Global markets endured a tough month in October, which continued the sell off trend from late July. A summary of key market returns is as follows.
| 1m | 3m | 6m | 1yr | 2yr (p.a.) | 3yr (p.a.) | 5yr (p.a.) | |
| Australian Shares | -3.78% | -7.19% | -5.30% | 2.95% | 0.44% | 8.88% | 7.18% |
| Australian Listed Property | -5.83% | -11.97% | -10.24% | -3.62% | -8.99% | 2.73% | 1.90% |
| US Shares (USD) | -2.20% | -8.61% | 0.58% | 8.31% | -4.57% | 8.65% | 9.11% |
| World Shares (Hedged) | 2.72% | -8.07% | -0.51% | 8.27% | -4.51% | 8.34% | 7.45% |
As can be seen above, it has been a tough 5 months for all markets with the only shining light being the US, their market was still down quite a lot but the drops in the Australian dollar has seen US market returns for Australian investors hold up ok. It is worth pointing out that over the 2 year period, returns are well below longer term averages. We are also seeing the averaged diversified Balanced and Growth funds showing negative returns, with the Vanguard Balanced Index Fund return of -3.63% p.a. for two years (that is, losing over 3% each year). Though frustrating, this is not unusual within longer term cycles, and whilst we would all like to see strong positive year on year returns this simply is not the way investment markets behave.
The big driving force behind the market sell off was an acceleration in longer term bond yields. Bond markets play a very important role in finance, and the bond market itself being bigger than equity markets. The ‘mother of them all’ being the US 10 year bond. This is commonly referred to as ‘the risk free rate’ and is a measure used to value all sorts of asset prices, particularly unlisted assets such as commercial property and infrastructure. With investors able to access 5% yields on ‘risk free’ assets, this means the required return of other assets becomes much higher, putting pressure on existing prices. This is the driving force behind commercial property valuations dropping significantly, and the double effect of higher borrowing rates means that those with too much leverage are facing worrying times.
In October, we saw the yield on 10 year US bonds trade over the 5% level. This is a long way from the all time low of 0.32% seen in 2020.
So what is driving these yields higher? Inflation has been the main story throughout the year however the acceleration can also be attributed to a reaction of markets to the need for the US to continue to fund its huge trade deficits. The US holds ‘bond auctions’ and the recent auction held a couple of weeks ago was met with reluctant investors demanding more yield from these bonds. This move may well force the US government into adopting more restrictive fiscal policy in order to reduce deficits. This doesn’t seem to be on Biden’s radar for the time being.
Locally, the RBA and Michelle Bullock are not going down “Without A Fight” in their mission to tame inflation. In what was a widely anticipated and expected decision the RBA decided to raise the cash rate a further 25 basis points on Cup Day bringing the cash rate to 4.35%. Bullock warned that taming inflation is proving more difficult than anticipated, leaving open the possibility of raising interest rates again. The market however interpreted and priced in this decision as a “dovish” hike with the market now implying that it believes this is to be the last hike of this cycle. Further inflation and economic numbers will provide vital information as to whether the RBA will need to consider hiking again.
The silver lining for investors is the availability of attractive interest rates on high-grade bonds, as highlighted by a torrent of new supply. Westpac priced a $1.25 billion Aussie dollar bond that paid 7.2 per cent annual interest. This deal offered 30-40 basis points in extra annual interest over our fair value estimates, showing the huge amount of cash looking for a home.
Moving forward, we are quite positive on bond markets and the investment prospect, particularly from a risk/reward scenario. The only scenario in which bond yields could rise substantially more is if the economy starts to overheat again. Given that labor demand was shrinking even before the latest tightening in financial conditions, that seems unlikely. Granted, concerns about the US fiscal outlook could lift yields even if the economy weakens. However, the fiscal outlook is no worse now than it was two years ago when the 10-year yield was less than 2%. As such, we see this sector as quite attractive moving forward.
Over to equity markets, we have seen markets rally over the past week or so, particularly in the US, after being in ‘oversold territory’. This has sparked the usual talk of a “Santa Claus Rally” and rightly so. Historically the next 2 months are a very good time for the stock market as below shows the average seasonal returns of the S&P500 since 1950 overlapped with current years returns. Interestingly this year has been quite correlated to the average and is why we are backing the rally off oversold conditions into years end.
If the there is a decline in economic conditions over the coming months, and a recession begins in the second half of 2024, this provides a short runway for stocks to move higher.
As always, trying to time short term market conditions is not for the feint hearted. We favour more strategic moves and are trying to capture the positive sentiment leading into year end, whilst also remaining cautious around a deterioration in conditions.
