What could dampen the equity rally?
Optimists and pessimists on the next move for markets.
“We live in interesting times,” says my colleague Graham Hand at Firstlinks. Amid inflation, the first Federal Reserve rate hike in almost four years, a pandemic, petrol prices north of $2 and the biggest European war in a generation, the ASX rose 6.4% in March.
What’s going on? Are equity markets ready to shrug off interest rates, inflation, war, and surging commodity prices? Or is this a sharp intake of breath before a plunge. Here’s how Kerry Craig, global market strategist at JP Morgan describes the current moment:
“The market is trying to determine if this is an inflection point,” he says. “Does this mean things will continue to move higher or are we still waiting for the bad news to come in?” He notes the market positioning of institutional investors suggests a lack of conviction in the current rally, in other words, it could reverse quickly.
Amid the uncertainty, both pessimists and optimists make compelling cases.
The risk central banks tank the economy in their campaign against higher inflation sits high in the minds of market pessimists. A recession would take company profits, dividends and equity markets along with it.
Using higher interest rates to ‘cool’ an economy is always a juggling act. Move too fast and the economy freezes altogether. Proceeding carefully is difficult due to record inflation, increasing the risk of a policy mistake, say pessimists. Higher petrol prices, falling consumer confidence, new lockdowns in China and the ongoing war in Ukraine add to the downside risks for growth. Randal Jenneke, head of Australian equities at T. Rowe Price, puts the conundrum like this:
“When we go through rate hike cycles. It’s like the Fed trying to land a 747 on an aircraft carrier. It’s a really tough ask at the best of time. War in Europe thrown into the mix complicates things so much more.” Of the last twelve Federal Reserve hiking cycles, a recession followed 75% of the time, he adds.
The nightmare scenario for pessimists is central banks hike rates enough to kill the economy but not far enough to contain inflation.
Growth warning signs flashed this week as parts of the US bond yield curve inverted. A common gauge of the future trajectory of the economy, yield curve inversion has preceded each of the six recessions in the US since 1978 (although recessions have not followed every yield curve inversion). Where the US economy goes, Australia tends to follow, notes Jenneke.
Booming economy buoys optimists
However, bond markets signals need to be taken with a grain of salt, says Craig. After a decade plus of central bank intervention, they may not be functioning as they once did.
Optimists emphaise the economy's strength. They see a post-pandemic boom with enough momentum to handle higher rates and commodity market turmoil. That’s positive for corporate profits and equity markets.
Growth and unemployment statistics read like a trophy cabinet: Australia’s economy expanded at the equal-best pace in 46 years during the December quarter. Unemployment is forecast to fall below 4% this September, the lowest level since modern records began in 1978. It’s a similar story in the US. Unemployment for Americans without a high school diploma is the lowest on record. The US economy expanded at the fastest rate since 1972 in the fourth quarter last year.
“There’s not really a strong chance of a recession even given what’s happened… the economies [in the US and Australia] are actually in pretty good shape. Unemployment rates are very low. Job prospects are good. Wages are growing. All of that works to offset the income shock that many households and companies are facing from rising input prices.”
Markets seem to be buying the message. Last month’s equity rally took hold following a press conference where US Federal Reserve Chairman Jerome Powell said the US economy was strong enough to withstand rate hikes.
Australia is particularly fortunate, say optimists: Bumper profits for local commodity producers are a cushion against higher prices at the pump, as are the roughly $200 billion stashed in individual savings accounts across the country. The economic impact of war in Ukraine is unlikely to travel the 13,000 kilometres down under. With local inflation around the 3% mark, less than half the 7.9% in the US, the Reserve Bank has more room to be patient.
Putting it all together, “we still there’s enough positive momentum in shares, in company earnings, in the recovery to keep shares higher over the six-to-12-month view,” says Diana Mousina, a senior economist at AMP Capital.
One of the comforts of long-term investing is a certain degree of sangfroid when it comes to those warning about calamity. Investing over 10 or 20 years almost guarantees dips and crashes, corrections, and bear markets.
Or as Mousina puts it: “there is always geopolitical risk.” Before Russia’s invasion there was the trade war between China and the US. Before that Brexit and Trump. Go a little further back and the Eurozone was on the verge of breaking up.
Ultimately, investing in interesting times is much the same as always: set goals, select your appropriate asset allocation, revisit them periodically and stay the course.