Article Quarterly Investor’s Report: Q3 2022 9 December 2022 Read time: 9 min Author Andrew Mackenzie, CFP® Expert Reviewer Matt Englund Quarterly Investor’s Report Q3 2022 Rising inflation, falling markets. The reset Central Banks believe we need to have. 20+ years of largely uninterrupted growth and the recent massive valuation overreach in tech stocks have finally come to an end. While this is painful for all of us, bringing inflation under control is crucial for long-term economic and social stability, and so central banks globally continued their rate increase cycle in this last quarter. A look back at global events. Since the Global Financial Crisis, central bankers from the G20 economies (including the Reserve Bank of Australia’s (RBA), Dr Phillip Lowe) have taken on rock star personas. Their impact on financial markets can be significant and through their market interventions they influence the day to day lives of ordinary Australians. Dr Lowe is tasked with walking a tough line – keeping inflation under control (the RBA’s primary mandate) whilst ensuring long-term economic prosperity for Australia. Financial markets love certainty, so back in 2021 when Dr Lowe was telling the market that the RBA did not expect the conditions for a rate rise, such as higher wages growth and a tighter labour market, to be met “until 2024 at the earliest”, he was believed and markets (including our residential property market) rallied.1 However, in February 2022, Russia invaded Ukraine, precipitating a global energy and agri commodity crisis. Combined with the continued Covid-19 led global supply chain disruptions and developed economies still running hot thanks to national government stimulus designed to see off a Covid-19 led economic downturn in 2020 and 2021, this activity led to massive spikes in inflation around the world. In the US, annualised inflation topped 9.1% in June 2022 and whilst it is now trending back down, it is still well above the Federal Reserve (Fed) target rate of 2% over the long term. In Australia, we experienced annualised inflation of 7.3% in September 2022, well above the RBA’s target of 2%-3% over the cycle. So what has happened in the last few months and how has it impacted markets? Australia The RBA began lifting rates in May 2022 (initially by 0.25%) and has not stopped. In June, July, August and September it lifted by 0.5%, before reverting to 0.25% rises in October and November. It’s expected it will continue to hike rates further over the coming months to bring inflation under control, but there’s debate over the pace and magnitude of future rate rises. Dr Lowe commented, “interest rates have increased very quickly…we recognise that the case for a slower pace of increase in interest rates becomes stronger as the level of the cash rate rises”.2 Despite these rises, business conditions remain sound, reflecting the combination of strong terms of trade, a healthy labour market, and a resilient consumer. Retail sales are also strong, with consumers seemingly still willing to spend. Chart: Despite interest rate rises, business conditions remain sound. 3 While the Australian market is better positioned for rising inflation and commodity prices than most other global markets, it remains extremely sensitive to substantial changes in cash and mortgage rates given its significant level of household debt and heavy exposure to banks. House prices dropped a further 1.4% in September, while housing finance and dwelling approvals have dropped around 15% over the year. The rise in the cash rate to 3.5% or 4% is likely to cause stress in some segments of the household sector, but the RBA believes the large savings buffers amassed by many households will help them ride out the short-term pain. US In July, the market was talking about the possibility of interest rate cuts from the Fed in 2023 to combat slowing economic growth. However, in August, the Fed clearly announced its intention to prioritise the fight against inflation, causing a rapid market selloff as investors sought a safe haven for their money. US growth expectations for 2022 and 2023 are now well below trend. The most interest rate-sensitive sectors of the economy continue to soften, with mortgage rates above 6% and affordability low. Existing home sales are down 25% this year and new home sales are 34% below their late 2020 peaks. Unemployment is also expected to increase to 4.4% in 2023, with the cash rate predicted to be at 4.0% by the end of the year and as high as 4.5% by March 2023. All this is weighing on consumer confidence, now at recessionary levels. Thankfully, price pressures are easing and payrolls look healthy, although companies are starting to place a freeze on new hires amid the ongoing uncertainty. Overall, markets are convinced the Fed is willing to risk recession in the pursuit of its inflation objective and with the Fed funds rate now above neutral and projected to rise further, markets are pricing in a high probability of recession. The market expects the Fed funds rate to be over 5% in early 2022 before easing off to 4.25% by late 2024. That would take the level to more than 2.5% above neutral – a level of restrictiveness not seen since the early 1980s. At the annual meeting of central bankers at Jackson Hole in August, the Fed admitted, “these are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain”.4 Europe Europe continues to face soaring energy costs, high inflation and an expected recession. The inflation rate for September jumped to 10%, with German inflation rising from 7.9% to 10%. The European Central Bank (ECB) lifted rates by 0.75%, with ECB President Christine Lagarde indicating at the central bank’s monthly meeting that moves on this scale were not “the norm,” but there would be “several” rate rises in the coming months to bring inflation down.5 Also undermining risk appetite Russian President Vladimir Putin’s announcement that Russia was “annexing” four regions in Ukraine, increasing the risk of an escalation in the war.6 UK UK inflation remains in double digits, hampering growth prospects. Towards the end of the quarter, the new UK government announced a pro-growth fiscal policy, which resulted in a selloff in UK gilts and the pound. This threatened part of the UK’s pension system and prompted a (temporary) reversal of the Bank of England’s tightening policy, such was the severity. Asia China is proving to be the exception to the rule – easing policy in response to an economy hampered by a property sector slowdown and Covid lockdowns. Chinese inflation has remained low, allowing the authorities to take an easier policy stance than most other countries. However, the Chinese currency is now being impacted by rising US rates. India too is surprising on the upside, proving to be one of the better-performing emerging markets, up 6.5% for the quarter. The economy has been resilient, with the latest PMI reading at 55.1, well above most other economies. The impact on global markets. Equities. In developed markets, global equities sold off 6.2% for the quarter, taking the year-to-date decline to 25.6%. This was largely the result of a surge in real yields, as well as inflation, central bank tightening, the war in Ukraine and the energy crisis. The US S&P 500 dropped through its June lows to end September at 3585.6. Overall, US equities were down 4.8% for the quarter, Europe ex UK fell 9.9%, the Japanese market ended down 1.73% and the UK market declined 3.8%. The only shining light was the Australian market, which managed to rise 0.4% for the quarter, although small caps declined slightly at -0.5%. The superior relative performance can be attributed to a less aggressive central bank in the face of lower inflation and wage pressure, a market structure that’s less sensitive to rising bond yields and a stronger banking sector. Emerging markets also struggled, declining 5.4% in Australian dollar terms. This lagged the performance of both Australian and global unhedged equities. The strong US dollar is forcing policy tightening in many emerging economies, with Hungary, Mexico, South Africa, India, Saudi Arabia, Poland and Chile all lifting rates in September. Property. Property was the hardest hit sector, with Real Estate Investment Trusts (REITs) down 10.5% for the quarter, despite a strong start in July. While REITs may benefit from higher inflation, they are extremely sensitive to rising real yields, which are the major driver of the discount rate used to value longer-term cash flows from property. Real yields reached a high of 1.77% in Australia during September, compared to late 2021 when they were almost -0.9%. Fixed interest. Bond markets continued to struggle with persistently elevated inflation and increasingly aggressive central banks, as well as the impact of rising real yields. This resulted in modest losses for Australian bonds as the market weighed up the risks associated with ongoing rate hikes. Australian bond yields ended the quarter at 3.92%. Internationally, the rise in bond yields was even bigger, as offshore economies battled harsher inflationary pressures. US 10-year bond yields ended the quarter with a 0.68% rise, making it the third consecutive quarter of losses above 3.8%. Ongoing high inflation and aggressive language from the Fed and the RBA saw markets re-assess the outlook for cash rates. The good news is that markets are factoring in a significant drop in headline inflation over the next year. A 25% decline in energy prices, softer durables prices and easing supply constraints have helped ease inflationary pressures. Markets are also confident the Fed will continue to “keep at it until the job is done”.4 Commodities. Commodity markets lost ground during the quarter as the US dollar strengthened and demand conditions deteriorated. Iron ore, copper, gold and oil prices all fell. In response to a decline in the price of oil, OPEC is considering cutting production by one million barrels per day, equivalent to around 1% of supply. Currencies. The Australian dollar has been declining due to the gap between US and Australian cash rate projections and depreciated more than 7% during the quarter. The US dollar continued to strengthen, reflecting its stronger economy and aggressive central bank policy stance. The euro broke through parity as the threat of recession in Europe rose with surging energy prices and the ECB tightening into a slowing economy. However, it sank to a 20-year low against the US dollar. However, the British pound dropped as low as 1.07 to the US dollar at one point during the quarter, as the pro-growth UK fiscal policy stance of the new leadership team coincided with a rapid rise in UK gilts. The Japanese yen has declined more than 25% year to date as the BoJ maintained its yield curve control strategy rather than tightening policy. The Chinese yuan is also down for the year, but the Chinese central bank has recently moved away from policy easing to make it more expensive to bet against the currency and cutting how much foreign currency banks are required to hold. Asset class performance. Chart: Asset class performance to 30 September 2022. 7 Impact on Ethos Managed Portfolios. Our aim for the Ethos portfolios is to work with managers who preference investments for our clients that are responsible, sustainable and seek to deliver outperformance over the long term. In the most recent bout of market volatility, funds have flown to large cap stocks (sometimes referred to as Blue Chips) as they are perceived to be less prone to significant revaluations in times of uncertainty. Unfortunately, most Blue Chip stocks have built their value on older, less green technology. Key contributors to performance over the quarter. Australian Large Caps. This asset class delivered strong performance, led by fund manager Melior. Its investments in companies exposed to clean energy materials such as copper, lithium and nickel proved extremely beneficial to the portfolios. Australian Mid Caps. Amongst the mid cap companies, Fidelity held some good positions that delivered positive performance for the portfolios. This included overweight positions in Pilbara Minerals (lithium), IGO Ltd (clean energy) and Altium. Global Small Caps. Within global small cap companies, the portfolios enjoyed good performance from the Technology and Healthcare sectors. Thankfully an underweight position in Real Estate was also beneficial given the sector’s poor performance over the quarter. Key detractors from performance over the quarter. Alternatives – Market Neutral. Within the Alternatives asset class, holdings in Newcrest Mining (weak gold price) and Wisetech by fund manager Firetrail unfortunately impacted performance negatively. In particular, Newcrest Mining struggled with the weak gold price over the quarter. Global Listed Infrastructure (Hedged). The strengthening US dollar impacted global Infrastructure companies, with fund manager Magellan’s holdings in Transurban, Atlas Arteria and Dominion Energy leading to some underperformance in the portfolios. Global Listed Property. Overall, the spike in real yields materially impacted the global listed property sector over the quarter. While there were some pockets of positivity, the asset class as a whole did not do well. The future as we see it. The economy. We expect central banks to get on top of inflation and interest rates to stabilise in the next 6 – 12 months. Once interest rates reach their new normal, markets should return to valuing companies based on their future profitability rather than just being reactive. In October we saw signs that interest rate rises were doing their job with some poor economic news leading (perversely) to market rebounds. We do expect that it will take 12+ months for market volatility to subside. The risk of a recession still looms large in the US, UK and Australia, although if Australia does fall into recession, it will probably be a shallow one – a technical recession. Australia’s obsession with real estate, a strong labour market that supports the residential housing market and in turn the big four banks is encouraging for the economy as a whole. However, it’s worth remembering, markets always sell off before a recession hits and rebound before we officially recover as their pricing is based on future economic indicators. And with inflation being the primary driver of current market volatility, it’s reassuring to know that, on average, the market responds positively following a peak in inflation – in the 12 months following a peak in inflation, the S&P 500 has on average increased by 11.1%. 7 Chart: S&P 500 & US Core CPI Peaks. 8 Our positioning. The Ethos portfolios’ meaningful exposure to emerging markets looks set to position them well over the short to medium term. Emerging market valuations look attractive. They are benefiting from lower inflation compared to the developed world, cheaper currencies versus the US dollar, rising earnings and financially stable economies that have already undergone deleveraging. And over the long term, the Emerging Markets Index has outperformed the MSCI World Index by approximately 2.3% p.a. Chart: Emerging Market Equities vs Developed Market Equities. 9 Always remember, investing in equity markets is for those with a long time horizon. Volatility will, and does, happen. But markets recover and the key to achieving good growth over time is to stay true to your goals and don’t overreact during periods of uncertainty. Full of questions? Hungry for more? Sing out if have any questions about our Quarterly Investor’s Report Q3 2022, or if you wish to discuss your personal circumstances. Give us a ring