Markets vs Central Bankers: The great valuation debate (part 1)

Articles 11/05/2022
Markets vs Central Bankers: The great valuation debate (part 1)

As we approach the halfway point of 2022, many investors will be hoping the second half of the year is more positive than the first. We are cautiously optimistic on the prospect of this occurring. As we discussed in February, global markets have been unsettled by the recent acceleration of inflation, with central banks looking to combat the issue by lifting interest rates. Given global benchmark interest rates are the building blocks for valuing almost all investment assets, markets are currently in a state of flux.  In the first of two notes we deliver some context around the recent volatility, the level of interest rates already priced into markets and what we think might actually be delivered. Next week in a follow-up note we will bring some focus back to fundamentals, providing feedback on how companies are managing the current environment and how we're managing our clients' portfolios.

Since the start of January, the technology stock-focussed US NASDAQ index is down 25% while the broader US S&P 500 equity index is down about 16%. Meanwhile, thanks to the spike in various commodity prices, our resource-dominated ASX is only off 5%. For bond markets, the first four months of the year have been tough, with the broad global index down 10% and Australian bonds also 10% lower. While our local market has been a source of relative resilience, there's been few places to hide for investors. Meanwhile, the US Federal Reserve has already lifted its benchmark interest rate from zero to 0.75% and the Reserve Bank of Australia has just raised the cash rate for the first time in almost 12 years from 0.10% to 0.35%. Both central banks are expected to deliver more increases shortly. While this is a period to be cautious, this shouldn't necessarily be of concern for long-term investors.

Indeed inflation has become an issue both abroad and domestically. The Fed's preferred measure of underlying inflation in the US (refer below left chart) is now tracking above 5% (well above the central bank's target of about 2%) albeit showing early signs of stabilising. While pricing pressures aren't quite as acute in Australia, they too have lifted above the RBA's target 2-3% band (refer below right chart). After making negligible advances for many years, wage growth is now starting to lift and central banks, keen to avoid an inflation spiral, have consequently begun lifting rates.

 

Yet investors need not run for the hills.

In February, we highlighted the significant and expeditious about-face in the market's view on inflation, resulting in a material degree of tightening (rate increases) from central banks being priced in. Since then this dynamic has continued, seeing expectations for rate increases lift even further.  In fact, while we felt bond markets were predicting somewhat aggressive interest rate increases a few months ago, we now see the implied rate increases to be outright aggressive. To illustrate, the Australian government bond market is currently suggesting the RBA will move the cash rate to 3.00% by December this year. This is higher than the implied US Federal Funds Rate priced into US bond markets of about 2.75%, despite Australian underlying inflation running considerably below the US! From a current rate of 0.35%, an implied December rate of 3.00% would require the RBA to lift rates every month for the rest of the year, with some of these increases being 0.50% increments. 

In light of the significant lift in household indebtedness, we doubt the Reserve Bank will have the appetite to impose such a significant interest rate burden on consumers. As the below chart demonstrates, each incremental increase in mortgage rates will have a much greater impact on household budgets than in previous hiking cycles. Were the RBA to follow through with market's implied level of rate increases, it would risk pushing not only the housing market but the economy into a downturn: an outcome the central bank clearly wants to avoid!

 

Global supply chains are continuing to recover from significant COVID-related disruptions. Furthermore, while energy prices have spiked on the back of the Ukrainian conflict (Brent crude lifted from US$70 in early December to US$113 per barrel today), we do not foresee a further 60% price uplift from here. As a result, we expect to start seeing a stabilisation in inflation data over the second half of the year, with some of the initial leading indicators suggesting as much. Should this occur, central banks will have reduced impetus for  lifting interests rates to the extent priced into markets. Our view is shared by the major banks with Westpac's economics team expecting the cash rate to be 1.75% come December (and only 2.25% by the end of 2023). A far cry from the 3.00% currently priced in to debt markets. 

Assuming a more modest level of rate increases are delivered, we shouldn't be surprised to see Australian house prices soften modestly over 2023 as higher interest rates start to impact affordability. However, given the raft of stimulus provided to households throughout the pandemic and a near-fully employed labour market, we feel households are well placed to navigate such an environment.

Unlike the experiences of 2008-09 (where credit markets effectively froze) and the more recent early 2020 period (when markets hadn't a clue how to price-in a temporary shutdown of economies from a global pandemic), the experience of 2022-to-date is one premised on asset price valuations. Unlike 2008, corporate balance sheets are strong with gearing sitting well below the stressed levels seen in the GFC. Notwithstanding some inflation-related pressures on near-term earnings, the fundamentals of high-quality businesses remains sound. Unfortunately, while the markets continue to debate the appropriate level for long-term interest rates, we expect asset prices to remain volatile. However as we've discussed, we have reason to believe that clarity will start to become evident as we progress through the year, allowing quality to shine though in both equity and bond markets.

Next week, we'll discuss the recent experiences in global equity markets as well as feedback from key business leaders on how they're navigating the current environment. Finally, we'll pull these perspectives together to discuss our approach to managing portfolios.

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