March 2023
The latest RBA statement highlights the problem of high inflation and that the path to a soft landing is a narrow one. It reiterates the RBA’s commitment to pursuing a 2 – 3 % inflation target, a target which notably the current RBA leadership has never sustainably achieved. It flags further interest rate increases too, as has the Federal Reserve. Markets think a further two rate increases in Australia are needed bringing the cash rate to circa 4% and, more importantly, home loan rates beyond 6%.
Home loan rates of over 6% will cause much pain to the average Australian mortgagee rolling off a fixed rate mortgage this year and make a meaningful impact on consumer discretionary spending. As such, we have already seen building approvals fall off in January and much anticipation that Australia will be heading in later 2023 for its first real housing-associated recession since the early 1990s. Much of the global economy is battling similar issues, and housing price falls.
Somewhat perplexingly, equities have held up in 2023 despite belated recognition from bonds that the interest rate pressures aren’t over and despite earnings margin deterioration and higher discount rates. Surely equities should have realised by now that we are heading for recession and that the cost of money has risen, so why are they so slow to get the memo?
The answer to this question is critical to the path forward. So, let’s consider it.
There are a few potential reasons for high valuations and equity market intransigence, led by the US:
(1) Corporations are still awash with cash because of the massive post-covid government stimulus and are still engaging in aggressive buybacks globally. These corporations feel the need to do something with their cash and prefer to spend it buying their stock regardless of price.
(2) The price-independent “passive investor” or buyer has become dominant in markets. Passive managers don’t value anything before they buy it and are price and outlook insensitive. This tends to boost market prices.
(3) The amount of speculation in markets remains incredibly high. Options markets now trade over $1 trillion in notional value daily, which is greater than physical buying. Much of these are one-day or less options capable of easily moving market pricing in the short-term due to its sheer leverage and dominance!
Equity markets have hence never been more casino-like and vulnerable to speculative flows. No wonder price movements defy belief in recent times and over short periods. Much of the market doesn’t care whether we are in a recession in late 2023 because it’s either price insensitive or only concerned with the current day’s price movements. How we got to this ridiculous scenario is another story.
So, it is indeed different in a meaningful way this time because of the character of market participants, but will it be different when we enter recession and earnings, and earnings margins take a more significant hit? This depends on the provision of one key factor, the actual amount of liquidity provided by central banks, commercial banks, and governments to the market.
Commercial banks are and will likely be less willing to lend money to the less creditworthy when the outlook is poor, but what about governments and central banks?
Governments, on the other hand, have become more fiscally irresponsible and dominant globally. They are likely to continue stimulating no matter what, given recent trends for greater government, the need for massive stimulus programs for infrastructure, climate change and increased military spending, and worsening dependency ratios and inequality.
The swing factor is central banks. Suppose central banks are true to their words and are committed to getting inflation down sustainably. In that case interest rates will increase further and potentially stay higher for longer in the face of economic weakness. Quantitative tightening will suck liquidity out of the market.
Given the above, the equity market is still likely to suffer and behave as it has in every other recession (assuming we get a recession, which leading indicators suggest is highly probable).
The challenge for the outlook is that markets don’t trust central banks to do what they say, and they have legitimate reason to be sceptical. Central banks could easily give up on tightening measures and reverse course in the face of weakening economies and rising unemployment. Equally, there is a solid case to be made given the sheer amount of debt in the global economy there isn’t a realistic option for central banks to become fully responsible now. It is simply too late as the economy has been overly financialised, and without ongoing stimulus, a deflationary bust will ensue which politicised central banks can’t tolerate. In other words, financial repression is needed whereby interest rates are kept artificially low to stimulate higher structural inflation to wear away high debt levels over time. This provides a potential path for equity markets to hold up and explains how it could be different this time.
In our view, both the bears and bulls will be wrong and right. Central banks are first likely to cause a market accident or hard landing particularly given the nature of market participants and speculation in today’s equity market, yet ultimately will be forced into a path of financial repression. It’s a matter of timing. So, while cash looks attractive today, its attractiveness is likely to be somewhat fleeting. Equally equities are unattractive today but will likely provide a great buying opportunity at some point later this year.
History has convincingly demonstrated that in every market sell-off investors don’t buy at the bottom and become afraid to become invested. Investors hence need to be invested, but just prudently at this point in time to avoid the risks of a hard landing in the short-term while still capture the likely benefits of financial repression over time. This means being invested with truly active and dynamic management that will buy into economic and equity market weakness when it arises but is investing cautiously with low equity market exposure for now, patiently waiting for the opportunity to strike. This management style will look to take advantage of an opportunity that we know investors are not structured to achieve and will otherwise miss. You need to be in it to win it, but equally you need to ensure the journey is tolerable too.
DISCLAIMER: WealthLander Pty Ltd ACN 646 957 119 is a corporate authorised representative (CAR; WealthLander) of Boutique Capital Pty Ltd (BCPL) ACN 621 697 621 AFSL 508011, CAR Number 1285158. CAR is the investment manager of the WealthLander Diversified Alternative Fund (Fund).
To the extent to which this document contains advice it is general advice only and has been prepared by the CAR for individuals identified as wholesale investors for the purposes of providing a financial product or financial service under Section 761G or Section 761GA of the Corporations Act 2001 (Cth).
The information herein is presented in summary form and is therefore subject to qualification and further explanation. The information in this document is not intended to be relied upon as advice to investors or potential investors. It has been prepared without considering personal investment objectives, financial circumstances or particular needs. Recipients of this document are advised to consult their own professional advisers about legal, tax, financial or other matters relevant to the suitability of this information.
The investment summarised in this document is subject to known and unknown risks, some of which are beyond the control of CAR and its directors, employees, advisers or agents. CAR does not guarantee any particular rate of return or the performance of the Fund, nor do CAR and its directors personally guarantee the repayment of capital or any particular tax treatment. Past performance is not indicative of future performance.
The materials herein represent a general summary of CAR’s current portfolio construction approach. Depending on market conditions and trends, CAR may pursue other objectives or strategies considered appropriate and in the best interest of portfolio performance.
There are risks involved in investing in the CAR’s strategy. All investments carry some level of risk, and there is typically a direct relationship between risk and return. We describe what steps we take to mitigate risk (where possible) in the Fund’s Information Memorandum, which must be read prior to investing. It is important to note that despite taking such steps, the CAR cannot mitigate risk completely.
This document was prepared as a private communication to clients and is not intended for public circulation or publication or for the use of any third party without the approval of CAR. While this report is based on information from sources that CAR considers reliable, its accuracy and completeness cannot be guaranteed. Data is not necessarily audited or independently verified. Any opinions reflect CAR’s judgment at this date and are subject to change. CAR has no obligation to provide revised assessments in the event of changed circumstances. To the extent permitted by law, BCPL, CAR and its directors and employees do not accept any liability for the results of any actions taken or not taken on the basis of information in this report or for any negligent misstatements, errors or omissions.
This Document is for informational purposes only and is not a solicitation for units in the Fund. Application for units in the Fund can only be made via the Fund’s Information Memorandum and Application Form.