Three upcoming events that will transform the outlook

Tim Toohey

Yarra Capital Management

There was no reprieve in financial markets in the closing months of the financial year, in fact the losses sustained in bonds and equities in the June quarter were of historic proportions. 

Where financial markets finished up

In the last 160 years of data on Australian bond returns, there have only been 30 that sustained a negative financial year return and only 2 years that have sustained a double-digit decline. The worst was the uncertainty surrounding Federation which contributed to Australian bonds declining 11.3% in 1900-01. Remarkably, this was almost eclipsed in 2021-22, when bonds declined 11.0%.

As bad as that sounds, it wasn’t a bad as global bonds which declined 15.3%.

Australian equities fared better in a relative sense but of course no one is thrilled with Australian annual returns of -6.5% including a -9.9% 6-month return. Again, it could have been worse if you were unhedged and offshore with global equities sustaining a 14.3% decline for the year.

But in yet another lesson in the virtues of the Australian dollar working as a cushion for local investors, the 8% decline in the Australian dollar over the year has mitigated the damage for an unhedged investor to -7%. Nevertheless, over the past 6 months, the Australian dollar has provided less shelter and a -16.4% decline for the unhedged investor is an experience they would clearly prefer to avoid.

The best place to hide, was by far, was commodities. The GSCI finished the financial year with a 47% gain, with oil providing much of the gains, but even here commodity prices have finally started to respond to signs of slowing demand and recession fears. 

Oil prices normally are a primary catalyst for recession and recessions have a strong habit of solving for lower oil prices. 

The process now appears to be in process with WTI dipping below $100 bbl on recession fears and the rig count in the US rapidly approaching 2018 highs.

The macro backdrop

I want to spend just a few minutes framing the discussion and touching on some of the issues that are no doubt front of mind for you as investors and advisors. In Australia, inflation is the highest in 40 years, the unemployment rate is the lowest in nearly 50 years. Interest rates are finally rising both here and abroad and financial markets are now looking for an aggressive series of rate rises which has contributed to a re-rating in risk assets. All this has occurred in a background where global financial markets are obsessing over the risk of recession in major developed markets, geopolitics are in flux, inclusive of the first land war in Europe since WW2, and a global pandemic continues to have material real economy impacts on supply chains.

It is of course a highly unusual set of circumstances. Some of it was unforeseeable – naturally the pandemic falls into that category and arguably the invasion of the Ukraine, although even here there were warning signs. Some of it was entirely predictable – here I would include the initial surge in US inflation, although few were looking at the right indicators. And some of it was made worse by policy error.

It’s easy to get lost in the noise and to lose perspective on what are the important things that matter for financial markets. One of my mentors once told me that in times of uncertainty, the key thing to remember is that there is always an underlying economic cycle which normally treads a predictable path. The trick is to identify where we currently are in that cycle and what of the various recent shocks has alter the impression of what happens next.

For 90% of the time, the underlying economic cycle is merely a variant of this stylised version of an industrial cycle. The other 10% is a more malign debt deflation cycle, which was the GFC experience.

If you stare at the first chart for a moment you can no doubt identify where we currently are in the Australian economic cycle. If your eyes are more drawn to the top right around “wages rise, interest rates approach neutral and purchasing power falls" then you are probably in the right space. But don’t take the gaps between the steps as an indication of time. We can move between the steps quite quickly and on occasion slide back a step or two due to a shock, but rarely are any steps in the cycle missed.

Chart 1 - Traditional industrial cycle

So by this guidepost we are quite close to a material slowdown in sales and peak demand on this ready reckoner for the cycle. However, there are two very unusual aspects that have distorted this cycle.

The first is the degree of fiscal stimulus deployed (over 11% of GDP in Australia – arguably the largest in the world depending on how you count it) in conjunction with the stop-start nature of mandated restrictions. This turbo-charged recovery in demand well before the supply chain could ever respond. So we moved through the sweet spot for the cycle quicker and more aggressively than the non-COVID world would have likely delivered.

The second major distortion was the perverse decision by many of the most important central banks on the planet, including the RBA, to engage in unprecedented monetary expansion and move to a new framework of backward-looking inflation targeting rather than the tried and trusted forward looking inflation targeting. Why does this matter? Although economics is not an immutable science, there are some bedrock underpinnings that for the past 40 years were left largely unchallenged. 

One of the most important was that if you desire stable price growth then you should grow money supply in line with the growth in the economy – a concept called money market equilibrium.

I apologise for using such an obtuse economic concept, but it is the best way I can think of to illustrate the challenge that lies ahead. The RBA likes to talk about its desire to ‘take out insurance’ against the COVID pandemic. 

The second chart speaks to the difference between taking out insurance and fuelling a monetary bubble. Much of the credit created was via the expansion of central bank balance sheets and much of that overhang contributed to both elements of excess demand and silliness in valuations. The problem for financial markets is that the distortion is so large that the late - cycle rate hikes now being hoisted upon us risk more than just a gentle slowing of economic activity.

Chart 2 - Money stocks excess

This brings me to the prospect of recession.

Since the start of the year, we have warned that the signs of recession in the US and Europe were steadily rising. Collapsing consumer confidence, spiking oil prices, and flattening yield curves were all flashing red. The invasion of the Ukraine cemented the case that parts of Europe would likely drift into recession through 2023 and by April, we were sufficiently convinced that the odds of US recession emerging by the end of 2023 had exceeded 50%.

That felt like a brave call at the time and sufficient to generate some headlines, but it is now very much approaching a consensus view, at least as far as equity markets are concerned.

Indeed, its rare that equity market sentiment is as poor as it is currently. This can be seen in a range of measures. We are currently in the third wave of risk aversion since the start of the Ukraine war and the next chart shows both our own cross-asset measure of risk aversion and US surveyed investor sentiment. 

The point is that, although cross asset risk aversion is high, it pales compared to equity risk aversion which is currently exceeding GFC levels.

Chart 3 - US AAI investor sentiment - Bullish less Bearish: Net % who believe the equity market will rise over the next six months

It’s curious that despite the financial infrastructure being on the brink of collapse in 2008, investor sentiment is worse today. It speaks to investors knowing that much of the growth recorded in the post-COVID period was building castles on sand, propped up by excessive fiscal and monetary stimulus.

Our financial conditions framework suggests that the US is heading for a recession before year end and our nowcasting for real time growth is suggesting the US is flirting with a recession now, not some time in 2023.

Chart 4 - MSCI USA: EPS momentum and financial conditions

So we know, and the market knows, that a wave of EPS downgrades lie ahead. It’s just a question of how much and at what point does the market look beyond the negative earnings risk. If we use consensus 2-year forward EPS growth as the benchmark, then consensus’s current +18% growth will likely need to be revised to a decline of 15% to adequately reflect a recession.

Much of those revisions should be hitting markets over the coming quarter.

From my perspective, I prefer not to stand in front of that wave. As we discussed last quarter, we moved overweight bonds in our multi asset strategies in May and June and we expect bonds to rally significantly further in the September quarter. The time to buy equities is approaching, and I have been on record as saying September-October should be the time to re-enter and take advantage of some relatively indiscriminate selling in quality equity names.

We are not there yet, but we are getting closer to three likely events.

  1. The Fed will likely pivot on growth fears by around September.
  2. We believe US inflation will start to surprise consensus on the downside through Q422 and into 2023. Not least because commodity markets are now in retreat and excessive inventories in the US will demand price discounting into slower sales.
  3. The RBA prospects of reaching the 3.5% currently implied by IB futures are slim at best. We think the RBA will finish the year with a cash rate of 2.35% and that will probably complete the local rate tightening cycle. Australia will likely just avoid a recession but growth will be scant in 2023. The silver lining for markets is that interest rates will likely be lower than what the market is currently pricing. The dark lining is we still have to work off the excesses of the prior period of monetary and fiscal excess which prohibits a return to above trend economic growth for the next few years.

The first quarter was tough for financial markets, Q2 was much worse and Q3 remains a challenge. 

The good news is that Q4 is my line in the sand where I expect equities to begin a more genuine rebound.

Hopefully we will be discussing the early signs of that when we do this all again in three months’ time. Best of luck and see you next quarter.

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Tim Toohey
Head of Macro and Strategy
Yarra Capital Management

Tim works closely with the investment team, advising on both the outlook for financial markets and asset allocation. Prior to joining Yarra Capital Management, Tim was Chief Economist of Ellerston Capital’s Global Macro team. With more than 25...

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