Markets were again on the back foot last week. However, despite a fair amount ofvolatility, most markets were flat or only down by 1% or so. There seems to bean ongoing battle of wills between markets and the various central banks who are keen to talk down markets, lest the wealth effects of a buoyant market detract from the ongoing fight against inflation. However, they don’t want to go too far in case moribund financial conditions exacerbate a potential downturn. Markets perhaps sense that this game is afoot, and some commentators have interpreted Jerome Powell’s slightly cheerful assertions that rates would stay higher for the longer than markets expected as quiet confidence that the back of the most recent inflation surge has indeed been broken. The market reaction has been a little more muted than ostensibly hawkish remarks would have provoked in the recent past.

The narrow path towards a soft landing being navigated by the Reserve Bank of Australia is arguably one of the wobblier tightropes that central banks have to negotiate, given the local economy’s sensitivity to short-term mortgage rates. While the results season is starting to imply that retail sales are weakening, a tight labour market has been less helpful, and there are few anecdotal signs just yet that inflation here has peaked (as the RBA fervently projected just recently). Then last week, the RBA governor Phillip Lowe may have intimated at a private briefing that local interest rates could be forced to follow closer to those of the US. The comments were later said to be taken out of context, but it was enough to move markets. The following graph illustrates the upwards pressure that we are still seeing on short rates, with rates now expected to touch 4% by the end of the year in Australia and to get above 5% in the US. On the other hand , long-term rates remain lower now than at the beginning of the year, implying that the market is now leaning back towards the idea that inflation-busting rate rises will also break something in what could end up being a harder landing for economies.

This was one reason why the local market was one of the worst performing last week, as interest rate-sensitive sectors like Real Estate Trusts (a big part of the market) led the way down. Signs of lacklustre corporate earnings as the local reporting season kicked off didn’t help either. Overseas, many of the interest rate sensitive tech stocks were also down, but it was a fairly mixed and noisy picture. Interestingly, the biggest positive contributor within the MSCI World equity index was Microsoft, which benefitted from its early association with and investment in ChatGPT, the Artificially Intelligent chatbot which many think will revolutionise internet searches amongst many other things. Google was the biggest detractor after its hastily launched home grown competitor missed the mark in a very public demo. Google’s parent, Alphabet, undoubtedly has the wherewithal and resources to compete in the space, but investors worry that ChatGPT and its ilk may represent the first credible competitor to Google’s dominance in 20 years.

Overall, it has been a risk-off start to the month that has seen the market give up a third of the strong gains made this year, as the market contemplates resolute central banks and slightly higher short-term rates. Meanwhile, bond portfolios fared a bit worse and have generally given up most of the gains made this year, through a combination of rising yields and widening credit spreads. Interestingly, that implies that equities are becoming a little less fixated on bonds markets and day-to-day correlations between bonds and equities (which were very high in 2022) have started to break down. That could be good news for diversification and evidence of resilience in markets. That tentative thesis may just have been confirmed overnight when the much-awaited US CPI print was published. It actually ticked up, but core services inflation minus housing was pretty tame.      

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