The Great Inflation
The themes for the quarter continue to be around inflation and the market trying to determine the 'terminal rate' for this economic cycle. Asset prices of stocks, bonds, and property all fell in 2022 as the worst inflation numbers in decades caused central banks to repeatedly raise cash rates. Inflation was due to three main factors:
- the end of expansionary fiscal and monetary policy due to the Covid-19 pandemic
- demand for services curbed by restrictions, and demand for goods leading to supply chain bottlenecks
- commodity price rises owing to strong demand, and the war in Ukraine which pushed prices even higher
It now appears that the higher cash rates are having their desired effect – all three of these factors may be abating, and the terminal rate for this cycle of increasing interest rates is close. However other variables, namely the low level of unemployment, building wage pressures, and relatively resilient household finances may keep inflation relatively elevated.
In financial markets there were two significant rebounds in stocks and bonds during 2022, despite the overall fall in asset prices. The first was from mid-June to mid-August when comments from the Federal Reserve were interpreted as pointing to an impending pause in rate rises. Hopes of a Fed pause evaporated as a Jackson Hole speech by its chair, Jerome Powell, triggered a further sell-off. Stocks and bonds hit their lows in mid-October.
A second rally has dominated the December quarter, resulting in positive returns for global equities and bonds. However, that rally ended on December 15th when the US Federal Reserve raised rates by an expected 50bps, projected further increases throughout 2023, as well as a rise in unemployment and a slowdown in economic growth.
The year ended much as it started; with markets trying to come to terms with how much further rates will need to go before the 'terminal rate' is reached – the rate that central banks consider enough to bring inflation back down towards their target band.
Market Overview
- Australian and Global Bonds have significantly underperformed cash. This has been the worst year in modern history for bond investors
- The Australian Equity Market has been the best performing market over the quarter and the year, due to the strong performance of the Resource sector
- The biggest influence on Developed Markets is the US, which makes up around 65% of the MSCI World Index, and then Europe which makes up a further 12%
- The strong USD resulted in depreciation of the AUD, so that a hedged exposure to global shares underperformed an unhedged exposure by 5.6%
- The biggest detractor in Emerging Markets was China, which makes up over 30% of the EM index, and is down 20% for the year
- Australian and Global REIT’s have been hit particularly hard by rising interest rates and have been the worst performing asset class over the last year
Major Markets Are All Negative Year To Date
Markets around the world have been hit by rising inflation, tightening monetary policies, the strong USD, and the ongoing uncertainty from the conflict in Ukraine. The high-tech stocks in the US are the biggest drag on the US market, while Chinese stocks have been hit hard with a Covid-Zero policy and a property market slump.
Domestic Factors
The yield on the Australian 10-year government bond topped 4% at the end of 2022 as concerns over global inflation and the need for additional interest rate hikes re-emerged after China moved ahead with the reopening of its economy after years of Covid restrictions. Borrowing costs are now at their highest in ten years, and this has been the fastest tightening cycle since 1989.
Global Factors
The US 2-10 year bond yield spread – closely monitored for its ability to predict the US economic outlook – is now near 80 basis points, warning of recession. However, the Federal Reserve has said its job is far from over. Inflation, while starting to cool, is still far too high, and interest rates are predicted to rise further.
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