Economic and Market Updates - September 2022

Rampant global inflation and central bank activity. Energy costs soaring. Covid supply chain disruptions. There’s no doubt that 2022 has seen a significant shift in market outlook. Despite months of market volatility, things are still a long way from normal – and financial markets performance in recent days is testament to current investor uncertainty and response to economic data.

The following detailed analysis of the current financial markets, the drivers for recent sell offs, and opportunities is latest thinking from RJS Wealth Management on how markets are performing through this uncertainty.

Market Movements and Performance

• Last week financial markets sold off - ASX200 (-2.4%), S&P AREIT (-5.3%), S&P 500 (-4.6%), Euro STOXX 50 (-4.6%);
• That week extends the selloff that has already occurred month to date - ASX200 (-6.4%), S&P AREIT (-11.8%), S&P 500 (-7.5%), Euro STOXX 50 (-4.9%); (although at time of writing, markets are currently up today 1.7%);
• Medium and longer term returns (3 years+) remain much closer to long term expectations;
• Asset class returns to 26th of September 2022 are shown in the table below:

What is causing the sell-off? Market themes

• Hawkish central banks remain the key driver of the downside in shares. While inflation is showing signs of peaking in the US, it’s not enough for the US Federal Reserve (Fed), which hiked by another 0.75% and remains very hawkish. High inflation also drove rate hikes from numerous central banks over the last week – with another 0.5% hike from the bank and a 0.75% hike from the Swiss central bank (although these were both catchups). There were also rate hikes in South Africa, Norway, the Philippines, Indonesia, and Taiwan.
  
  
• While the Fed’s 0.75% hike to 3-3.25% was expected, its post meeting statement and comments were very hawkish (meaning they advocate for aggressive tightening monetary policy). The Fed’s interest rate expectations was revised up by 1% for this year to 4.25-4.5%, its inflation forecasts were revised up, its growth forecasts were revised down and its unemployment forecasts were revised up to 4.4% next year. While the Fed is not yet forecasting a recession, its forecast rise in unemployment would normally be consistent with one and it appears willing to tolerate a recession as its “overarching focus” is to bring inflation down to 2%. Fed Chair Powell said, “we will keep at it until the job is done.” To slow the pace of tightening, Powell wants to see a slowing labour market and more evidence inflation is slowing. Another 0.75% hike looks likely in November.
  
  
• The danger and risk to markets is that the Fed and other central banks make a policy error and tighten monetary policy too quickly and cause a severe recession.

‍

What does this mean for Australia?
‍

The Reserve Bank of Australia (RBA) has also been raising rates aggressively from close to zero up to its current rate of 2.35%. However, there are a number of reasons that we believe the RBA should be less hawkish than the Fed;

1. Household debt to income ratios in Australia are almost double US levels – at 187% in Australia vs 102% in the US;
2. Household debt interest costs in Australia are far more responsive to rising interest rates – as most borrowers are on variable rates tied to the Reserve Banks of Australia’s (RBA) cash rate and the rest are on relatively short dated fixed terms many of which mature next year, in contrast to the US, where most mortgages are 30-year fixed, so only new borrowers are impacted by rising rates. Combined with the first point, this means that a given sized rate hike in Australia will be more potent in slowing consumer demand than in the US;
3. Inflation is lower in Australia, at least for now.
4. Wages growth (a much stickier part of the inflation number) is running around half what it is in the US.

One of the most common questions we get from clients is where do you think Australian interest rates will rise to? Rather than guess or try to predict where the cash rate will move to the below chart from the ASX provides the cash rate future implied yield curve (how the futures market is currently pricing the cash rate). It should also be noted that mortgage rates would typically be 2-3% higher than the cash rate.

What opportunities does this give rise to?

The good news for long term investors is that historically market selloffs present an opportunity to buy assets at cheaper valuations and therefore produce higher expected returns going forward. The following chart shows 12 month returns from the start of an equity market correction (defined as a 15% market sell-off). This means any investor that purely buys shares after a 15% sell-off has historically benefited by generating an outsized 15.2% p.a return. Also, of note is how aggressively the market has historically bounced from the trough. 12-month returns following the trough of a market are on average 40%.

What are we doing in portfolios?

• Despite the sell-off and acknowledged outsized returns available after a market sell off we are taking a prudent approach within this cycle and haven’t yet increased our allocation to growth orientated shares from their broadly neutral position. We have however formulated our plan for when we will do this by analysing previous market cycles and identifying 4 key signposts. These signposts are central bank policy, earnings cycle, valuations, momentum. For brevity we won't go into these indicators in this note.
• Within portfolios, we have increased the duration of our fixed interest assets (bonds). Increasing duration means buying longer dated bonds. Longer dated bonds:
• - Have higher interest rates meaning higher increased expected returns;
  - Will provide capital gains if interest rate expectations come down (if interest rates don’t rise as much as what is priced in or the economy enters a recession).

So our key message for RJSWM clients is to stay focused.

As you know, RJSWM clients have a structured investment plan that is specially crafted for your situation and takes into account your timeframe, risk and growth profile, goals and objectives. Nothing in these markets causes us to re-think the foundations of our advice – but please keep the following important points in mind:

Message 1: Take a long-term perspective

Take a long-term perspective and trust that over the long-term markets work. A famous quote from Warren Buffett is “In the short run, the market is a voting machine but in the long run it is a weighing machine.” What Warren Buffett means by this is that in the short-term market prices are determined by buying and selling often reacting to short term problems (such as rising interest rates, wars, pandemics etc). However, over the long run asset prices are determined by the quality of the asset to produce returns and income for the asset owners.

The chart below is part of our investment philosophy of “investing differently”.

We are investors rather than speculators. Research shows that making investment decisions based on fundamental analysis and empirical evidence rather than short term noise delivers better long-term investment outcomes;

Message 2: Markets Work

The table below shows the annual returns for Australian shares over the past 120 years sorted by total return. There are a number of key takeouts from this table:

• While there are negative years the overwhelming majority of yearly returns 81% are positive (it doesn’t pay to bet against the market);
• The most common return is for 10%-20% but there is a lot of movement around this median (markets don’t go up in straight lines);
• Average annual returns have been 11.8%pa (and have outpaced inflation maintaining purchasing power of your wealth).

In summary, although we are currently experiencing increased volatility, it is important to stay focused on long-term objectives – share markets do move up and down, and the current ebbs and flows are no different to movement we have seen previously. Staying invested and taking advantage is the key – whilst markets do drop, they do recover as well, and historically, they recover quite quickly.

Our focus at RJS Wealth Management is, and always has been, founded in solid rigour and data analysis. Long term asset prices are fundamentally decided by the quality of the business and its ability to grow and provide an ongoing dividend.

If you have any questions about these insights or would like to speak to a Planner, please contact us on (03) 9794 0010.