Equities turbulent but resilient as interest rates rise
The global investment market in February 2023 is looking optimistic. The world economy has largely recovered from the pandemic that swept through the global markets in 2020-2021, and investors are once again taking a chance on stocks, bonds, commodities, and other securities.
In the United States, the Dow Jones Industrial Average rose to a record high of over 40,000 points, a sign of a healthy economy and renewed investor confidence. The S&P 500 and the Nasdaq Composite also reached all-time highs, buoyed by strong corporate earnings and the continued progress in the vaccine rollout.
As you might have guessed, none of that happened in the real world in February, only in the febrile imagination of an AI (another version ChatGPT that uses up to date information). We thought that maybe it had picked up a commentary from a year ago, but the Dow Jones has never been anywhere near 40,000. There are however, numerous books and articles about it reaching that number, perhaps demonstrating that it is still difficult for juvenile bots to distinguish between fact and fiction. To be fair, the month-end is only hours past, and these algorithms still rely on the written work of humans to parse from. We also asked the same bot what happened in markets last week, where it proved to be not only a good way of finding something decent to crib off (if that’s your game), including references, but it also appeared to have quite a succinct, and dare we say it, authentic (if not original) turn of phrase. We have found some more useful applications (see below), but it seems likely that some point bots will provide a faster and probably better way of summarising goings on in markets. In the meantime, rest assured that for now we appear to still have a job and we will tell you exactly what and when we choose to outsource to the algo’s.
What actually happened in markets was considerably less rosy than ChatGPT imagined, but there were some positives if you squint hard (sort of). Increasingly, markets have acknowledged residual inflationary pressures in the US, which became apparent throughout February. This leads to the follow-on thought that this will probably entail higher rates, which will in turn increase the probability of a harder landing. On Friday the widely followed US PCE inflation data was published, and it tied a neat bow around this thesis with broad based inflation measures covering core as well as volatile items like food and energy higher than expected. Most categories of both goods and services were up strongly, and when you drill deeper the influences seem to be equally split between supply and demand pressures. This has sent bond yields sharply higher, but markets have actually been better behaved in the last month than one might have expected in the face of stagflation (high inflation and lower growth) after the experience of 2022.This suggests some resilience, while of course a booming US economy and reopening China (albeit with a few speed bumps) will be helping as well. That said, these are also the markets that have been the most volatile and where traders have expressed their worries. Last week the S&P 500 traded in a 3%range, having done a 2% round trip on Thursday, followed by a 3% fall on Friday after the inflation data release and then another almost 2% round trip yesterday. Emerging markets were the worst performing, down 4% for the week. This was to a large extent driven by political and economic uncertainty in China and yo-yoing of the large Chinese tech stocks, and despite a very strong earnings report from Alibaba last week. Taking a step back though, most equity markets haven’t given back that much of their gains from January, while Europe and the Nasdaq remain up 10% for the year.
This is somewhat encouraging as it implies that markets, now at lower valuations, are becoming less sensitive to interest rates, which rose sharply around the world and across the yield curve, especially in Australia where short-term rates moved the most. It is too soon to say whether the RBA has lost credibility through another apparently inept communication debacle, but with a few weeks hindsight it seems that the hints dropped at an unofficial lunch earlier in the month reflect the reality that they RBA is having to revise upwards its projected cash rate increases. The chart below shows that the market is now expecting cash rates to peak at 4.25%in about a year’s time, still below the projected US Fed Funds rate peak, but a substantial 0.7% above where the market though rates would get to a month ago.
This, along with a fairly mixed reporting season, has not helped the local market, where the banks were a big negative contributor, although the knock-on effects of uncertainty in China had a bigger impact via a 7% fall in the big miners in February. Otherwise, some local stocks like Brambles, Aristocrat and QBE have surprised on the upside, while Domino’s has been the most significant ‘miss’ of the local reporting season so far.
For bond investors, who endured a particularly torrid 2022, January proved to be a false dawn, and most strategies gave upmost of their January gains in February, with both government yields and credit spreads ending back where they were at the beginning of the year. We note though, that many local investors seem to have little duration (exposure to government bond risk) and have retreated to high quality floating rate corporate debt, which has been much steadier, and even hybrids have been relatively steady so far.
