Hopes of a soft economic landing permeated markets last week and even the hapless UK market caught a bid late in the week, leaving it up a percent along with the ASX, while Europe, Japan and he US ended the quarter on a high note, up by 2-3%. Credit markets also reacted positively, while bond yields rose amid concerns that this economic optimism might hamper the efforts of various central banks around the world to rein in inflation. The economic news from China was a little weaker than expected, and emerging markets were flat for the week.

Funnily enough that’s pretty much the summary of the month, quarter, and arguably the whole Australian financial year which just ended. During that period markets have been generally up, which may surprise some investors, but the dispersion in returns and where the strongest returns came is even more striking. Europe, US Tech (Nasdaq) and Japan were up by some 25-30% in the last 12 months, and the Australian market was up by 10%, while emerging markets were flat (dragged down by a stuttering Chinese recovery that struggled to exit from its draconian COVID regime). Throughout the period, economic data in the West has surprised to the upside, and the European winter (and associated energy crunch) was not as bad as expected. As a result, US and most multinational earnings have so far proved resilient, and consumer spending (especially in the all-important US market) remained robust. However, Asian inventories have been steadily rising, the Germany economy has slid into a technical (so far modest) recession, and the US industrial economy has also been increasingly week. While the wider US market was up by almost 20%, if you split out the IT sector and a handful of global tech champions that are seen to be AI beneficiaries, the rest of the market was only up around 7%.

In contrast to previous years the one thing that didn’t really move markets was interest rates, as medium-term expectations for rates have remained remarkably stable after moving higher in the first few months of the financial year, despite the gyrations at the very short end of the market. The main story in interest rate markets was the slope of the yield curve in the US, as persistent inflation and an increasingly hawkish Fed moved short-term rate expectations higher just as fears of a recession in late 2023 pushed longer term rates down.  In Australia the market had not been forecasting as much of a recession and short-term rates have been held lower by the RBA, resulting in a much flatter yield curve, with more persistent inflation and higher rates expected eventually.

What markets really care about though is the real (after inflation) rate of interest (shown in the bottom panel of the chart above), and perhaps the real surprise over the last year is that markets have staged a recovery, especially in the US, while real medium-term interest rates have been as restrictive as they have been since well before the GFC at around plus 2%.. While longer term inflation expectations remain anchored at around 2% and 3% in the US and Australia respectively, the US authorities are still trying to cool down a hot consumer economy, while the RBA is increasingly cognisant of persistent inflationary pressures in the Australian economy. This suggests high real rates might be with us for a while longer, at least until we see tangible signs of an imminent recession.

With all this in mind, Australian diversified investors can feel fortunate getting to the end of the Financial Year with a 4-10% return for risk profiles ranging from conservative, mainly defensive, portfolios to 100% growth portfolios. The risk/return chart below also shows how the average actively managed diversified fund has performed compared to a passive, indexed portfolio of a similar risk profile. After falling behind precipitously in early 2022 due to higher allocations to negative yielding government bonds, passive portfolios (especially the more growth-based ones) made a comeback in recent months. This time it was most probably due to having higher weights in US equities and large tech companies, which most active asset allocators and fundamental investors are underweight in. The chart also shows that actively managed funds are still taking less risk and seem to be positioned relatively cautiously.