It’s good that we have such a strong mineral export industry, but a disproportionately large amount of our economic prosperity relies on just a few key commodities. Should demand for these abate we run the risk of a downturn. For reference, whilst bulk commodities have been strong some other mineral sectors had a dreadful year, notably lithium and nickel, the prices of which collapsed in 2023 due to excess stockpiles and oversupply.
In 2024 inflation will continue to subside, which means central bank interest rates will probably not rise. This is modestly positive for share prices, but heightened volatility will remain whilst geopolitical risks are elevated. Financing risks will be a feature of 2024 as governments, corporates, and households cope with significant increases in refinancing costs. Indeed, a primary ‘watch out for’ issue in 2024 is the refinancing of commercial real estate loans in locales that are suffering lower tenant occupancy and higher credit costs.
The market expectations for forward interest rates turned in late 2023 and are now indicating the probability of central bank interest rate reductions, particularly in the United States. Australian cash interest rates are less likely to fall until inflationary pressures further subside. There is an important difference here between the central bank cash rate and the market-influenced bond rate. The latter is the prime determinator of investment asset prices and may remain susceptible to refinancing supply pressures, even if the central banks start cutting short-term rates.
In 2024 more people will cast a vote in a general election than any year in history. Elections are being held for more than half the world’s populace, including Taiwan, Indonesia, India, Mexico, Russia, the United Kingdom, the European Union, and the United States. The US election will feature prominently in media, and may lead to some market volatility, particularly should Donald Trump secure the Republican nomination.
2024 will also see continued rapid technological development in machine learning and forms of artificial intelligence. Generative AI will feature more prominently in many business, political and social functions but AI may also cause cyber risks to become even more sophisticated. Scams and cyber risks are omnipresent, against which vigilance must be maintained.
The topic of excessive executive remuneration needs some comments as the difference between the remuneration of some senior executives of many large corporations and their average employee has become so stark that it is outrageous.
Now, effort and ability should indubitably be rewarded with promotion and higher pay, but chief executives now seem to be routinely rewarded $5m to $10m per annum even when the business lacks performance. Take Westpac (a good example, but there are many others), which has declared a maximum potential remuneration of $8.344m for its chief executive and more than $3m for a further eight executives in 2024. Westpac has a responsibility to various stakeholders – customers, shareholders, employees, the community, the environment and more. In recent years its performance has been average (at best) against these expectations. Westpac’s share price closed 2023 at $22.90. It was $22.49 at the end of 2005!
When a company spends unduly and excessively it comes from shareholders, the owners. It is reasonable that such excesses should be reemployed in the business or dispersed as dividends rather than rewarded to a small handful of senior executives. Should a shareholder agree with these comments you should vote against remuneration reports or express your views at a shareholders’ meeting, vociferously if necessary.
Australian Shares
The Australian stock market, as measured by the S&P ASX200 Index, rose by a pleasing 7.7% in the December quarter and by 7.8% for the 2023 calendar year. Dividend payments were higher in 2023 and added a further 4.6% to investors returns.
The improvement in share prices came in the final quarter, triggered by a US interest rate projection about-turn. Long bond yields touched 5% in Australia then promptly fell more than a full percent, causing a rapid reallocation of funds to shares.
Within the market subsectors energy, healthcare and banks had a lackluster year, as did the consumer staple sector. Bulk commodity mining, technology and consumer discretionary stocks were amongst the better performing sectors. There was little corporate activity in the form of new listings, but plenty of merger and acquisitions action.
The effect of higher interest rates will feature regularly in company reporting this year. Many companies astutely locked in very low funding costs during the RBA induced period of ultra-low rates. Many of these cheap loans will soon need to be refinanced, at rates significantly higher. The big four banks must reset at a materially higher cost the last tranches of their ultra-cheap 0.1% term funding facility. The private credit sector is promoting 8% to 12% rates, which might be good for debt investors but rather alarming otherwise. This corporate (also government and household) refinancing burden represents a key financial market and economic constraint in 2024.
Australian shares had a tremendous couple of months, driven by a sense of relief about abating inflation, lower bond yields and reasonable profit and dividend expectations. The higher prices have reduced the value opportunity that existed last year. Prospectively, average dividends should rise in 2024 and our assessment of market fair value points to higher prices, but only modestly. The market should remain buoyed whilst confidence persists but will likely have to cope with various risks and events that inevitably trigger periods of greater volatility.
Global Shares
In the December quarter the MSCI world stock market rose by 11%, and for the 2023 full year was up by 21%, fully reversing the awful performance of 2022. The strong recent market performance was driven by a handful of names, including those US stocks dubbed the magnificent seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla) which collectively rose by more than 60% in 2023. This group benefited from the strong investor demand for artificial intelligence and technology growth exposure. Such relative outperformance is not likely to recur this year.
Most developed market central banks have finished their interest rate rise cycle, the notable exception being the Bank of Japan which has persisted with its ultra-loose yield curve control policy. The plateau in rates is seen by the stock market as a precursor to reductions which provided the catalyst to higher share prices in the closing months of 2023.
Asian share markets generally disappointing in 2023, particularly Hong Kong and China. However, the Indian and Japanese markets were strong. Singapore is a market that screens prospectively on both macro and valuation grounds so is an appealing investment target.
The Hong Kong stock market fell 13.8% in 2023, its fourth consecutive annual decline. Hong Kong investors have faced a myriad of issues; the pro-democracy clampdowns, more regulatory intervention, a particularly tough COVID period and a lessening of global relevance of some of their (and China’s) technology leaders. Hong Kong is the only significant stock market to trade on single digit price to earnings multiple, on a cyclically adjusted basis. Their shares are very cheap and are unlikely to suffer a fifth consecutive decline this year.
In Europe, the British stock market was the notable underperformer, caused by a stubbornly weak economy and a lack of meaningful global businesses in growth sectors such as technology. Conversely French and German stocks performed strongly as did Italy and most other continental markets. The Danish company Novo Nordisk became Europe’s largest due to the success of its diabetes and obesity treatments.
Shares in the United States were driven higher by a resurgence in technology stocks, stirred by rapid development in generative artificial intelligence and associated industries. The tech-heavy NASDAQ share index rose a spectacular 43% in 2023 (having fallen 33% in 2022). It’s hard to now see good value in the US as the market is trading at higher than its long-term multiple despite elevated bond rates, which doesn’t make much sense. However, we will retain a modest allocation invested in US shares due to the global dominant status of many of their companies. US election campaigning may be an unusually large contributor to market volatility, particularly should Donald Trump attain the Republican nomination. We’ll be watching long-term US treasury bonds as policy pronouncements that may worsen the US’ fiscal deficit could cause a spike in yield and trigger stock market volatility.
The outlook for the international markets is satisfactory, as a global economic slowdown is thankfully proving to be only modest. There are pockets of excellent value, and others overpriced, and an unstable and uncertain geopolitical environment. Hence there are plenty of ups and downs ahead for markets.
Property Securities
The prices of listed Real Estate Investment Trusts (REITs) rose by 15.1% in the December quarter, a sharp improvement from previously lower prices. REIT prices rose by 12.7% for the 2023 full year and distributions added a further 5%. The recent recovery reflects a lessening of unease about rising interest rates.
Employment is a driver of solid real estate outcomes. Australia’s job vacancy rate remains low, and employment high, leading to ongoing demand for space in retail, logistics, services and industrial property.
Commercial property landlords have not experienced such strong demand but have largely been prepared to accept realistic conditions by raising lease incentives to about 35 percent. These attractive incentives have been necessary due to the gradual increase in office vacancy, now averaging about 13% in Australia’s capital city CBD’s.
Valuation (capitalisation) yields have been rising in tandem with interest rates and occupancy demand. Commercial valuations have suffered as evidenced by Dexus, who reported a 6% decrease in the value of their properties for the six months to December 2023, and a 0.32% rise in the weighted average capitalisation yield for their office properties. Valuers are sensibly raising valuation yelds, but are doing so with a dearth of comparable sales data – sellers and buyers of commercial property are in a standoff period – sellers hoping for a stabilsation of conditions and buyers holding out for a bargain.
Interestingly, the stock market continues to price some REITs at a big discount to their underlying net assets. Take GPT for example, whose share price after a recent rebound is still about 20% below its asset value of about $5.80. In 2024 GPT should generate cash funds from its operations of about 31c per share and distribute 25c as a dividend, so its market price is still appealing, yet investors remain wary.
Housing is a big property (and economic) issue in the years ahead. A large uptick in net overseas migration plus natural population increase has added to demand for residential accommodation and is straining the rental market. It’s a perfect storm as strong demand has been met with weak supply. Construction businesses have suffered from high material and labour costs, and in some cases are unable to complete fixed-price contracts. Construction workers have more choice with many government infrastructure projects and mining jobs luring workers away from house building. Councils and government regulators have created a tangled web of red and green tape bureaucracy, regularly creating unreasonable obstacles to development and often hypocritically styming the very social good they perceive as their mandate. This has all contributed to a worrying strain on the residential market which will inevitably lead to even more government regulations and fix-it schemes.
Interest Rates
The process of normalisation of interest rates is largely complete. Australia’s cash rate rose to 4.35% from its RBA induced artificial low of 0.1%, and our long bond rate rose to nearly 5% in late October but has since eased to about 4.1%. Current rates should be considered as fairly standard, being a small margin over the expected trend in inflation. In the months ahead it would not surprise if rates neither rise nor fall by very much.
Inflation is a key catalyst for interest rates. There have been four distinct recent inflationary phases. Firstly, COVID lockdown of supply chains caused a significant spike in wholesale and consumer prices in 2020/21. Secondly, central banks went on a spending binge, printing money with abandon in the vain hope (they really should have known better) that inflation wouldn’t follow. Thirdly, Russia’s invasion of Ukraine caused a sharp inflationary rise in some commodity prices. The last and most recent phase is the rapid decline in inflation, as price pressures from these three factors are all now abating with pace. Indeed, China has experienced several quarters of negative inflation (deflation) which is an economic worry. It wouldn’t be a surprise if some quarterly readings in developed markets also print negative in the coming year, which would provide cause for financial markets to fret about the economic outlook but give central banks room to consider rate cuts.
Investing in government bonds has become more appealing due to the higher prevailing rates and a reflection of their low-risk status.
Bonds have become an important and rewarding component of an interest-bearing investment portfolio, now offering solid income with very low maturity risk. Bond interest rates are about 4% across most durations so offer a solid portfolio choice in the fixed income category. Some bond capital appreciation will accrue should market interest rates move lower. Term and cash deposits also offer decent interest rates, typically 4% for cash accounts and closer to 5% for longer-dated deposits. If you have a cash account that is currently paying less than 4%, change accounts or change banks.
Private credit has become a popular investment category. Essentially, this is a pool of investor funds loaned to a broad portfolio of corporations. These loans will usually be relatively short term (a few years) and carry some degree of collateral. The manager of the private credit pool will collect interest from their borrowers and pass it through to their investors, after extracting their (sometime significant) fee. Private credit is encroaching on banking territory, and thus will cause some competitive tensions. Investors in private credit pools are seeking high rates of return, the attainment of which requires the manager to charge high interest rates to the borrower. Herein lies the risk – to get an (after fee) 10% return the manager may have to lend to riskier corporate customers, some of whom may default.
Inevitably, in the years ahead, some private credit pool will fail or suffer significant losses, following which investors will flock to the regulator complaining about not having been informed of the risk. Readers of this report have been informed.
Outlook
The recent rally in share and bond prices has diminished the projected forward return prospect, at least for a short while. It feels like six months of return got compressed into a rapid-fire six weeks. Markets therefore are in pause mode, waiting for a direction setting catalyst, of which there are likely to be plenty of the positive and negative type.
We are watching interest rate and inflation trends, how central banks react, and the degree of ease by which borrowers manage to refinance maturing loans. We are also watching and worrying about geopolitical events, and the electoral mood and swings in the many countries heading to the polls this year.
Our stock market modeling suggests Australian shares to be approximately fair value on a risk-adjusted basis. Corporate profits and dividends should rise this year, so share prices should be positive in most markets, though not without bumpiness. Interest rates probably won’t rise, but from time-to-time the bond market vigilante perspective will prevail and cause sharp gyrations in long-term rates.