By far the dominant theme in global financial markets in 2022 has been the rise in interest rates and bond yields. Central banks are fighting inflation, they have left it late to do so, and they’ve spent much of 2022 trying to catch-up. The US central bank raised rates in increments of 75 basis points. Not since 1995 has it raised rates by this amount in a single meeting, and that was once. In 2022 we had four of these unusually large rate-rises, all one after each other.
In Australia, the central bank has pushed through four consecutive 50 basis point increases and now have interest rates back to levels last seen in 2014. The sharp increase in interest rates has been felt in other markets. In the US bond market, the bedrock of global discount rates, we find the 10-year bond yield was 4.2% until recently and 270 basis points higher than start of year levels. Never have US bond yields risen so much in a single year.

Driving the cost of money higher has been a combination of surging inflation, solid economic activity, central banks lightening their own positions in government bond markets via quantitative tightening programs and, a litany of other liquidity issues. These liquidity issues include Asian central banks selling US bonds to try and hold up their own currency because they, too, are afraid of surging inflation. Meanwhile, UK pension funds are being forced to sell down their US Treasury positions to make margin-calls back home.

Surging interest rates and bond yields are leaving a trail of disaster elsewhere. In the past it has been the equity market which has collapsed when bond yields have surged. This was the case in the early 2000s and the decline was centered around expensive tech stocks. The S&P 500 sold-off by 50% back then and the ASX 200 was down 22%. Equity markets again crumbled around the time of the financial crisis and after central banks tightened policy. The Australian central bank was considerably more hawkish back then and raised rates as the crisis was kicking off. The Aussie equity market dived more than 50% as did the US equity market. In both the early 2000s and during the global financial crisis equity markets were fragile, a house-of-card perhaps. They were held up by low interest rates but when that went they came tumbling down.

The house-of-cards now, if there is one, is amongst the village of the new assets. They are unregulated, exist for opaque purposes and, spent their infancy in a world of ridiculously low interest rates. Now the price of money is rising and they are struggling. The collapse of FTX is so far the most stunning part of the crypto trainwreck. As long as interest rates remain high, we think there will be more collapses, perhaps less spectacular, in this corner of global finance.
There have also been pockets of the global equity market which have proven to be flimsy in the face of higher interest rates and bond yields. They have been more speculative stocks and include companies which don’t generate a profit. Over the long-term a revolving basket of unprofitable companies in Australia would have generated returns of -20% p.a. (yes that’s a loss) and this year this group of stocks lost investors 35%. The lessons are clear — tread with caution around the most speculative stocks and assets, especially when the price of money goes up.

While the carnage of rising interest rates and bond yields has been brutal, we expect most of this is now behind us. We forecast moderating bond yields ahead. The decline has already begun and will continue with lower inflation, slower economic & profit growth, the coming end of central bank hiking cycles and, an alleviation of the acute liquidity concerns in government bond markets.

The concern for equity investors in 2023 is likely to revolve around profits. Global profits have made a stunning recovery from the depths of the pandemic. In the US and Australia EPS has increased by more than 60% from their 2020 lows. Now corporate profitability is at elevated levels with US RoEs at 18% and 2 standard deviations higher than the 40-year average. In Australia profitability does not appear as extended and RoEs are at 15% or 1.5 standard deviations higher than the long-term average. Still local RoEs have only been at or above current levels twice in the last 40 years. Despite the vulnerability, for several reasons we don’t forecast a profits collapse. Importantly, policy is currently not tight enough to deliver a broad-based decline in earnings. In the US and Australia real interest rates remain negative. This may change however if central bank decide to keep interest rates high even when inflation is falling rapidly. While this is not our central forecast — central banks appear willing to respond to rising and falling inflation — it does remain a possible scenario. The bottom-up consensus outlook is for 2% EPS growth for the ASX 200 in both the 12 months to June 23 and June 24. Anemic growth rates like this are consistent with our ‘soft-landing’ for corporate profits.

Our forecast is for a modicum of EPS momentum and, a decline in discount rates, which should mean Aussie equities eke out a small gain by the end of 2023. We target the ASX 200 to reach 7400. Our assumptions here include a year-end PE ratio of 14x vs 13.5x now. The long-term average has been 14.5. Our forecasts will prove to be too optimistic in a hard landing scenario. We expect Aussie equities will outperform those in the US where valuations are still more expensive and the profits outlook appears more problematic.

The US equity market lacks the same level of profits support as in Australia. US profitability, in part due to the lockdowns during COVID, are starting this period of vulnerability at an especially elevated level. Meanwhile, while not our central forecast, the sharp rise in US interest rates puts at risk the current slowdown turns into something worse. While weak US profits momentum will have an influence on Aussie earnings momentum too, local earnings are greater beneficiaries from (1) easing policy in China and, (2) a less aggressive central bank. Our preference would be to make bigger allocations to US equities further through the current period of slowing earnings and at, hopefully, a stronger AUD vs USD.

Within the market we continue to target several themes that should help investors deliver better than index returns. We highlight these themes below.

The stimulus taps remain on in China and we expect this will support a recovery in economic activity. The official data suggests a rapid slowdown in the 1H22 and early data for 2H indicates a recovery. The recovery will be supported by a lightening of the COVID restrictions and direct support for the Chinese property market. A China recovery should be positive for the miners and our preferred ones include BHP and Iluka Resources. Rising China steel prices may also support prices in the US boding well for Bluescope.

The time has come to add a little duration to portfolios. Global bond yields have risen to levels beyond our initial forecasts and we believe there are early signs of moderation. We continue to avoid some of the more highly priced and speculative growth stocks where there could be clearer earnings concerns or have no earnings. However, investors should consider former high growth stocks which continue to benefit from solid profits momentum like Goodman Group.

We expect further downside in residential property prices indices driven by weaker lending and higher interest rates. While housing valuations have improved, according to the gross rental yield, higher mortgage rates suggest they will rise further. During previous periods of falling house prices the Banks have been consistent underperformers. We also find the resi-developers, like Mirvac have struggled. Meanwhile, we find Australian household balance sheets are strong which suggests the downside to discretionary consumption will not be as significant.