Report Card

In our last update on 13 October 2022, we signed off with: 

“Asymmetry is appearing in the market, and that usually proves the best time to invest.”

As the rest of the market, driven by the headlines were wrestling with negative messages, we spent the balance of October working through how we were going to implement our views for the balance of 2022. 

Our messages were: 

• If reported earnings were anywhere near consensus (versus a market pricing of significant downward revisions), combined with confirmation of our view that inflation would moderate (and it did, both in the US and Australia), a clear path existed for markets to appreciate between 15% and 25% up to the end of the year. 
• The strength in the US Dollar (in our view, significantly over-valued) and the 15% decline in the Australian dollar since March on the USD / AUD cross rate provided an opportunity to build a strong margin of safety into a hedged AUD position. We saw upward movements of up to 10% to get back towards fair value. 
• Greater visibility over the terminal Fed funds and RBA rates was imminent. The signal that the rate of increase would decline and potentially pause was going to be a bullish market signal for interest rate sensitive assets. 
• We also said that the best dollar we invest for the next decade may occur in the next 3-6 months. 

The table above is a report card on our views from 13 October. 

• Firstly, earnings per share growth for the S&P500 for Quarter 3 was +2.2% - a surprise having regard to where the market was pricing earnings to land and while our view was counter-consensus, it was pleasing to have this confirmed. 
• Secondly, US Inflation (annualised) continued to moderate for the fourth month in a row to 7.7%. In Australia the annualised rate of inflation moderated to 6.9% (a surprise to many). 
• In Australia, the RBA gave the market a clear signal that they were not wedded to hiking rates and would balance their mandate of pricing stability (including home prices) and full employment. This gave the market a greater insight as to where the terminal rate would end up for the RBA (although there are still a variety of opinions with the lowest being CBA at 3.10% and the highest Goldman Sachs at 4.10%. 
• Yesterday the Federal Reserve in the US softened their (hawkish) stance on interest rates as labour market data signaled that they were at risk of making a serious policy mistake if they continued to hike rates apace. Bond yields fell as a result and interest rate sensitive sectors such as Technology (Nasdaq), infrastructure and real estate rallied. 

During the period since our last report, we deployed the majority of our cash positions into the market. Our Low Volatility portfolio benefited from changes which increased the running yield of the portfolio while also benefiting from a modest increase from market linked positions. Our Mid Term portfolio was re-balanced to reduce weight to floating interest exposure and increase equity market exposures. Finally, our Long Term portfolio moved from a near 30% cash position to 2% and enjoyed a double digit return for the month of November. 


Wonderwall - 1995 Comparison

The period in market history that most closely replicates the present day (e.g.: period of high inflation, central bankers aggressively hiking rates and moderating as data) is 1995.
 
During 1994, a speech from the Chairman of the Federal Reserve announced that the hiking spree through 1994 might have been overdone, and a mild recession could ensue.  At the time in the US inflation was 3% and interest rates were 6%.  When the speech was made markets had already rallied off their 1994 lows, and 1995 continued the trend across most asset classes.  The best performing assets were equities in 1995 with both growth and value posting above average returns.  

Fed Governor Powell’s yesterday which drove markets was potentially such a tipping point for the present day.  The message from Powell was that the auto-pilot for increasing rates was being turned off and that any adjustment to rates would focus on the 3 components of inflation – core goods (falling as supply chains normalise), housing services (not yet falling, however activity data suggests that it will imminently), and non-housing services, where labour and in particular wage growth is the most important factor (slowing but may still be too high). 

What does all this economic babble lead us to? In the near term, it means that wage growth, demand for labour and the components of labour productivity are key to how the Federal Reserve will be viewing their interest rate response to inflation. Put simply, a disappointing set of numbers in wage growth or demand for labour would be a good thing for markets and our thesis above. Strong numbers would be bad. A surprise (really) bad number would also likely lead to a poor market reaction. These figures will be reported Friday night Australian time (2nd December in the US). 


Santa Claus or Grinch

• Labour market outcomes remain the most critical component for a continuation of the year-end rally. Evidence of softening (but not a sharp drop) could drive a strong December performance as it would indicate to Central Banks to slow or halt rate increases. 
• Markets will turn their attention to Q3 earnings in due course early in the new year and this may moderate any buoyancy. We will look for signs of too much Christmas cheer against consensus earnings – this would be the primary driver for us to take some risk off the table and return some funds to cash.  
• Later this month, we will be sending out our assessment of what we see as key for 2023 and update our report card.