2022 was a momentous year for Joseph Palmer & Sons, as we celebrated our 150th year, moved office, and contended with elevated financial market volatility and a rapid increase in interest rates. Thankfully some of the market and economic obstacles – notably inflation and supply chain disruptions – had begun to ease by year-end such that the outlook for 2023 is beset by fewer uncertainties.
A key feature of 2022 was the rapid rise in interest rates, the Reserve Bank of Australia (RBA) having raised its reference rate in eight successive months. The purpose of this aggressive policy tightening is to dampen consumer and business demand, and thereby help arrest spiraling consumer price inflation. Indubitably this will happen, so a slowdown in economic activity is regrettable but inevitable, the question of course is by how much.
An unfortunate trend of late is breathless hyperbole and exaggeration in media reporting. Presumably sensationalism and tagging everything as ‘breaking news’ is deemed strategically necessary for media outlets’ self-interest. Anyway, there’ll be lots of dramatic reporting about forthcoming recessions, financial calamities, and any number of topics of woe in 2023, much of which should be considered with discretion. Yes, there will be a slowdown because of higher interest rates, and yes there is the other side of the money printing/government debt hill to navigate. But there is good news too – employment is strong, wages are increasing, household wealth is high and our agricultural and mining industries are underpinning a strong terms-of-trade position. We encourage clients and investors to be pragmatic when assessing the future, as we are, and have reasonable regard to all relevant factors.
One lingering area of uncertainty is the war in Ukraine, which we hope ends soon for the sake of the suffering of the disaffected people.
Assuming no major extraneous events, our outlook for 2023 includes an expectation of further volatility in share markets (but no significant or lasting decline), some further modest rises in interest rates, but a pause by mid-year, and some oversupply pressures in commercial and residential real estate. 2022 had many political events (including the Australian election, US mid-terms and the Chinese 20th National Congress), but 2023 has very few, though we’re on the lookout for our budget in May as it will likely contain some revenue raising measures.
Australian Shares
The Australian stock market, as measured by the S&P ASX200 Index, rose by 8.7% in the December quarter, recovering some of the losses of previous quarters. For 2022 the market was down 5.5%, or down just 1.1% when dividends are included.
This was a sound result for Australia relative to more significant declines elsewhere. The variation in sectoral performance was dramatic. Energy sector shares were up 39.7% in 2022, utilities up 24.2% and materials shares (including mining) up by 4.8%. The laggards were consumer discretionary shares, down 22.7% and technology shares, down 34.3%.
Clearly the turmoil in energy prices and markets globally had a net positive outcome for Australian share investors, though we caution that this won’t likely recur in 2023 as some commodity prices have already fallen sharply.
One constant with Australian shares is dividends, which rarely vary from approximately 4%, a notable exception being during the pandemic period. Dividends have now reverted to near normal, with some exceptional payouts from mineral and energy companies, and a recovery from pandemic affected payouts elsewhere. Commonwealth Bank, for example paid $2.10 per share in September, close to their highest ever payout of $2.31, and a big improvement on their miserly $0.98 distribution in September 2020.
Three distinct market volatility phases occurred last year. Firstly, the Russian invasion of Ukraine destabilised markets (particularly commodities) in February, then mid-year (and again in September) rising inflation and bond yields spooked investors and caused a rapid though temporary decline in share prices. When interest rates rise so too does the hurdle for share valuations to overcome. The relevant interest rate is the long-term bond yield, often referred to as the risk-free rate. When an investor can get a decent return from a risk-free bond (or term deposit), shares with more uncertain profit trajectory are often priced lower, to reflect the investor requirement for risk compensation. This phenomenon has certainly been apparent in technology shares as investors who hitherto had priced in unbridled growth whilst interest rates were close to nothing, ran for the hills when rates rapidly rose, and growth rates proved illusory.
Global Shares
In the December quarter the MSCI world stock market index rose by 9.4%, a pleasing recovery from the carnage of previous months, but for 2022 the world index fell by 19.5%, representing the worst year since the 2008 GFC.
The United States stock markets had a tumultuous year with extreme sectoral divergence, from positive 64% in the energy sector (Exxon Mobil, Chevron etc.) to negative 40% from the technology, discretionary and communications sectors (Meta/Facebook, Amazon etc.) The NASDAQ share index, (which contains lots of technology related stocks) fell a whopping 33%, as frothy market valuations were found wanting when interest rates rose. Moreover, the supposedly bulletproof technology titans started to lose their profit growth momentum and suffered significant share price falls. Inevitably (and perhaps already) such share price collapses overreact, and rebound sharply. It is likely that some of the better US discretionary and technology stocks deliver strong investor returns at some point this coming year.
The unsurprising collapse in many cryptocurrency investments and the unveiling of widespread frauds and scams amongst some so-called exchanges and platforms added to investor woes in 2022. Whilst we avoided such speculation there was inevitably some rub-off onto main stream investments.
European stock markets also fell in 2022, beset by a combination of rising inflation and interest rates, the Ukraine crisis and volatile energy supply and prices. European economies have contracted sharply and will likely remain weak during 2023. The European Central Bank and domestic authorities have provided monetary and fiscal stimulus but are now inclined to back off for fear of intensifying inflation. Lower share markets in Europe have created some pockets of excellent investment value.
The Bank of Japan is the last of the major central banks to (doggedly) persist with yield curve control measures. In December they caught the market by surprise by raising the tolerable band for 10-year Japanese bonds up to 0.5%, from 0.25%. This seemingly minor adjustment caused ructions in financial markets, illustrating just how fragile markets can be in times of uncertainty.
Property Securities
The prices of listed Real Estate Investment Trusts (REITs) rose by 9.7% in the December quarter, making the 2022 cumulative decline 24%, one of the worst sectors of the market. Distribution (dividend) payments have been reliable, and the sector now carries an average yield of nearly 6%.
Property investments are very sensitive to movements in interest rates for a few reasons. Firstly, the shares (REITS) typically have high dividend (distribution) payouts, reflecting their typical part-trust structure. Hence the distribution yield needs to be higher (and share price potentially lower) when comparative interest rates rise. Secondly, REITS tend to be leveraged, using debt to fund property acquisitions and developments. Hence higher interest costs when debt is refinanced can crimp their profitability.
However, REITS have the attraction of being underpinned by fixed real assets, which provide a defensive characteristic, and many leases have CPI increments, which protect cashflows from inflation. The key valuation metric is the funds from operations – real cash receipts – to which the stockmarket seems to have taken a worst case outlook, presumably due to increasing vacancy rates during an economic slowdown.
The REIT sector can be split into the various property types. Industrial properties such as warehouses and distribution centres have been popular investments in recent years due to the growth in ecommerce. Goodman Group is the industrial leader but has suffered a large share price decline – because of a previously excess valuation rather than any operating problem. Dexus is the leading office/commercial REIT and screens as an excellent investment, notwithstanding declining office occupancy. GPT and Stockland are large diversified REITS and these too offer excellent value, providing investors a broad spectrum of property exposure and a good distribution yield.
Residential property prices have gradually slipped in most cities and regions, partly due to lesser immigration and the slowing economy and the effect of higher mortgage rates. There is much conjecture about a calamitous fall in house prices on the assumption that mortgagees will struggle with higher repayments, particularly when low interest fixed-rate loans revert to higher variable rates. To date there is little evidence to support this theory as household savings have been strong, and unemployment low. The Commonwealth Bank, the largest lender, reports consumer arrears and troublesome loan data quarterly, and their most recent observation (30th September 2022) actually shows an improvement in arrears, which is rather surprising. 2023 will reveal a deteriorating status which will probably lead to extra supply hitting the market, and further softening of prices.
Interest Rates
A key feature of 2022 was coordinated policy directional change by almost all central banks, with the notable exception of Japan. A rapid reversal of stimulatory settings (money printing and ultra-low and controlled interest rates) precipitated a rapid shift upwards in interest rates, both short term and long.
The stated purpose of the policy change was to stymie rampant inflation. However, an unstated reason was a (belated) recognition that governments and central banks simply can’t keep loading themselves with debt and money-printed funded bonds forever, for doing so would create an inevitable financial catastrophe of epic proportion. So, its good that that policies are adapting, notwithstanding some short-term negative consequences of the higher interest rates.
Rising interest rates mean savers finally receive a return on their deposits. Cash bank account rates are now typically above 2.5% (from virtually nothing) and term deposit rates have risen to 4%, partly due to bank demand as they roll off their Reserve Bank stimulatory cheap funding. Investment securities such as bank hybrids and subordinated notes that pay dividends/interest linked to bank bills and variable rate bonds have also benefited from the higher rate. Investors in very defensive assets will receive decent interest with little risk in 2023.
Government and corporate bonds with fixed coupons suffered significantly in 2022, indeed one of the worst years in history. This is because of the mark-to-market effect of rising rates, amplified by the central banks reversing their artificially contrived low-rate settings. A bond that has a coupon of just 1.5% for example, loses market value if rates quickly move to 4%, which they did. Government bonds have become an attractive low-risk investment again now that rates have adjusted higher and are less controlled by monetary authorities. Defensive and income seeking investors can and should include bonds in their portfolio.
In 2023 the Reserve bank of Australia is likely to keep raising rates but will do so now with a wary eye over their shoulder, watching out for signs of deteriorating demand and waning inflation. The current rate of 3.1% will probably be raised by three or four increments of 0.25%, suggesting a rate of 3.85% to 4.1% by mid-year. Bonds will remain volatile, but with inflation and economic growth fading are unlikely to spike materially higher, in the absence of any material extraneous event. The US Federal Funds rate will also rise, probably above 5%, but markets will then start considering the timing of potential rate reductions, perhaps in 2024.
Outlook
It’s a difficult outlook to predict as there are some negative economic and profitability trends tugging one way, yet positive employment and savings and waning inflation tugging the other way. In such a scenario market prices can shift rapidly as the bullish and bearish waves variously gain their respective upper hand.
Expect market volatility in 2023 and expect periods of negative news. Be prepared to be active in portfolio selections, buying market or specific stock price dips and trimming during periods of strength. Stay abreast of prevailing interest rates and move your funds if your bank is not paying a proper rate.
Yours sincerely,
Malcolm Palmer
Joseph Palmer & Sons