins from here is likely to be more difficult as the cost of doing business for many companies continues to rise at elevated levels (especially wages and rent in Australia), with company pricing power diminishing as consumers become increasingly challenged with the higher cost of living and increased interest costs.

The recent rally in the stock market has the S&P/ASX200 entering 2024 at its 12-month high PE ratio, however market expectations for company earnings growth for 2024 are not demanding, and could even surprise on the upside due to buffers such as the impact from the spike in migration and big spending baby boomers. As the year progresses and it gets closer to the point of the first-rate cut, share prices will likely look through any economic softness, which could set the stage for another constructive year for the equity market overall.

Australia’s fourth-quarter CPI will be released next week on the 31st of January. Thanks to monthly data, we already know roughly two-thirds of the number. Expectations are for a 0.7% headline and 0.8% underlying quarterly outcome.

A three-month annualised rate would also see inflation near 3%, though rents in Australia are unlikely to provide the same relief as in the US.

Electricity subsidies (if and when they come off) are an added uncertainty in Australia. These softened the 20% price hikes down to only 10% in recent CPI numbers.

The hope is that falling wholesale prices might offset any removal of subsidies.

The RBA forecast of 3.5% inflation by mid-2024 looks reasonable.

Unlike the US, this would leave inflation still 1% above target, making the case for rate cuts more difficult.

But if inflation can stabilise closer to 3% in the medium term — as the current pulse suggests — then the need for tight monetary policy would lessen. The hope would be wage outcomes could then moderate from the current 4% levels.

Did you know?

Very few people would have forecast a 24% return for the S&P 500, and if they did, they certainly would have expected the Australian market to do better than 8%, in itself a reasonable return, and 12.4%, including dividends.

Much of the difference in return between the two markets can be traced to the extraordinary performance of the “Magnificent 7”. These mega-cap stocks, all listed in the US, had an extraordinary year:

1. Apple (up 53%),

2. Amazon (up 77%),

3. Alphabet (up 57%),

4. Meta Platforms (up 184%),

5. Microsoft (up 57%),

6. Nvidia (up 246%), and

7. Tesla (up 130%).

There were many reasons for their strong performance – strong underlying fundamentals, beneficiaries of the coming AI boom, seemingly immune from the vagaries of interest rates, and other reasons. What is clear, though, is that these 7 stocks inflated the performance of the US market, contributing roughly three-quarters of the total return in 2023.

The effect of this can be more clearly shown by the difference in the performance of the tech-heavy NASDAQ, which returned 44.5% for the 12 months, vs the Dow Jones (which largely contains the more traditional companies), which returned only 13.7% for the year.

In that context, the performance of the Australian market (i.e. with no ”Mag 7”), at 12%, has done reasonably well, albeit noting that the majority of this return came in the month of December.

2024 is also a US election year. Election years tend to be strong years for the S&P500. S&P500 returns historically were positive 83% of the time during presidential election years (only 4 out of the past 24 election years were negative, i.e. 17%).

Final reMarc

The overall domestic and global outlook at this point remains positive. The following are some of the key factors that will drive returns.

• How will AI affect things this year? The below chart shows AI investment in each of the past five years.

• The US presidential election is in November.

• Unemployment rates in the US. Australia is likely to remain around the current low levels.

• What will China do – it has had a weaker 2023 both economically and in equity markets with stimulus efforts not producing the fruits anticipated. What will be done in 2024?

• What will official central bank interest rates do? Will they come down as much as expected? A significant number of Central Bank rate cuts globally are already priced in, and markets could be disappointed if these don’t all come to pass. A possible warning signal for markets.

• Will the ongoing wars have an inflationary impact again, and will the wars broaden to include other countries? We only have to look at recent events in the Red Sea which are complicating shipping channels and significantly increasing the cost of transport (primarily for Europe) to understand some of the potential consequences.

• In Australia’s context, investors will be looking to see how inflation can be successfully controlled and what the economy does. On a per capita basis, we are already in a mild recession, which most of us feel. In a broader economic sense, the economy is still growing (slowly) but largely due to the enormous levels of immigration.

"It’s not a matter of can or can’t but will or won’t."

Anonymous

Key Facts & Figures

1. The Australian Cash Rate was kept on hold in December at 4.35%.

2. The RBA Cash Rate is likely (100% chance) to remain on hold in February when the RBA next meet.

3. Our annualised inflation rate is 5.4 %. This is well above the upper end of the RBA’s target band of 2 - 3%.

4. Australia’s unemployment rate is 3.9%.

5. The US Federal Reserve cash rate band is 5.25% and 5.50%.