Falling bond yields and bullish sentiment saw 2023 begin with a bang, with most global markets rallying strongly. As the rally gathered momentum, widespread short covering meant that several lower quality stocks were pushed higher, including those that lack positive earnings and have poor balance sheets. This so-called ‘junk rally’ or ‘dash for trash’ throughout January meant that the ASX 200 completely recovered last year’s losses, while a searing rally in tech stocks drove the US Nasdaq 100 to its best start to a year since 2001. Bond markets also continued to fight back, following an atrocious 2022 where returns were the worst in modern history. Sovereign bond yields moved sharply lower and credit spreads were not showing any signs of stress.
However, a shock US jobs report at the beginning of February halted the rally in its tracks. Non-farm payrolls came in at almost triple the consensus estimate, sparking fears that the US economy had more underlying strength than many had thought. When key inflation gauges unexpectedly accelerated, and previous months recorded significant upward revisions, interest rate expectations surged upward. This dashed hopes that the central bank hiking cycle would soon end and culminated in yield curves shifting higher. As investors sought to take risk off the table, the benchmark S&P 500 fell 2.6% in February and the Dow slumped 4.2% lower.
Meanwhile, Australia was not spared from economic drama. The December quarter CPI inflation printed well above expectations, reaching 7.8% for 2022 and the underlying ‘trimmed mean’ measure of inflation came in at 6.9%—easily exceeding the RBA’s 6.5% prediction. With the unemployment rate remaining in the mid-3% range, there were growing concerns that the RBA would need to lift rates well above 4% in order to contain inflation. Hawkish commentary from the February RBA board meeting helped push the S&P/ASX 200 Accumulation Index 2.5% lower in February.
Just as investors had repositioned for higher peak rates, and for rates to remain elevated for longer, a banking crisis suddenly reared its head. Equity markets lurched lower and bond market volatility reached levels not seen since the GFC. The hint of systemic banking issues breathed new life into the crypto sector and reinvigorated gold investors. Regulatory authorities quickly and forcefully intervened. Uninsured depositors were bailed out and a special lending facility was created that would value certain bank-held securities at par, well above market valuations. These measures helped stem the crisis and in effect reversed the Federal Reserve’s quantitative tightening program. However, it did not take long before falling confidence beset Europe’s banks and Credit Suisse was required to be taken over by UBS. An outright collapse of Credit Suisse would likely have destabilised global banking, given its size and interconnectedness. Unusually, this wiped-out low-ranking bond holders before equity holders, reversing the typical pecking order.
As markets became more comfortable that the crisis would not become systemic this sparked a fierce relief rally that carried through to the end of the month. For the quarter, the S&P 500 advanced 7% and the Nasdaq rallied close to 17%, while the Dow just held its nose above water. It was the best quarter since 2020 for the tech-heavy Nasdaq, buoyed by widespread cost-cutting and by slumping risk-free rates later in the piece. Domestic shares were flat overall, but resources (particularly gold) was the strongest sector, while the property and banking sectors were significantly weaker.
On the interest rate front, the RBA lifted the cash rate to 3.6% in March and hinted that further tightening was required. Labour market data continued to print stronger than market expectations and reinforced that conditions remained tight, despite huge migration inflows. While monthly CPI measures revealed that inflation was now slowing, unions ramped up a campaign for another large hike in wages. In the US, the annual Core Personal Consumption Expenditure index, which excludes food and energy costs, slowed to 4.6%. Employment measures remained strong and drove solid increases in personal income and consumer spending. Despite the uncertainty from the banking crisis, the Federal Reserve hiked interest rates by 0.25% to 5%, but refrained from a larger increase as some economists were predicting just weeks earlier.
In Europe, Eurozone PMIs surprised to the upside in the March quarter as the relatively mild winter calmed the energy crisis. Natural gas prices slumped and consumers began to ramp up spending as disposable incomes improved. Inflation slowed in broad terms, despite stubbornly high food prices. The ECB raised rates by 0.5% in February and again in March to a new post-GFC high of 3% and forecast inflation to return to its 2% target by 2025. Finally, China’s economic recovery showed further positive signs with the ongoing rebound in its services sector. This added to improved retail sales in the March quarter, which saw the strongest rises take place since mid-2022. The recovery in consumption came after Beijing suddenly abandoned strict Covid restrictions in December. China has set a modest GDP target of around 5% for 2023, which analysts expect to be easily exceeded.
While the March quarter of 2023 turned out to be a topsy-turvy affair, investors reaped the benefits of diversification. Periods of risk-on were soon followed by risk-off, and so on. The initial impact of the banking crisis saw an equity market sell-off cushioned by a fierce rally in bond markets. Fixed interest appears to be returning to its familiar defensive role and this has gone some way in preventing the banking crisis from turning systemic. Many banks purchased bonds near peak prices with the intention of holding until maturity. As a result, interest rate risk was not adequately hedged and the sharp rise in yields post the pandemic lows placed capital values well under water.
As risks of a recession continue to grow and market valuations force investors to think twice about allocating to risk assets, yields have again shifted lower. This has, in part, seen the crisis become self-correcting by reducing the extent of unrealised losses sitting on bank balance sheets. A special lending facility created by the Federal Reserve in response to the turmoil has further softened the blows by allowing banks to offer bonds as collateral as though these were trading at par value. The initial take-up of the facility easily undid the Fed’s quantitative tightening program, boosting liquidity and loosening financial conditions.
While the path that the banking crisis might take currently appears unclear, the preliminary fallout is being felt in the form of credit tightening in the US. This has come at a time when creditworthy borrowers are becoming harder to find. A reduction in savings rates and a material increase in personal debt became strongly evident in the second half of last year. While this does not resemble a far more serious credit crunch, the risk of morphing into one cannot be downplayed. Some sectors are already feeling the strain of tighter lending conditions, most notably commercial real estate, where sources of debt funding have started to dry up and asset valuations are looking fragile.
With the Fed Funds Rate now at 5%, a persistently inverted yield curve implies that bond markets are positioned for a recession, with traders mainly concerned about issues around timing and depth. Equity investors seem far more optimistic. Despite the March Fed minutes warning of a “mild recession” in 2023, share markets have thus far maintained much of this year’s gains. Analysts are predicting that company earnings will be flat throughout the course of 2023 and that a healthy rebound awaits in 2024, on the back of moderating inflation and lower interest rates. Some investors are hopeful that a recession will be avoided and have already deployed excess cash into risk assets. Tight labour market conditions, ongoing personal income growth and a cessation in US house price falls (in nominal terms), provide some support for this view.
At the opposite end of the risk spectrum, a ‘hard landing’ awaits. Should this come to fruition, company earnings will finish the year well in the red and fund flows will flood into the safety of cash, bonds and precious metals. Given market moves since the start of this year, the upside potential from a ‘no landing’ scenario seems relatively limited when compared to the downside risks from a ‘hard landing’. In assessing the current landscape, we note that a contraction in manufacturing has already commenced and new claims for unemployment benefits are beginning to rise. Fewer workers are quitting their jobs and some sectors are finally letting go of staff that were once scarcely available during the post-pandemic reopening.
The Conference Board Leading Economic Index (LEI) has an enviable record when predicting recessions. Over the last twelve months, the LEI has been contracting, with the falls gathering pace in the most recent six-month period. It is currently signalling a recession, perhaps starting in mid-2023. This is consistent with the New York Fed’s Recession Probabilities Model, which suggests the odds of a downturn are approaching 60%, the highest since 1982. The recent Fed Beige Book is also pointing more towards a downside scenario, while an escalation of issues around the US debt ceiling may add to any potential drama.
On the domestic front, inflation appeared to peak at the end of 2022 and the RBA is close to ending its hiking cycle. Goods prices are now well contained while food prices look to be permanently higher but might not spike again without a specific shock. The steam is also starting to come out of the stickier services component of the CPI. Big business and the federal government are pinning their hopes on a strong migration program to prevent a recession and curtail wage growth at the same time. This approach worked in the post-GFC period, but there was much more economic slack at that time.
While the RBA has noted the risks to prices from the impact on spending from new migrants, a bigger risk appears to be gathering on the wage front. The Fair Work Commission will be under pressure to ensure real wages do not go backwards. If 2022 is anything to go by, the unions will be demanding an increase in the minimum wage of around 7% (equal to the annual increase in the March quarter CPI). If this coincides with a slowdown in activity, then we could expect to see an increase in layoffs, particularly among low skilled workers. The construction sector is already bearing the brunt of the pain caused by rising interest rates and higher input costs.
In residential property, an improved March quarter renewed hope for a housing market recovery, following a year of price falls and uncertainty. Values have at least stabilised in most capitals, with Melbourne and Sydney starting to post rises. Auction clearance rates are up and motivated buyers have brought some relief for beleaguered vendors. As the fixed rate cliff begins to take hold, Australia is increasingly vulnerable to changes in the economic cycle. China played a starring role in helping Australia avoid recession during the GFC. Its sudden reopening is a welcome development and positive signs are continuing to emerge from the world’s second largest economy. However, China’s recovery looks to be more internally-focused this time around. Regardless, Australia stands to benefit from a thawing in relations. Protective barriers are starting to come down and this should provide a boost for certain sectors, while boosting sentiment more broadly.
Some analysts also point to India as a longer-term investment opportunity, with the nation’s population now exceeding China. While the recent decline in energy prices is a welcome relief for the Indian economy, geopolitical concerns, higher interest rates and slowing global growth presents a tough operating environment for listed Indian equites.
Overall, Australia continues to lag the global economic cycle by about three to six months. In the absence of a sharp downturn, we do not expect the RBA to cut the cash rate this year. The second half of this year is expected to be more difficult to traverse and a significant market drawdown in 2023 cannot be ruled out.
Disclaimer: This economic and market update has been prepared by Evergreen Fund Managers Pty Ltd, trading as Evergreen Consultants, AFSL 486 275, ABN 75 602 703 202 and contains general advice only.
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