We have witnessed a situation in global share markets that has seemed to defy economic reality. The overarching theme is that global central banks have needed to aggressively hike interest rates to fight runaway inflation at a time of record government and consumer debt levels. For example, the Reserve Bank of Australia (RBA) has increased rates 12 times since May 2022.
This has had a significantly negative impact on global economic growth.
Throughout the year, nearly all economic indicators were flashing a recession led by the US. We saw a debt crisis in the UK in September 2022, followed by a collapse in several large US Regional Banks in March 2023.
Yet global share markets largely shrugged off the recessionary outlook, especially in the US, which returned 23.6% for the full year and 9.1% for the June quarter. However, Australia, which led the market in the first half of the financial year, returned 4.8% for the year and only 1% for the final quarter. The drivers of return were very different in the second half of the financial year, with the returns of the US share market dominated by large-cap technology-related stocks – Nvidia being the standout. Australia underperformed due to the lack of technology exposure and continued uncertainty about China’s recovery.
Why the share market performed well against expectations.
Share markets were saved by consumers. Spending was resilient during the year despite the huge increase in the cost of living due to historically low unemployment and associated wage increases and large savings accumulated during COVID-19. Later in the year, markets took heart from the fall in US inflation. Australian inflation has also fallen, albeit still at high levels.
What does the year ahead hold?
The times we face are essentially unchanged and are very uncertain, as described by the following snapshot presented by Magellan.
Inflation, while falling, is well above targets. Central Banks (including the RBA) seem willing to risk recession to achieve their inflationary goals. So-called ‘sticky inflation’ (services inflation) remains stubbornly high. Further, surplus consumer cash from COVID is expected to be exhausted by the end of September 2023, putting downward pressure on the economy and likely increasing unemployment. Overall, we are in a low growth period, with the OECD forecasting Global GDP growth of 2.7% in 2023, rising to 2.9% in 2024. Growth in 2023 is projected to be its lowest annual rate since the global financial crisis, apart from the 2020 pandemic.
Against this background, some analysts and fund managers expect a ’soft landing’ where a US recession is averted, and the rally in stock markets continues. This may be overly optimistic, and our base case expectation is a US recession for the following reasons (noting that Europe and the UK are already in recession):
- Inflation is very unlikely to fall to Central Bank targets over the next 12 months, with sticky inflation and interest rates likely to be held at high levels for longer than markets expect.
- Falls in consumer spending will continue with significant negative impacts on corporate earnings.
- Bank lending officers have tightened credit conditions to ‘credit crunch’ recessionary levels.
- Corporate insolvencies are increasing rapidly globally (a 50% increase on the prior year in Australia).
- The yield curve is significantly inverted, which is a strong recessionary indicator.
- China’s economy appears to be in trouble, with major real estate collapses continuing, indicators such as exports and imports plummeting, and unemployment rising rapidly.
- Data sets such as small business confidence, consumer confidence, and corporate CapEx intentions are at low levels.
The odds of a recession in Australia were 50/50, primarily due to confidence that record-high prices for iron ore and coal would continue. The outlook is now significantly more uncertain due to the deflation of the Chinese economy. The significant pressure on households due to the ‘mortgage cliff’ will worsen in the months ahead.
What does this mean for portfolios?
Uncertainty leads to volatility in investment markets, especially for markets where valuations are stretched, like the US market (which is 70% of the world market by capitalisation). A US recession would cause a sharp fall in share prices globally as corporate earnings and PE multiples fall and unemployment increases. This recession is hard to predict but will likely be in the last quarter of the 2023 calendar year or early 2024. We expect that the recession will not be deep, and the economy may recover quickly. It may be the case that share market returns will be low and volatile for several years.
Nevertheless, with volatility comes opportunity. While we would be cautious in adding to equity exposures now, there may be opportunities if a correction does occur. Further, the increases in interest rates have resulted in good returns for term deposits and fixed interest and attractive opportunities for profits in long-term bonds when interest rates do come down.
Overall, we believe it is important to maintain a quality theme in portfolios in uncertain times and be prepared to make changes to your portfolio as opportunities arise.