Investing Compass: Market outlook: Are investors too optimistic?
Our market outlook looks at the current state of the market and themes investors should be aware of.
Mark LaMonica: Alright so, we had a plan today – and we talked about before that we've been going to these ridiculous exercise classes together.
Shani Jayamanne: Yes, body pump body, yeah.
LaMonica: And we were supposed to go today. And where do we go instead?
Jayamanne: We went to Guzman.
LaMonica: Yes, which is like the opposite.
Jayamanne: I had a bit to drink last night, and I wasn't really feeling like lifting weights, so.
LaMonica: Yeah. And I was looking for any excuse not to go.
Jayamanne: To not go – but you also went to a class by yourself yesterday.
LaMonica: Well, I went to a new class. I've been by myself before, but I went to a new class and it was during the day we went to a Sharesight event yesterday, which was great. But in the morning I worked from home and I went to a class at 9:30. It was just a very different crowd. I was the youngest person there.
Jayamanne: So how did the class go?
LaMonica: Well, so I thought while I was there, I figured I'm the youngest person there, so finally – cause normally it's just like all these really fit people and I'm just like, labouring away trying to get through stuff. And I was like, alright, here we go, like this is the class that I'll do well and I was in the back, cause I hide in the back, and the instructor got off the stage and walked all the way to the back to correct my form. So it was very embarrassing.
Jayamanne: Your form on what?
Jayamanne: Well, there you go.
LaMonica: Yeah, anyway. Let's get into this before we talk about my humiliation or we talk too much about my humiliation. We're going to do a market review today Shani.
Jayamanne: Which are always really popular episodes.
LaMonica: Exactly. Yeah. So Shani, you can do the whole review. What's happening with markets right now?
Jayamanne: Well, let's sum it up by saying it feels like we're in a bit of a waiting game it. \
LaMonica: That's true, I agree.
Jayamanne: What we're waiting for is the impact of the interest rate increases that have occurred globally over the past year and a half – Have they brought inflation under control? Have they pushed the economy into a recession? Will there be more increases? Will they start to be cut?
LaMonica: That's a lot of questions Shani, so why don't we start breaking these down? So we of course, all know what has happened with interest rates, but let's review where we are with inflation.
Jayamanne: So we can start in Australia. The last official look at inflation came out in late July and measured the increases in prices in the quarter, finishing up at the end of June. The annualised rate of inflation came in at 6%.
LaMonica: So that's obviously a lot higher than where it needs to be, but it is an improvement. So the previous quarter, the annualised rate was 7%, it was 7.8% the quarter before that. And the RBA does believe that we are on the right track. They predict that inflation will drop to 3.5% by the end of 2024. And will be back into their preferred range of 2 to 3% by the end of 2025.
Jayamanne: So that sounds like good news. Are we out of the woods?
LaMonica: Well, the RBA doesn't exactly have the greatest track record in predicting future inflation, or anything else for that matter, and we do need to remember that we got into this mess in the first place because the RBA and central bankers around the world told us that inflation was transitory and wouldn't get out of control in the first place.
Jayamanne: And that is the first part of our waiting game. Will these forecasts come to fruition? Because ultimately, the level of inflation will dictate what happens with interest rates.
LaMonica: And we did an episode, and I remember you were very perplexed about the naming of this episode, but we called it ‘The ghost of Paul Volcker.’
Jayamanne: I feel like it wasn't just me.
LaMonica: Okay maybe everybody. And that talked about the mistakes that were made during the battle against inflation in the 1970s, so go listen to that episode. But in summary, central bankers took their foot off the pedal too soon and inflation came roaring back. And this kept happening until Paul Volcker basically took inflation out to the woodshed and beat it into submission with interest rate increases and that triggered a huge recession.
Jayamanne: That was very intense. Alright, so Mark seems sceptical that inflation is under control but the market does not share that scepticism. Right now, the market is pricing in that interest rates have reached a peak and that the next move will be a cut, although the forecast is that it won't happen until the third quarter of 2024.
LaMonica: To an extended pause.
Jayamanne: Very much so. And there is still the expectation that the Fed in the US will raise interest rates and there's also the expectation the rates are close to a peak.
LaMonica: And this optimism about interest rates extends to the economy. Many forecasters are now saying that in Australia and in the US, we can avoid a recession. So, happy days inflation is under control. Interest rate cuts are coming. And no recession.
Jayamanne: I'm sensing some sarcasm.
LaMonica: Well, I'm all for being positive Shani despite I guess the way that I generally act, but this just seems a little too optimistic. The highest inflation in 40 years has been brought under control without throwing the economy into a recession, and it seems to be ignoring the structural changes in the economy and just thinking, hoping perhaps, that we can go back to the pre COVID environment where we didn't have to make any trade-offs between low interest rates, inflation and economic growth.
Jayamanne: So maybe things will work out. But as we've said many times, expectations are baked into the market. So as investors, we need to at least consider alternatives. And it's also important to know that while the equity market is very optimistic, there are other points of views. So let's turn our attention to the bond market.
LaMonica: So the equity market has famously been portrayed by Ben Graham as this manic creature called Mr Market that swings from optimism to pessimism. Well, the bond market is a bit different. It's supposed to be the sober adult in the room, which Shani was not last night.
Jayamanne: It's not really the group you would want to invite to a party.
LaMonica: Yes, the bond market, not you though.
Jayamanne: Yes. Yeah. Don't invite me either. I'm in bed by 8:00 PM most nights.
LaMonica: But that of course does not mean that the bond market should be ignored.
Jayamanne: And if you follow the bond market at all, they're saying not so fast. We can take the US, for example, the 10-year Treasury yield has increased significantly. They were recently trading at 4.21%, which is just about the highest level since the collapse of Lehman Brothers in 2008.
LaMonica: And this is important because longer term bond yields represent expectations for the level of interest rates over the course of that bond. Because of course, if you buy a 10-year bond, you're forgoing the opportunity of buying shorter term bonds over that same 10 year period.
Jayamanne: So what the bond market is telling us to do is snap out of this fantasy. And honestly, it is a fantasy that we hear a lot. We hear it from home owners who are optimistically thinking that rates will return to COVID levels. We hear it from investors who are expecting the same old valuation levels to return. These are the same investors that have led to the NASDAQ to gain close to 28% this year.
LaMonica: And I think there are too many structural shifts in the economy to expect rates to return to those COVID lows or to look like what we've seen since the end of the GFC. We've talked about these changes in other episodes, but they include a step back on globalisation, more spending on climate related projects and military spending and an increasingly polarised world.
Jayamanne: And we do need to talk about one more thing that is influencing markets, and that is China. And let's just say that China is going through a lot of economic issues right now. And some of these challenges are unique to the Chinese economy.
LaMonica: We've obviously been talking a lot about inflation, but China is experiencing deflation. Official data, which I should add is viewed with a healthy amount of scepticism, showed that consumer prices fell 0.3% over the prior year. Producer prices have fallen for 10 straight months, for a total drop of 4.4%. So Shani what gives?
Jayamanne: Well, we should point out that Chinese officials are saying that deflation is transitory.
LaMonica: I'm trying to remember where we heard that before.
Jayamanne: Exactly. But the fear is that China is going through something similar to what Japan experienced starting in 1989. That falls in the price of assets like real estate and the share market and heavy debt burdens, led to consumers spending less and the economy falling into a period of deflation. And once again, the issue is COVID. Many commentators are suggesting that the impact of the brutal lockdowns impacted consumer confidence, and that many small businesses did not receive the level of support that was available in Western countries.
LaMonica: And the Chinese real estate market seems to be a bit of a mess. Previously we had Evergrande, which was running into trouble back in late 2021, as they struggled under $300 billion in debt, and now we have Country Garden, which is in danger of defaulting. UBS is predicting that new property construction will drop 25% this year and 10% next year. And as property prices come down, it is expected to further depress consumer spending as 60% of household wealth is property.
Jayamanne: And in Australia we’re very reliant on exports of commodities to China to support the resources sector. And the concern is reflected in a dropping iron ore price and predictions for continued drops. The iron ore price was over $220 US per tonne in 2021 and is now trading at just over $100. Iron ore is, of course a key ingredient in making steel, which is used in construction.
LaMonica: And the question is, what are we supposed to make of all this as investors? Well, the first thing is to repeat what we said earlier. As investors, it's important to understand what is priced into the market and despite markets pulling back in August, I would say that there is a fair amount of optimism baked into it right now. Optimism that inflation will continue heading in the right direction and that we can avoid a recession.
Jayamanne: And we saw this with the recent employment results that were released in Australia, July job numbers came in weaker than expected as unemployment rose to 3.7%, which was slightly higher than expectations and largely the market took this as good news. That would mean the end of rate hikes.
LaMonica: And my cynical view is that people are living in a bit of fantasy land, that we're going back to the raid environment we saw pre COVID and through COVID that the current rate environment is going to be the exception and not the rule. I guess I just don't see it.
Jayamanne: So you're aligning yourself with the bond camp here.
LaMonica: I guess I am. Please feel free to make some jokes about how I'm boring Shani like bond investors.
Jayamanne: I think you called bond investors sober, so that's definitely not what I'm calling you.
LaMonica: You're one to talk right now, but anyway. What I think we're just going to have to mentally get over is this low-rate mentality. And I think unfortunately there are lots of people, companies and governments who are in too much debt for our current level of rates and many investors have expectations of equity valuations, that are too high for this environment.
Jayamanne: And ultimately, we need to remember what companies these high valuation levels impact the most. Companies with high projected growth rates and earnings far out into the future. These include startups and companies that may not be profitable yet. The same companies that did so poorly last year and have bounced back so much this year. If valuation levels come back down, it may benefit some of the value plays that did so well on a relative basis last year – so-called boring companies that pay dividends.
LaMonica: For example, we talked about how much the NASDAQ is up this year. We've talked about how narrow the rally we've seen so far this year in the US has been basically propelled higher by some of the large tech shares.
Jayamanne: Over the past year, large cap US growth shares have outperformed large cap value shares by 20%. The Dow Jones US Dividend 100 index, which has the 100 highest yielding shares in the US, has underperformed the S&P 500 by 11%.
LaMonica: And finally, we can turn back to someone we mentioned a lot last year, value investor Jeremy Grantham, who's gained himself a reputation of being a bit of a Permabear, a charge he refutes by countering that he is just being realistic. He thinks that the deflation of what he has called a ‘super bubble’ has just been interrupted by speculation on AI.
Jayamanne: And just remember that if we're at a transition period between ultra-low rates and a more normalised interest rate environment, it's going to be a hard time for many investors and consumers to get used to, which may mean a lot of volatility.
LaMonica: And one point we should make is that if you were looking for an excuse to not invest, you will always find one. If you're looking for reasons to change your investment approach and dramatically shift your portfolio, they will always be there. You'll hear from friends and commentators who make compelling cases for why you should do one thing or another.
Jayamanne: And there are many different investing approaches at work, but consistency is key, which means believing in the investment approach that you're following. Great companies will find their way through any situation. They have survived wars, depressions, and political revolutions. So don't let today discourage you.
LaMonica: All right. Well, that is our episode, we made it. Maybe we should go back to Guzman now.
Jayamanne: I think so. I'm ready.
LaMonica: Yeah, you can get more – what did you get, Nacho thighs?
Jayamanne: Nacho fries, yeah.
LaMonica: And for people who haven't been to Guzman, those are literally nachos on top of fries instead of chips, but that's the situation here. We hope you're having a great day and thank you very much for listening.