After a rally extending all the way from 2020’s Covid lows, 2022 has proven to be a difficult year for investors.
Australian equities are down 2% in price terms year to date (+2% including dividends). Global equities have fared significantly worse, having dropped 9% in AU$ terms (16% in USD). Local and global bond indices are down 8% and 15%, respectively, making 2022 one of the worst years for bonds on record.
Stubbornly High Inflation Awakens Central Bankers from their Policy Slumber
The underlying macro force dragging down both equities and bonds in 2022 has been a much more resilient inflation pulse than the market (and central banks) expected. Inflation was relatively high coming into this year (6.7% in the US) but the expectation was that it would fade, particularly over the second half of this year.
These hopes were disappointed for much of the year. Russia’s invasion of Ukraine certainly did not help matters, with prices for oil, gas and many soft commodities spiking in Q1 and staying high throughout much of the year.
While headline inflation (at least in the US) did reach a peak relatively early in the year, it proved to be more of a plateau than a peak. This stubborn trend in inflation prompted the Fed to become increasingly hawkish in its policy actions and guidance, which clearly unnerved investors.
US core inflation did not actually peak until September (driven mostly by sticky services sector inflation), before finally showing signs of easing in the October data release. We believe US consumer price index (CPI) data for November, scheduled for release this week, will likely be pivotal for market sentiment moving into 2023. A consecutive benign US CPI reading would likely add fuel to the recent global equity rally, as well as supporting the more positive recent trend in the AU$. Conversely, another upside inflation surprise in mid-December would likely reinstate the previous market downtrend.
This year’s “stubborn inflation” narrative drove a significant about-face from what were previously mostly dovish central bank attitudes to containing inflation. Indeed, much has been made of the Reserve Bank of Australia’s (RBA) “no rate rises until 2024 policy guidance”. As a result, both the US and Australian official cash rates rose sharply this year, albeit from a starting point of close to zero. The domestic cash rate is now 3.1%, while the rate is just below 4% in the US. This contrasts with market expectations at the start of the year that rates would still be very low by year end. Indeed, the Fed’s own December 2021 guidance was for cash rates to end 2022 at around 1%.
The futures market currently expects a cash rate peak of 3.6% next year in Australia, and around 5% in the case of the US. The US Fed meets again this week and is widely expected to hike rates by another 50 basis points (bps), taking the cash rate to ~4.5%.
At present, market sentiment is oscillating between hopes for a slower pace of hikes and a first-half rate peak, balanced against fears that the tightening done this year and incremental tightening into the new year may cause a US recession. The market appears less concerned about the prospect of an Australian recession, though the ebb and flow of US recession fears are still dominating equity market sentiment.
Surging Bond Yields Weigh on Equity Valuations
High inflation and higher cash rates have also driven long-term interest rates higher this year. After starting the year at 1.5%, the US 10-year bond yield climbed to a high of 4.2% in October, before easing back to a current level of 3.5% (as at 6 December), with inflation and Fed rate fears easing somewhat. Australian 10-year yields also hit a high of 4.2%, although the peak was closer to the middle of the year in Australia’s case. Domestic bond yields have also eased back to a current level of 3.4%, as US yields have fallen back and as the local market moderated expectations for the peak RBA cash rate next year.
Higher long-term interest rates placed downward pressure on equity valuations, particularly the “long duration”, high price-to-earnings (PE) growth stocks that dominate the US market. This has been less of an issue for the Australian market with its relatively low technology weighting and high weighting to resources and banks.
Rising Rates Have also Darkened the Growth Outlook
The sharp rise in cash and bond rates this year has caused increasing angst around the outlook for the global economy and corporate earnings into 2023. Global growth slowed in 2022, although growth remains relatively resilient in the US with the labor market still tight and the services sector still in Covid recovery mode.
Australian growth has also remained resilient (even more resilient than the US) in spite of rising rates. We expect that while domestic growth will slow significantly in 2023 (to sub 2%), Australia will avoid a recession.
European growth is clearly weaker, making a recession likely. The impact of surging energy prices is undoubtedly hitting growth via impacts on both household and business spending. The European gas price surged to an astronomical level in 2022, fueling a huge surge in European inflation. The price has retreated in recent months and this price relief is now starting to feed through to some easing in European inflation. However, the surge in inflation this year appears to have set Europe up for an almost certain period of economic contraction.
China was arguably an even bigger growth disappointment than Europe this year, with the country’s zero Covid policy combining with a dysfunctional housing sector to drag growth to its lowest levels in some time. Sentiment towards the China growth outlook has improved in recent weeks, as signs accumulate that China is both providing incremental support to the housing sector and laying the groundwork to move away from its zero Covid policy. We expect growth to pick up in 2023, although it may still fall short of its strategic 5.5% growth target.
Commodities Buck the Trend on Supply Side Disruption
Despite the weak growth pulse emanating from China this year, commodities have generally had a strong year, leading to an unusually strong year for resource stocks in the face of a weakening broader market trend. Performance for energy commodities was turbo-charged by Russia’s invasion of Ukraine, with thermal coal and global gas prices in particular surging due to acute supply constraints. Energy commodity prices have eased somewhat recently, while more China-focused commodities such as iron ore and copper have staged a comeback on hopes of China reopening in 2023.
Key issues for 2023 – Still about the Path of Inflation and Economic growth
As we head towards year end, the investing environment is delicately poised. We retain our neutral stance on both equities (with Australia preferred) and fixed interest. After a tough year, equities and bonds have staged a rally on hopes of peaking inflation and a reasonably imminent peak in central bank policy rates. While we think a moderation in the inflation cycle has begun, this week’s US inflation data will likely be critical to near-term market direction. The Fed’s forward guidance on rates this week will also be closely watched. Further signs of peaking inflation and a less hawkish Fed could add fuel to the recent rally but there is likely limited scope for inflation to disappoint given the significant equity rally from October lows.
Beyond inflation, the outlook for economic growth and the earnings cycle will also be critical for the 2023 investment outlook. While growth will slow, we believe the US and Australian economies can avoid a hard landing in 2023, while Chinese growth can actually pick up after a difficult year. So, our base case for inflation and economic growth should support at least moderate gains in equities and a more benign backdrop for fixed interest.
We will discuss our market outlook for 2023 in more detail next week in our final note of the year.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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