October 2023 Review: Higher yields & geopolitical concerns dent confidence
For the third consecutive month, global share markets declined over October.
Once again, the sell-off on equity markets was accompanied by higher bond yields.
A weaker Australian dollar assisted in reducing the size of the decline in unhedged global investments.
A combination of further increases in bond yields, and the outbreak of War in the Middle East, eroded confidence on global equity markets last month. Losses of between 2% and 4% were recorded across major markets, with the average decline over the past 3 months now totalling 8.1%. None-the-less, global equity returns over the 12 months to the end of October remain a positive 8.1%.
The fall on equity markets came despite continued strong economic data, particularly in the United States. Payroll data in the U.S. for September showed an unexpectedly large increase in employment of 336,000, with the unemployment rate remaining unchanged at 3.8%.
Conditions in Europe appear weaker, with unemployment nudging up 0.1% to 6.5% in September. Overall, it would appear that bond markets have concluded that economic growth is proving too resilient to provide any scope for central banks to cut cash interest rates in the near term. As such, longer term bond yields have continued to adjust upwards to reflect this likelihood that current cash rates will be maintained for an extended period. In turn, equity valuations have adjusted downwards to reflect these higher interest rate expectations.
Emerging markets fell by a similar magnitude to developed markets last month, with the decline in the MSCI Emerging Markets Index (unhedged) being 2.0%. China (down 3.1%) continued to underperform and most Middle Eastern markets recorded larger than average losses. Surprisingly, despite the seriousness of the conflict in Gaza, the global oil price fell 10.8% over October after increasing sharply in recent months.
Although infrastructure performed in line with global equities more broadly over October, listed property continued to demonstrate a high sensitivity to bond yields and recorded sharper declines. Global listed property declined in value by 4.5%, with Australian property 5.7% lower.
Australian equities fell by more than the global average last month, with the S&P ASX 200 Index falling by 3.8%. In annual terms, returns remain positive at 3.0%. A reversal in the fortunes of energy companies, due to the decline in oil prices, was one source of this under performance. Additionally, expectations that cash interest rates would be increased further, weighed on consumer stocks and banks, which fell by more than the market average.
Resource stocks, however, continued to hold up relatively well. The resources sector has been supported by a lower Australian dollar over recent months, as well as a surprisingly resilient iron ore price. Despite the ongoing weakness in Chinese construction activity, the iron ore price rose by 2.1% last month to be 48.8% higher for the year. Possibly due to heightened geopolitical concerns, the gold price was also stronger over October, rising by 7.3%.
Fixed Interest & Currencies
Central banks continued to keep cash rates steady over the month of October, however the Australian Reserve Bank announced an increase of 0.25% in the cash rate in early November to 4.35%. There continued to be significant activity at the longer end of the yield curve, with U.S. 10-year Treasury yields jumping from 4.59% to 4.88% - after briefly reaching 5.0% during the month.
The increase in Australia was even greater, with 10-year yields moving from 4.48% to 4.93%. Australia’s November cash rate increase, and its greater adjustment to longer term yields, are likely to reflect a view that inflation is remaining stubbornly high here. The Consumer Price Index for the September quarter showed annual inflation falling only moderately from 6.0% to 5.4%.
The prospect of higher interest rates and the stronger iron ore price failed to generate support for the $A last month. Against the $US, the $A fell U.S. 1.1 cents to U.S. 63.5 cents. The $A was also weaker against the Yen (down 1.1%) and the Euro (down 1.9%).
Despite the magnitude of the recent shift in bond yields, and the uncertainty created by the tragic events that have occurred in the Middle East, the response on share markets continues to be measured and logical. The 8% fall in global share market values that has taken place over the past 3 months is an appropriate adjustment to the higher bond yield regime. This revaluation ensures that equities continue to be priced in a way that provides for a likelihood of a longer term return premium over bonds from this point forward.
Although the correction on equity markets over the past quarter represents a sharp turnaround in the trend that prevailed in the previous 9 months, the longer term performance of the asset class has been in line with historical averages and largely unremarkable.
One year returns for hedged global equities currently stand at 8.3%, which is the same annual return received on average over the past 3 years. Notably, the return sits at an historically high margin above the cash interest rate, which has averaged just 1.5% over the past 3-years.
The fact that equities haven’t fallen further in response to recent events highlights an underlying resiliency in the economic environment, creating a climate conducive to ongoing favourable earnings results. In addition, the lack of any significant dysfunction in the financial system, or outbreak of corporate credit defaults, has meant that the catalysts most likely to produce a serious sell-off on share markets have been absent.
With bond yields having risen so rapidly over the past quarter, the scope for further yield increase must now be more limited. Inflation is in decline, albeit more modestly than previously hoped, and this should cap the range of any further yield increase. The speed at which 10-year bond yields retraced back from the 5% level over recent days suggests that 5% could potentially be a cyclical ceiling.
If the potential for further bond yield increase has become more limited, then one risk to equity markets has been diminished. Share market risk in the period ahead may therefore become more focused on company earnings and whether these can be maintained in an economic environment still digesting the impact of a rapid rise in interest rates.
Arguably, company earnings expectations may be too optimistic, with a complacency set in given the economic resiliency demonstrated to date. However, not all equities are priced equally. Implied earnings expectations for mid and smaller companies, as well as in regions such as Europe, are much less demanding than those for the U.S. Technology sector, which has driven much of the recent share market growth. Active managers could still perform relatively well, even if there is a downgrade to earnings at the macro level.
For investors, the positive aspect of recent market movements is that diversification across both equities and bonds is now likely to produce more robust risk management. Should current economic and earnings forecasts prove to be too optimistic, then central banks would be likely to cut interest rates to avoid further economic weakness.
Hence, any earnings led correction on equity markets would likely be accompanied by a decline in bond yields – thereby creating a capital gain on bonds that could help cushion the impact of a weaker equity market. At current yields, therefore, the value of longer duration bonds goes beyond the attractive interest rates on offer. Bonds also provide a genuine risk management feature, which complements an equity market exposure that is becoming much more dependent on the nature of the economic cycle ahead.
The following indexes are used to report asset class performance: ASX S&P 200 Index, MSCI World Index ex Australia net AUD TR, MSCI World ex Australia NR Hdg AUD, FTSE EPRA/NAREIT Developed REITs Index Net TRI AUD Hedged, Bloomberg AusBond Composite 0 Yr Index, Barclays Global Aggregate ($A Hedged), Bloomberg AusBond Bank Bill Index, S&P ASX 300 A-REIT (Sector) TR Index AUD, S&P Global Infrastructure NR Index (AUD Hedged), CSI China Securities 300 TR in CN, Deutsche Borse DAX 30 Performance TR in EU. Hang Seng TR in HKD, MSCI United Kingdom TR in GBP, Nikkei 225 in JPY, S&P 500 TR in USD.
General Advice Disclaimer
This document has been prepared by Y Partners Wealth & Advisory Pty Ltd trading as Y Partners Wealth & Advisory (ABN 89 097 681 322). Y Partners Wealth & Advisory Pty Ltd is a Corporate Authorised Representative of Hillross Financial P/L (ABN 77 003 323 055) Australian Financial Services Licence and Australian credit Licence No.232705. Any advice provided is of a general nature and does not take into account personal circumstances. Any decision to invest in products/investments mentioned in this document should only be made after reviewing the relevant Product Disclosure Statements. Past performance is not a reliable indicator of future performance.