Everything everywhere all at once
The March quarter has been dominated by the collapse of Silicon Valley Bank and the ensuing banking crisis, set against a background of cooling inflation, continuing rate hikes, and the prospect of global recession in 2023.
But the markets started the quarter with optimism. Economic data continually reinforced the narrative that inflation had indeed peaked – around December 2022 – and that central banks would reach the “terminal rate” much earlier than previously predicted. The ASX 200 gained 6.2% in January, the best January ever for the benchmark index. In the US, the S&P 500 also rose 6.2%, its best start to a year since 2019.
Everything everywhere came crashing down all at once a few days after Federal Reserve Chairman Powell said the Feds are likely to take rates higher than previously anticipated and could move at a faster pace if needed. The bond market immediately repriced the peak interest rate to be significantly higher and yields jumped up – and bond prices plummeted.
Silicon Valley Bank – which had half its assets in bonds – became insolvent. Its collapse, the collapse of several other smaller US regional banks, and the turmoil surrounding Credit Suisse Group spurred a frantic rush for safety, evoking memories of the GFC. Volatility gripped global markets and yields on bonds fell dramatically as the likelihood of global recession increased.
Throughout the quarter the prevailing market mood has switched from “hard landing ahead” in the economy to “soft landing’” to “no landing” and then back to hard landing again. High tech stocks have had their best month since June 2020 while the battered bond market has had its best gains since 2008. The fall in the banking sector is proof that when interest rates rise as rapidly and as high as they have then it is not surprising that something must break.
Bond traders and equity investors are now scrambling to make sense of the most challenging macro setup in a generation as the global banking crisis potentially signals an impending recession while the ongoing battle against runaway inflation muddies the picture over the future of interest rates. The combined effects of higher rates and tighter credit conditions will certainly slow growth throughout the rest of 2023
he 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.
- In the quarter Australian and Global Bonds have significantly outperformed cash, as yields have had steep declines since the banking crisis in mid-March
- Despite market volatility and large swings in sentiment, returns of the Australian equity market have been relatively flat both over the quarter and the year
- The Developed Markets are the best performing asset class in the quarter, mainly due to the rebound in tech stocks despite the global banking crisis
- The strong USD resulted in depreciation of the AUD, so that a hedged exposure to global shares underperformed an unhedged exposure by 2.1% in the quarter
- The recovery in China from the pandemic lockdowns has helped the broader Emerging Markets, although a strong US dollar is a tailwind to returns
- Australian and Global REIT’s have been hit particularly hard by rising interest rates and have been one of the worst performing asset classes over the last year
Factors are very volatile over short time periods. Looking over the course of the last 12 months, value stocks
out-performed growth stocks by 1.7%, as lower relative price companies on average did better than higher relative
price companies. However smaller companies have under-performed the broader market by 13.3%.
The story is much the same in developed markets, where despite the bounce back this quarter in the IT sector there is a value premium (value – growth) of 5.4% over the last 12 months. Global small companies have underperformed global large caps, although not to the same degree as in Australia.
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