[Editor’s Note: Gemma Dale is presenting at the upcoming ASX Investor Day on this topic. To learn more, register for ASX Investor Day].

The last three years have been somewhat extraordinary for investors, certainly when compared to the prior decade. 

A global pandemic and ensuing global recession, zero interest rates and historic levels of fiscal and monetary stimulus, war in Europe and decades-high inflation, followed by the most aggressive interest-rate hiking cycle in recent memory… yet the S&P/ASX 200 index is within 2% of its pre-COVID-19 high. 

While the short-term impact of these events has been significant - including a 3-week 30% fall in the ASX200 in early 2020 – the medium-term impact has barely registered. 

So, what could the next 12 months hold that could shake investors’ faith in the market, when all of the above has had little long-term impact?

S&P ASX200 (XJO) over five years

Source: nabtrade (price performance only)

Inflation

The scourge of inflation remains the key driver of concern for the economy; after being discussed widely for more than 12 months, high and rising prices are clearly being felt by households and businesses. 

Initial hopes that elevated levels of inflation in 2021 were “transitory” have been well and truly dashed, and despite recent evidence that both core and headline inflation are past their peak, both remain too high. The latest Australian Bureau of Statistics (ABS) quarterly data has the annual rate of inflation falling to 7% in March from 7.8% last December. 

Supply chain bottlenecks are easing, but food and energy prices remain areas of concern. At this point, while a tight labour market with record low unemployment has businesses struggling to find staff, there is limited evidence of rampant wage increases, and no evidence of the wage-price spiral that typified the stagflation era of the 1970s.

The latest data has wages increasing below 4% per annum, roughly half the level of inflation, meaning workers’ take-home pay is falling in real terms. This is positive for the RBA, but not so great for workers or for consumption in the economy.
 

All groups CPI, Australia, quarterly and annual movements (%)

Source: ABS, RBA
 

After two decades of inflation that barely managed to stay above 2% (according to ABS data), it’s easy to forget the real impact of inflation – reduced purchasing power for households and businesses, particularly those on lower incomes. 

The traditional strategy to tame inflation has been to raise interest rates, as many have learned for the first time over the last 12 months. 

Despite increasing rates at 11 meetings (since the April 2022 RBA meeting), from 0.1% in early 2022 to 3.85% in May 2023, the impact of the RBA’s monetary decisions on inflation has so far been modest (based on ABS inflation data this year). Even so, markets are increasingly confident that the RBA’s hiking cycle is at or close to its peak. 

Even more astonishingly, markets are pricing in rate cuts in 2024, suggesting that economic activity will slow dramatically and the RBA will be forced to reduce rates to stimulate demand again.

Graph of the Cash Rate Target

Source: RBA
 

Underlying economic strength

Despite high inflation and talk of a potential – even impending - recession (including GFC-level consumer and business confidence), the economic data suggests that consumers and businesses are holding up remarkably well (according to ABS data). 

The received wisdom is that central banks will increase rates “until something breaks” – usually a lot of businesses fail and households cut their spending, leading to a recession, and a large increase in unemployment - yet there is little evidence of anything breaking at present. 

This creates a conundrum for the RBA and for investors. Will the RBA have to keep raising rates to ensure that inflation doesn’t get out of hand again? Or will consumers stop spending as mortgages come off their fixed rates throughout 2023, as many assume? 

Economic growth is actually okay, certainly not recessionary, yet consumers and businesses say they’re doing it tough. 

So, what’s the real story? So far, the market is relatively relaxed about the downside economic risks.
 

Are markets a guide?

The running joke is that markets have predicted seven out of the last three recessions, and are generally an imperfect predictor of the economy. So, why do interest rate predictions matter so much for investors? 

The first reason relates to relative valuations. Generally, equities, along with all other asset classes, are valued with reference to a “discount” or risk-free rate. That risk-free rate is generally the 10-year bond yield or a similarly safe investment. 

When bond yields were close to zero, the yield on equities – more than 4% for the ASX200, along with franking benefits and the potential for capital growth – looked attractive. 

This was particularly true of long-term “growth” stocks, which don’t make a profit now, but could offer potential as they grow (thanks in part to low funding costs). As interest rates have risen, the discount rate has also increased and now investors are able to generate a return of 4% or more on relatively safe investments like term deposits, making equities relatively less attractive. 

In Australia, an increasing discount rate (ie lower relative company valuations) has had a limited impact on the ASX200, although some profitless growth companies have suffered dramatic declines in their share prices. This is largely because our sharemarket has less exposure to high-growth sectors like technology that were somewhat dependent on ultra-low rates to fund their growth, and higher exposure to financials, materials and energy, which are less affected by inflation and rising rates (to a point). 

The Nasdaq Composite Index in the US, comprised largely of tech companies, fell more than 30% from its peak as US rates increased in the first half of 2022, while the ASX fell just 10%. 

The Price Earnings (PE) ratio, a rough estimate of what investors are willing to pay for equities, is a little above its long-run average for the ASX – a sign that the market doesn’t see huge downside.

The second reason is that our sharemarket is comprised of companies that generate – but are also affected by – economic activity. Consumers who have lower spending capacity due to higher inflation and a greater burden of mortgage repayments are, theoretically at least, going to buy less in retail stores, and cut back on big purchases. Businesses with higher input costs, large overdrafts or less access to capital are going to reduce their output or see their margins cut. 

As a result, a rational investor would see higher interest rates leading to lower corporate profits, and be willing to pay less for shares. Generally, this doesn’t appear to be happening – at least yet. 

Analysts are not predicting a meaningful downturn in corporate profitability, and investors have not dramatically decreased the price they’re willing to pay for a share of profits, once the discount rate differential has been taken into account. 

To that extent, many are concerned that markets have not yet “priced in” a hard economic landing, despite cash rate predictions suggesting the inevitability of a downturn.
 

Conclusion

So, who will be right? Bullish equity markets, which are assuming businesses will broadly continue to perform? Or bearish bond markets, which have been predicting a recession for some time (hence that predicted cut in interest rates in the next 12 months)? 

Obviously it’s very difficult to say, and that’s without considering potential “black swan” risks such as COVID-19 and the war in Europe that have blindsided markets in recent years. 

How is an investor to build and maintain a portfolio in such an environment? Ultimately the best advice might just be to buy quality assets at reasonable prices, ensure you understand the risk you’re taking, and to diversify your portfolio to minimise risk. And maybe even put a bit back into term deposits if you’re worried about the downside.

DISCLAIMER

Analysis as at 30 April 2023. This information has been provided by WealthHub Securities Ltd the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Whilst all reasonable care has been taken by WealthHub Securities in reviewing this material, this content does not represent the view or opinions of WealthHub Securities. Any statements as to past performance do not represent future performance. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, we recommend that you consider whether it is appropriate for your circumstances.