Australia’s Reserve Bank has become less forceful with its interest rate policy, pausing the cycle in April, raising by 0.25% increments in May and June, then pausing again in July. Supply side inflation, that is inflation of capital goods and commodities primarily caused by COVID related trade blockages, has unsurprisingly fallen, as bottle necked trade logistics ease. Inflation, once entrenched, has a habit of snowballing, such that services and consumer prices are now suffering from the increased price passthrough effect and higher wage growth.
It’s a conundrum for the RBA – should they persevere with their interest rate raise cycle and bluntly beat inflation (and the economy) into submission, or back off in the hope that they’ve achieved their ‘neutral’ rate setting and expect that economic supply and demand will find its own equilibrium. Irrefutably, the RBA’s actions have caused a savage hit to consumer sentiment.
One factor weighing on the RBA’s policy contemplation is the extent and pace of interest rate raises elsewhere. The US Federal Funds rate is now 5% to 5.25%, the Reserve Bank of New Zealand rate is 5.5%, and the Bank of Canada rate is 5%. Our 4.1% rate is low by comparison.
The risk-based investment markets (shares and property) have been staring down the central bank hawks. Shares had a good quarter (and indeed a good 22/23 financial year) whilst property values have largely been resilient. Markets seem to be pricing a goldilocks scenario, a bit of inflation (but not for too long) higher interest rates (but not too high), and an economic contraction (but not too severe). This is most notable in higher risk growth shares, which have rallied despite bond yields rising – but this doesn’t make a lot of sense so is likely to revert in the coming months.
Australian Shares
The Australian stock market, as measured by the S&P ASX200 Index, rose by 0.4% in the June quarter, exhibiting a little less volatility after a short bout of banking industry nervousness calmed down in April. The market rose by 1% for the quarter when dividends are included. For the 2022/23 financial year shares rose by 14.8% (including dividends) which was an excellent result, though it must be remembered that the period commencement last June was deceptively low following a sharp but short-lasting decline that month.
There are many factors that drive share prices, including economic and profit trends, investor sentiment, and the prevailing relative value, when referenced (in particular) to interest rates. Interest rates rose in the June quarter, by a full 70 basis points for the ten-year bond – just the scenario to trigger share price stress. Yet the technology market sector also rose sharply despite its reputation for being sensitive to rate movements. This was partly due to heightened interest in artificial intelligence, a bit of a rebound from a selloff earlier in the year and an understanding that technology has become a more significant and lasting component of the global economy.
Energy utility shares have risen as they benefit from higher wholesale prices, and their ability to pass through inflationary costs to customers. The energy sector, from upstream exploration and production to generation and distribution is in a state of flux, competing with more stringent regulation, a great need for significant investment in transmission infrastructure and societal demand for a more rapid transition to renewables. According to reports, we are well behind our 2030 target of 82% use of renewable energy which will create challenges and opportunities in the energy sector for years to come. The development emphasis is on firming projects, the process of smoothing electricity output when supply is intermittent, and filling out the transmission network and interconnectors to connect renewable projects, a massive task given Australia’s vast size.
Bank shares have lacked much momentum despite the industry’s profit margin being a beneficiary of higher market interest rates. Profit growth is being hindered by the likelihood of increased customer arrears and generally high operating costs. Shares in the retailing sector have been weak, particularly some of those that sell more discretionary items. There is an economic contraction underway caused by goods inflation and the consumption arresting mechanism of elevated interest rates.
Consumers are tightening their belts so retail businesses are likely to face tougher operating conditions for a while, which will crimp profit growth and share price prospects for this sector.
Global Shares
In the June quarter the MSCI world stock market index rose by 7.3% and a pleasing 16.6% for the 2022/23 financial year.
There were two distinct and contrary phases - a period of sharp volatility between June 22 and March 23, then a more sustainable rising period of late. Markets are now pricing a less troubled economic outlook, expecting a tapering of inflationary pressures and only a modest period of economic contraction.
The United States market was having a mundane phase but came to life in May as investors strongly embraced artificial intelligence and related shares, which powered a strong final quarter. But much of the recent strong performance can be attributed to just a few stocks, which highlights a lack of breadth and suggests that this rally will quickly run out of puff. The valuation conflict remains, as market prices contend with a considerable rise in the risk-free rate and economic activity is subdued.
European shares have recovered well, particularly in Germany and France where the energy price crisis that arose from the Ukraine invasion partially abated. The continuation of the Ukraine crisis is disturbing and tragic. A peaceful resolution is badly needed as the Russian authoritarian state is looking more fragile, which may lead to even more dramatic outcomes. Meanwhile, the European Central Bank has raised its reference rates eight times and has signaled further rises ahead. The ECB is following global trends, seeking to tame rampant inflation and to build some monetary capacity for the next economic cycle.
Asian markets have been mixed. Chinese shares had a relatively poor year as their reopening from COVID lockdowns was later than elsewhere, and their economic direction remains uncertain. Japanese shares have been strong in 2023, their economy generating far less inflation than elsewhere, and their large industrial and technology companies enjoying good demand.
Looking ahead, it’s hard to see a strong rally continuing, as interest rates aren’t falling any time soon. There’ll probably be more market volatility in the second half of 2023, the possible catalysts being a reaction to events in Ukraine, or a spike in bond yields. More generally, the inexorable rise in global sovereign indebtedness must have a reckoning, and when this time arrives market reactions should be expected to be severe.
Property Securities
The prices of listed Real Estate Investment Trusts (REITs) rose by 3.4% (including distributions) in the June quarter, and rose by 8.1% for 2022/23, a pleasing bounce back from the poor prior year.
Rarely has there been such wide valuation disparity between types of real estate. House prices, particularly detached dwellings in capital cities, have largely ignored the effects of higher mortgage rates and constrained houshold affordability. Meanwhile, CBD and suburban commercial propery valuations are slumping as occupancy rates decline. Property investment security (REITs) prices are widely dispersed. Some of those with portfolios of office properties have been trading at 30% or more discount to their most recently published asset value – the market expressing uncertainty as to how much further commercial real estate values will fall.
Dexus recently announced a revaluation of 175 of their 181 properties, which resulted in an overall decline of 6%. The value of their office properties fell by 7.7% whilst their industrial portfolio rose modestly. Dexus used an average capitalisation rate of 5.12%, (up by 32 basis points) reflecting higher market interest rates. Clearly, commercial valuations are weak, so stock market prices are placing more emphasis on the sustainability of rental cash receipts and (by consequence) the funds from operations.
Scentre Group, the operator of the Westfield centres, and other large format mall operators are enjoying strong operating conditions. Scentre reported 500 million visitations for the year, occupancy of 99% and record sales turnover in its stores. However, a slowdown in consumer discretionary spending is underway so mall operators are unlikely to see much more turnover growth for a while.
After weighing the pros and cons we think property REITs to be fairly priced, offering sound distribution yield and the prospect of good capital growth when the negative revaluation cycle ends.
Interest Rates
The Reserve Bank is taking a more watchful approach now that they have raised the cash interest rate twelve times to 4.1%. The yield curve, being the shape represented by the difference between shortterm and long-term interest rates, inverted recently, a sure sign that the higher rates are starting to bite economically. This, and the emergence of some waning of inflation have influenced Reserve Bank thinking, as has an understanding that continuous interest rate rises can have an unreasonably large effect on a small cohort of society.
Bond yields remain elevated, and moderately volatile. The Australian government ten-year bond, reflecting the long-term risk-free rate of return has been fluctuating either side of 4% for a year now. It is reasonable to surmise that bond rates have now normalised, and it is unlikely that the rate will move sharply higher (or lower) for a while. Investors therefore can include bonds in their portfolio, gaining reliable income from a low-risk asset.
There are many interest-bearing securities that pay interest at a margin above the prevailing bank bill rate. These include bank tier 1 and tier 2 (hybrid) instruments, various corporate loans and credit securities, and products that contain collections of these. Some of these securities, particularly those of the big four banks, offer excellent variable interest rates, and can form a component of a broad-based interest-bearing portfolio.
Term and bank deposits rates are also an attractive investment option. Banks need funding to replace the expiring RBA term funding facility so have been offering 4.5% to 5% rates for various terms.
Outlook
There are mixed market messages at present. Our key stock market modeling suggests shares are overpriced on a risk relative basis, but only by a smidgen. The economic outlook is weakening, unsurprising given the dual pressures of higher interest rates and elevated inflation. Interest rates probably won’t rise much more, but neither will they likely fall any time soon. Corporate profits will be a Source: Morningstar mixed bag, strong in some sectors including energy and commodities, but weaker for discretionary industries.
In this environment share investments should prove satisfactory, but not without some price volatility, perhaps sharp in some instances. We will carefully assess corporate profit results as they are announced next month and expect to increase our allocation to shares in the second half of the year. In the meantime, we are happy to hold excess cash and deposits as the applicable interest rates are currently appealing.