Perhaps counterintuitively global equity markets had one of their best months in over 40 years as investors considered the likely increase in interest rates and its impact on the global economy. As a forward-looking indicator, equity markets tend to value companies based on where they are likely to be in 12 to 18 months’ time. It also reminds us of the danger of trying to time markets with the risk that money is not invested at a time when markets move quickly. The graph below shows the historical performance, what are monthly basis which should of course be interpreted against the background or very poor markets for the preceding three months’.
Interest Rate Rise – Australia
Domestically as expected the RBA lifted interest rates by 25 basis points on Melbourne Cup Day. This lifts rates from 10 basis points to 285 basis points over six months. One of the most aggressive increases in interest rates since the early 1990s. It is anticipated that a further rate rise of 25 basis points will occur in December and the RBA will then review the impact this has had on the economy at their February meeting. The key goal remains to manage inflation expectations noting that the impact of the coronavirus on the economy and savings patterns is still working its way through the system. Having just returned from overseas for the first time in three years it is clear that there are still significant supply problems in the economy which are not affected by increasing interest rates. What is required is the full reopening of our borders to provide more labour as needed to distribute goods and services in an efficient manner, which will have the effect of reducing supply issues and ultimately inflation.
United States – Interest Rates and Elections
Overnight the US Federal Reserve increased interest rates by 75 basis points and indicated that they would continue to prioritise reducing inflation even at the expense of putting the economy into a significant recession. In their decision making they are relying heavily on historical data. This may already be out of date as they try to assess the longer-term trends for inflation once one-off items including energy costs coming out of Ukraine are discounted. This is very much a balancing act where their chairman is seeking to bring inflation down while at the same time not damaging the economy. It is Likely that their economy is already in recession and a slowdown in future interest rate increases will be implemented after the midterm elections next week.
Their upcoming election will be dominated by their economy and will give a good indication of the future priorities expected of their elected representatives. With much of the mortgage market in the US being 15-to-30-year fix rates rising interest rates are not so relevant as in the Australian context. You would intuitively think that interest rates should peak early next year as further data demonstrates that much of the inflation has been sucked out of the market.
In essence both companies and individuals are spending more of their money on interest payments leaving less for discretionary spending. With the substantial stimulus of global economies over the last few years individual countries including Australia will need to meet much higher interest repayments on their debt. So, on balance a short sharp shock followed by moderating interest rates towards the end of next year appears to be the most likely scenario at this stage. On a positive note, this does allow conservative clients to get a reasonable guaranteed return on their money for the first time in well over a decade.
Labor’s First Budget
(Budget Summary link)
The newly elected Labor Party delivered their first budget last week which was a quiet and sober affair. The main goal being to keep the domestic economy ticking over while we wait for global partners to fully recover. Attached is a full summary of the budget with little affecting financial advice at this stage and importantly no adverse changes were made to superannuation arrangements. Age criteria for downsizing has been reduced to 55 which will allow clients at a younger age to top up their super significantly from the sale and downsizing of the family home. This is very welcome as we seek to keep high balances of superannuation for clients in retirement to draw down an adequate income stream to meet their living expenses.
One of the positives of rising interest rates has been a significant improvement in term deposit and annuity rates now around 5%. This means for clients who wish to take no risk in the future we can lock away these rates in some cases on a lifetime basis. There is however a limit to how high rates can rise before there is significant defaults on mortgages which would then impact on investors capital. It would seem to me that we are close now to an equitable balance between the needs of investors savers and mortgage holders.
We should not underestimate the effect that they war in Ukraine has had on the global economy including increasing the cost of energy particularly in Western Europe. These costs are now declining rapidly and should assist in getting inflation under control over the next 12 months. One of the consequences of reliance on energy in Western Europe has been the quicker adaption of new technology to utilise alternative energy replacing traditional fuels. The likely solution in Ukraine is still very difficult to assess and clearly has ramifications for other jurisdictions around the world. However, at some stage there will need to be some kind of settlement and compromise which will generally be well received by equity markets.
As you would expect, rising interest rates reduce the capacity for people to be approved for higher mortgages which has had the effect of forcefully reducing property values. We have seen this cycle many times before. The reestablishment of migration into Australia and an economy back up to full efficiency should be a net positive for property prices particularly if interest rates peak at a lower level than originally anticipated and possibly even decline in 12 months’ time.
The reality is that most client’s largest asset is their property followed by their superannuation balance and there is a limit to the amount of pain that the economy can stand due to rising rates. This is well understood by policy makers with the intention being to get inflation under control while causing as little damage to the economy as possible in the meantime. This has also limited risk taking in the economy and there is a sense of conservatism amongst the client base to protect existing assets rather than taking additional risk to increase wealth.
As we approach Christmas, we have a number of functions planned for clients including a major one at the Manly Skiff Club. It will be a busy time as we review portfolios and where desired, reduce risk excepting higher guaranteed returns reflecting current market conditions. Thank you again for your support and we look forward to seeing you all very soon.