Wealth Architects Quarterly Economic and Market Update September Quarter 2023
Quarter in review
Global equities advanced at the start of the quarter amid signs of easing inflationary pressures, resilient economic data, and growing confidence among investors that the Federal Reserve may have orchestrated a ‘soft landing’. However, this momentum was dampened after the Federal Reserve signalled that it’s likely to keep the benchmark interest rate high further into 2024 than previously forecast.
Tech stocks fell due to rising long-term yields after their bout of strength this year. Global energy stocks rallied due to tighter supply pressures and improving economic data. The FTSE 100 Index outperformed as the Bank of England’s rate pause pushed bond yields lower, providing relief for risk assets despite signs of slowing economic activity (Figure 1). Euro area bonds similarly rallied as the European Central Bank (ECB) paused its hiking cycle.
Broader risk-off sentiment and higher oil prices from an OPEC cut late in the quarter also hit emerging markets, particularly oil-importing nations, where currencies depreciated. A softer Chinese economy, broader U.S. dollar strength and the wider differential between the U.S. and Australian interest rates contributed to a depreciation in the Australian dollar. Australian equities declined over the quarter with Australian dollar-denominated international equities outperforming (Figure 2).
Economic and Market Outlook
Despite a sharp rise in interest rates, most major developed economies have avoided recession this year. But there are clear regional differences. The United States has been growing at a brisk pace, with growth still in line with the pre-COVID trend, boosted by the Biden administration’s USD 1.9 trillion stimulus package (see Figure 3).
Australia has also performed well, with high energy prices supporting mining companies and government revenues. The pace of Australian growth has however fallen below trend this year as households tighten their belts in response to cost of living pressures. The story elsewhere has been very different, with economies
in Europe flirting with recession since the start of the year, and China slowing considerably after a brief post-pandemic boom.
There is a risk that higher interest rates will trigger a recession in most developed markets, although the timing may be delayed as tighter policy slowly works its way through the economy. Historically, inflation outbursts of this magnitude have required significant rate hikes to bring inflation back in line with central bank targets and have typically been followed by recessions.
One key risk to the Australian outlook is the recent slowdown in China given the substantial trade relationship between the two economies. China’s slowdown has been driven by low business and consumer confidence, weakness in the property and construction sectors, and a smaller-than-expected policy response. Australia’s trade relationship with China is largely concentrated in the mining sector (see Figure 4), driven by China’s demand for exports such as iron ore and coal, which is significantly impacted by property and construction activities in China. As such, any further slowdown in these areas of the Chinese economy is likely to weigh on Australia.
As the economic picture continues to evolve, markets have remained focused on the path of interest rates. While markets are pricing in a ‘higher for longer’ rate scenario, there’s evidence that equity valuations remain stretched in certain markets, and it’s possible that company earnings will continue to come under pressure.
In the U.S. equity market, the majority of gains year-to-date were concentrated in growth stocks, where rising valuations were supported by relatively resilient earnings. Even as markets reprice, U.S. equity valuations appear stretched considering the macroeconomic environment (Figure 5).
Valuations are fairer for Australian equities, but given the near-term headwinds from China’s slowdown and tightening monetary policy across developed markets, earnings growth may struggle to match the strength of the past few years. However, sticky commodity prices could yet again prove to be an upside surprise for the resources sector.
Meanwhile, long-term bond yields rallied over the quarter as central banks signaled higher-for-longer rates, particularly in the United States. Upside risks for yields remain, with the potential for rate hikes beyond market pricing should inflation remain sticky. However, fixed income remains attractive relative to recent years
as higher yields and a recovering term premium mean improved compensation for holding bonds and a larger buffer against future bond price movements.
As market volatility and uncertainty persists, some investors may be drawn to cash securities, including term deposits, which offer liquidity and capital preservation, and have been buoyed by rising rates. However, while cash may seem attractive in the near term, there are risks for long-term investors, including inflation risk (the erosion of purchasing power over time due to rising consumer prices) and reinvestment risk (the risk that wealth is reinvested at a lower rate).
Over the long run, investors should expect fixed income to provide some term and credit premium over cash, and equities to provide a further equity risk premium driven by long-term economic growth. For investors with sufficient risk appetite and an ability to time markets, there may be opportunities. But for most investors, a prudent asset allocation and a long-term investment plan may present a better chance for investment success.
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