Investment & Economic Review October 2022

An easing of financial market unrest in July and August proved temporary as all major investment asset classes resumed their negative trend in September, driven by persistent inflation, successive interest rate rises globally, and the ongoing conflict and energy market stresses in Europe.

Central banks are rapidly reversing their COVID period emergency policy settings and have been unflinching in their ambition to raise interest rates to ward off inflationary pressures. Raising rates is not uncommon (it happens every cycle), but the current pace of change is rather startling. The Reserve Bank of Australia’s (RBA) board has met six times since May and raised rates on each occasion by a cumulative 250 basis points (from 0.1% to 2.6%). Compare this, for example, with the up cycle which commenced in early 2002 and took a full five years to achieve 250 basis points. The RBA is indeed in a hurry, and this clear urgency has contributed to the short-term dislocation of asset prices and currencies.

Of course, the RBA has good reasons to reverse policy. Firstly, the prior settings were understandably temporary, being positioned artificially low (in concurrence with Federal Treasury fiscal policies) to stymie the potentially damaging economic and social effects of the pandemic. Secondly, when there was a (close to) zero interest rate there is limited capacity to counter the next economic downturn, so rates need to be normalised to accommodate such. Lastly, it is incompatible that real interest rates (the prevailing interest rate less the inflation rate) remain negative. With demonstrable increases in inflation comes the need to normalise rates.

One immediate consequence of rapid policy change is the repricing of risk. Credit spreads widen, risk-free and capitalisation rates increase, and real asset (shares and property) prices generally fall. To counter, higher interest rates increase the running yield of interest-bearing investments, such that diversified growth and defensive based portfolios will enjoy a meaningful increase in investment income this coming year.

The global economic outlook has taken a severe hit, such that some regions (notably Europe) will report at least two successive quarters of negative GDP, (a common definition of recession). In the absence of a major geo-political event this economic decline is likely to be mild, and relatively short-lived, but nevertheless a burden on corporate growth and asset prices. In the US, consensus GDP for 2023 has been pared back to just 1%, from 3.5% previously, and an increasing number of forecasters are penciling in negative numbers.

Thankfully, in Australia our robust terms of trade (mostly commodity exports), low unemployment and high household and business savings should mitigate the extent of the global downturn and allow us to economically muddle through 2023.  

The Australian stock market, as measured by the S&P ASX200 Index, fell by 1.4% in the September quarter adding to the precipitous decline of the June quarter. For 2022 to date the market is down 9.6%, including dividends. A feature of corporate profits for the 21/22 year was the increase in dividends. The mining and energy sectors, bolstered by strong commodity prices, declared very large dividends, whilst other sectors, including banks, resumed higher payouts that had been sharply lowered during the pandemic.

The market has been particularly volatile this year due to a combination of factors, notably the spike in inflation and interest rates, the Russian invasion of Ukraine and its contribution to an energy crisis, and a general uneasiness about the economic outlook. There has been extraordinary divergence of individual stock performance, Woodside, for example up by more than 50% whilst some technology stocks plummeted by more than 50%.

Share prices are ultimately an accurate reflection of a company’s fundamental value, but from time-to-time markets misprice, both higher and lower, and we have endured some mispricing periods in recent years. It is usually speculation that drives some stocks unreasonably high, and fear that drives them too low. In the depths of the COVID period some technology stocks rose on the back of frenzied speculation, only to crash this year. At present market fundamentals are sound, yet some stock prices poorly reflect this due to investors fear of loss. Australia’s market price/earnings ratio (cyclically adjusted) is now lower than the long-term average, inferring an undervaluation. Moreover, our profit growth and GDP projections, whilst softening, remain positive. Add to this generational low unemployment, a terms-of-trade surplus, high household savings and improving business investment and its hard to justify share prices remaining low for much longer.

One way of assessing stock market value is the application of an equity risk premium, being the excess compensation return a share investor requires over a risk-free investment. The government bond yield is a good risk-free proxy, and in our assessment, prospective share returns are currently more than adequate on a risk adjusted basis. There will be further periods of volatility ahead but share investors should be looking through the short-term issues in expectation of improved returns next year.

In the September quarter the MSCI world stock market index fell by 6.6%, bringing the decline for calendar 2022 to -26%, representing the worst year since the 2008 GFC. The US Nasdaq Index (containing many technology stocks), continental European bourses (energy crisis & Ukraine proximity), and China (slowing economy) were the worst performers, whilst Britain and Japan were less affected.

In the United States the dispersion of relative performance is extraordinary – the technology and communications sectors down a whopping 30+%, but energy stocks up by more than 30%. This wide distribution of returns will quickly narrow; however, an interesting observation is that the inflation of energy prices and the resultant energy crisis (Ukraine war and underinvestment in supply) runs contrary to societal expectations of emission reductions and an accelerated transition from fossil fuels. Indubitably, this crisis will precipitate a more rapid conversion to renewable energy and associated capital investment, and a greater acceptance of the need for sensibly timed transition, including an ongoing demand for gas, liquefied and natural.

There are lots of underpriced shares in the United States at present, including many in the downtrodden multinational technology sector. Investors can increase their US market exposure, though be conscious of the weak buying power of the Australian dollar. The strength of the US dollar is one of the stark features of global finance in 2022, this strength driven by a global flight to quality and the aggressive interest rate rises initiated by the US Federal Reserve.

In Europe, the economic outlook is more obviously weakening, as the interruption to the supply of gas has exacerbated supply chain inflationary forces, leading to severe consumer cost-of-living pressures. The European Union will suffer a short recession, (as will the United Kingdom), which has already translated to reduced profit projections and weak share prices. Lower share prices create investment opportunity, and it’s clear that sectors and stocks such as some German industrials, Europe-wide healthcare, banks, and consumer discretionary companies are good value – however, investment timing is important as the negative outlook has not yet abated.

In Asia, the Chinese markets (both Hong Kong and Shanghai) have been very weak as domestic economic growth wanes, and their zero-COVID policy persists. The 20^th National Congress in China will likely precede a renewed stimulatory effort by authorities, and probably an easing of their COVID policy, which may quickly debottleneck supply chains and boost consumption – in other words Chinese shares will probably stage a strong rally in 2023. Markets in Japan and Singapore have been less volatile, and have exhibited greater certainty with better market governance, so it is these that have garnered most of our investment attention. The Bank of Japan has acted contrary to their global peers by not raising its cash interest rate (it’s been -0.1% for 6 years!), and regularly intervening in the market to maintain their policy target of just 0.25% for long term bonds. Their justification is the lack of inflation in Japan, just 3% compared to +8% elsewhere, caused by very high domestic savings from an aging and declining population. This interest rate policy gas kept the Yen low, making Japanese shares more price appealing to foreigners.

The prices of listed Real Estate Investment Trusts (REITs) fell by a further 7.5% in the September quarter, making the 2022 cumulative decline about 30%, one of the worst sectors of the market. Thankfully distribution (dividend) payments have held up, and the sector now carries an average yield of nearly 6%.

Whichever way we assess the REIT sector it appears underpriced.  Funds from operations, a key metric of cashflow, are generally steady, though under moderate pressure in the commercial sector. Most property valuations have held up despite higher interest rates, however increases in the capitalisation rate are inevitable, hence some lower real valuations in 2023. Many REIT’s are now trading at a very large discount to the tangible value of the underlying properties. GPT Group, a large, diversified property group, for example, disclosed last month a net tangible asset value per security of $6.26 per security, up 2.8% for the year, yet their security price has recently been about $4. This seems an unreasonably sharp discount and likely an overreaction to a property market that is soft, but not calamitously so.

Industrial property has been a popular (and highly valued) sector in recent years. This is partly due to the ecommerce boom, and the associated demand for big-box distribution facilities. Of late, there is some indication of a softening of capitalisation rates in this sector, hence peak cycle has likely passed. Large developers such as Goodman Group are still likely to be successful, but trusts that own industrial sites without development appeal are expected to suffer lower valuations.

The retail property sector recovery continues, with a pick-up in in-store shopping and a corresponding reduction in on-line shopping at the major malls. Most large malls in the major capital cities are now experiencing retail turnover higher than pre-COVID, so are recommencing development upgrades and expansions.

The residential property market has softened nationwide, but not yet by a meaningful amount. Demand from investors remains healthy and household balance sheets are generally sound. Meanwhile, there is little present indication of oversupply nor widespread loan arrears. However higher interest rates will have an effect, probably causing additional supply and the general price softening to persist into 2023.

Central banks of most major economies (Japan the notable exception) have continued their policy U-turn, now raising interest rates quickly and generally abandoning their COVID bond-buying and yield target support mechanisms. Modern Monetary Theory, recently so popularly espoused, is proving not to be the panacea. Inflation is the problem, having spiked so sharply due to COVID supply chain constraints and a lesser globalisation trend, exacerbated by the Ukraine war. Thankfully, core energy and food inflationary pressures have begun to wane, so further increases in rates should be at a gentler pace. 

The Australian Reserve Bank raised the cash rate in six successive months from 0.1% to 0.35% in May, 0.85% in June, 1.35% in July, 1.85% in August, 2.35% in September and 2.6% in October. This most recent raise was just 0.25%, suggesting a tapering of their aggressive monetary approach. The RBA noted that inflation remained too high, expected to be 7.75% in 2022, 4% in 2023 and 3% in 2024. They deliberated over the need for a 0.25% or 0.5% rise in October but settled on the lower number due to the wish to assess the effect of the prior larger rate rises, and the opportunity to review forthcoming global and domestic economic data.

The RBA’s interest rate setting has a direct impact on household and consumer loans such as mortgages. Banks passed through the rate increases to customers almost immediately, thereby curtailing credit growth and increasing pressure on household expenditures and budgets. Many mortgages have been set at fixed terms and rates in recent years. When these loans expire, they will likely be refinanced at higher rates, thereby adding to the contractionary outcomes the RBA is seeking to achieve.

The 10-year bond and 90-day bank bill rate have both trended higher – the bill to about 3% and the bond to about 4%. For investors, this is now good news as the capital hit from bond repricing is mostly behind us and the cash running yield is much higher. 

Government bonds, with their risk-free face value and coupons, have become a more appealing investment and should be a cornerstone investment in the defensive component of a diversified portfolio. Securities that pay variable interest with reference to the bank bill rate, and are of good credit quality, are also more appealing, as their distributions have increased materially.

Term deposit rates have steadily risen and are now over 3% for 6+ months. Term and cash deposits represent part of a banks funding mix, so the rates offered will sometimes vary depending on a banks specific funding need. Term deposits remain an appropriate and low risk investment.

We remain reluctant to invest in higher risk credit-based investments due to the possibility of a widening of interest rate spreads, and a general wariness about taking unnecessary risk. As always, if an interest rate looks too good to be true, it probably is.

Looking ahead, the Reserve Bank has indicated their preparedness to continue to raise short-term rates till its lower inflation and financial stability objectives have been met. This suggests a target cash rate of between 3% and 4% by the middle of 2023. Government bond prices will remain volatile, driven by changing inflationary expectations and treasury demand.