Crystal Wealth Newsroom
Market Report – June 2023
The first quarter of 2023 saw generally reasonable returns from markets, despite significant banking failures in the US and Europe, further interest rate increases and widespread fears of a global recession. This illustrated the value of ignoring the news and focusing on the longer-term outlook for asset pricing. The June quarter provided mixed returns amid the growing realisation that inflation is proving stickier to address than most commentators had anticipated.
In response, Central Banks around the world have surprised markets by the extent of their cash rate increases over the last year. The end result of this inflation outlook globally is that interest rates worldwide are now expected to remain higher for longer than most had previously thought. The negative sentiment caused by these rate surprises has unevenly impacted markets. The biggest impact has been on fixed-rate bonds, where yields have risen, leading to negative returns over the quarter.
Nonetheless, again we see value in diversification. The following table illustrates that over three months, one year and two years, there has been a large dispersion of returns between the different asset classes. Because we cannot pick or likely time these short-term dispersions, we remain well diversified and instead concentrate on identifying and avoiding any over-valued markets where we expect long-term returns to be poor.
Performance (%pa) for periods ending 30 June 2023 (Total returns, Farrelly’s)
Australian equities
June was a subdued quarter for Australian equities, with a greater-than-expected increase in cash rates dimming market enthusiasm. The resources sector was weaker than the market as a whole in response to sagging commodity prices, weighing on the broader ASX index.
International equities
In contrast, after a difficult 2022, International equities continued their very strong performance with the best quarter for US equities since 2021 (driven by a surge in the main components of the NASDAQ index on the back of ‘AI’ excitement and some moderation in the inflation outlook). However, the increases have not just been in the United States, where the broader market returned 17% for the first half (albeit driven by a narrow selection of stocks), but also in Europe, where the market was up 11% and in Japan where the market was up by a remarkable 23% so far this year (in local currency terms).
Listed property
A-REITS continue to hold up reasonably well despite poor market sentiment and rising bond rates, which normally cause them to be revalued down. However, most of the bad news in this sector is now well known, reflected in price reductions and as a result, further such news is having a limited impact on returns.
Bonds
Most fixed-interest securities gave back some but not all of their gains for the first quarter as interest rates rose across the board. (The value of bonds with interest rates that have been fixed at lower than market levels fall in value when interest rates rise.) Similarly, when interest rates fall, fixed-interest securities with higher-than-market rates rise in value). However, floating rate (or variable) securities continued to increase their respective income payments in line with movements in bank bill rates during the quarter.
Cash
The RBA continued to lift cash rates. which benefited returns from short-term investments. Domestically, the May CPI result was encouraging, but the signs and prospects for future inflation remain mixed. On the one hand, commodity prices are largely not displaying inflationary signals, but there is the potential for future inflation pressure from other areas, such as increasing energy costs, wage costs and rent costs. Hence, while the RBA paused in July at 4.1% p.a. We believe that there may be one or two more rate increases still to come before beginning a very gradual easing of rates back to more normal levels (although the timing of this remains uncertain).
Inflation and interest rates remain the key
As we have said before, the outlook for inflation and interest rates remains critical for returns and valuations. There are many ways to look at inflation and different baskets of goods can be considered to offer different outcomes (and interpretations). This contributes to the monthly debate around readings suggesting that we are past ‘peak inflation’ but not yet where we need to be. While we have no doubt that Central Banks are determined to bring inflation under control, it is becoming more apparent that this may be more difficult than previously thought. This means there is a growing risk that higher levels of inflation may be with us for a few years yet. For example, US Federal Reserve officials don’t expect to cut rates while ‘core’ inflation (which strips out more volatile food and energy prices) remains above their target.
Disentangling the consequences from, and thus normalisation of, pandemic-related policy has made assessing the normal economic outcomes and reactions all the more difficult. Hence, it would not be surprising to see that a standard ‘recession’ may not arise in this more unusual business cycle.
While some US indicators (such as weakness in manufacturing) point to an impending recession, as does the inverted yield curve, underlying consumer spending and employment demand remain robust. For example, the net result could be a more modest recession overall with unusually low job losses (by historical standards), or an outcome similar to a ‘soft landing’ scenario. But this will depend on how tight monetary policy remains, the level of unemployment deemed tolerable and no systemic breakdowns.
For growth markets, it will also depend upon an anticipated recovery in earnings catching up to current valuations, and this will be challenging in a slowing economy. Undoubtedly, it will test the robustness of the more cyclical areas of the economy with a lower growth backdrop.
Given this, we are actively looking for assets that are likely to give better-than-expected returns in the event that inflation remains stickier in the short term to balance longer-term positions.
Some of these areas for consideration include Global Infrastructure, Higher Yielding Debt and Inflation-linked Bonds to counter relatively underweight growth assets (domestic and international equities and property). This includes considering positions in structural long-term trends such as energy transition and artificial intelligence (AI) where it makes sense.
Importantly, we are also building in underlying assets that have the potential to pass on higher rates/inflationary effects as well as an improvement in post-COVID distribution rates.
While the short-term remains uncertain, the longer term (i.e. five to ten years+) remains positive still based on forward return estimations where our expectations for long-term returns have changed only marginally over the past quarter – even taking into account higher interest rates and inflation risks.
The forward-looking forecasts are built up from assessing what we are likely to earn from dividends, how fast we expect company profits and property rents to grow, and how much we expect future investors will pay for those profits and rents. While they are obviously based on estimates and are far from perfect, they provide the framework for looking at whether different markets are considered overpriced, cheap or somewhere in between.
While there is a constant temptation to speculate in volatile markets and trends, over the long term, a consistent strategy to investing is the more rigorous approach. This can be considered best by selecting investments where the future value of the asset is not totally dependent on the amount that someone is likely to pay. In other words, you are buying into a cash flow now or the likelihood of a cash flow in the near term.
Portfolio adjustments
In the coming quarter, we will continue rebalancing portfolios as required to reflect our target asset allocation views, keeping a close eye on the long-term outlook for markets. In particular, we will be focusing on assets that are likely to be resilient in the event that inflation (at least domestically) remains higher for longer.
If you’d like to discuss your investment strategy, please get in touch with your adviser.