What a Fool Believes 

The volatility in markets stepped up a notch in September.  Central Banks’ war on inflation continued with more interest rate rises even as inflation in the US moderated as expected. The current rate rises are the fastest in history – so if you are struggling to understand why portfolios are down, this is a pretty good place to start.
 
This was only a small part of September’s story.  The new UK Chancellor, Kwasi Kwarteng announced an expansionary budget at a time when the ECB has been hiking rates to control soaring inflation.  This resulted in an extreme sell-off in UK bonds - particularly 30-year bonds (known as Gilts) and resulted in many market commentators comparing the UK to an emerging market economy.
 
A bond market reaction of this nature is relevant for three reasons.  Firstly, it tells you what market participants think of the UK’s future credit worthiness; the answer, a resounding “not much”.  Secondly, as an ageing economy with large pension liabilities, the immediate value of assets funding UK pensions were hammered - and I don’t use that term lightly.  The 30-year GILTS were trading as low as £0.45 (against a face value of £1.00 – down 65%).  A significant portion of UK pensions are funded with Gilts due to their perceived safety - pension funds were sitting on extreme paper losses until the ECB intervened by supporting the pound and buying Gilts.  The bounce from low to high added 25% back to values but the net outcome at the time of writing remains significant losses.  Upon release of this note, the ECB has given pension funds a firm deadline (3 days hence) to get their rebalancing in order; their support of the pound stops on 14 October, 2022.
 
The third effect was that many participants who owned Gilts found themselves in a position where they were forced sellers of other securities to create liquidity.  This impacted securities as far and as wide as residential mortgage-backed securities issued by Australian banks and equities held by pension fund managers.  It then flowed through to longer dated assets that are priced off bond market movements such as real estate and infrastructure.
 
Such were the moves in asset prices that market performance for September was profoundly negative across the board, with both the main US indexes down circa 9%, listed real estate across the world down 12-15%, Australian shares down 6.5% (partially cushioned by the fall in the Australian dollar and strong terms of trade on exports) and diversified bonds fell circa 3.5%.

A Little More On Rates, and Why We Are Starting to Form a Positive View   

When we talk about interest rate increases, it is helpful to understand why this happens and how the mechanisms work in different economies. Increases in the official level of interest rates influences the cost of money in all areas of the economy.  The level of interest charged by lenders is dependent on timeframe of borrowed funds and the risk of the lender.  The net effect is that as rates increase, there is less money available to spend in the economy, which then impacts business profits, employment and ultimately taxation revenue.  Of course, this is by design – the Central Banks’ role is to control the supply of money and influence the cost of goods and services (increased rates reduce money supply and eventually demand) as well as capacity in the economy through employment levels.

Not All Interest Rate Increases Are The Same   

Now bear with us here because this is important.  Interest rate increases impact economies in different ways.  An example of how this can be seen right now is to look at the US and Australian Mortgage markets.  In the US, the majority of borrowers in the last 5 years, refinanced their mortgages to 30-year fixed rate mortgages in response to record low interest rates and the ability to lock in pricing certainty on their largest asset (and liability).  In Australia, most borrowers are on variable rate mortgages, although a good proportion locked in fixed rates for between 2 and 5 years (generally, fixed rate terms over 5 years are not available).
 
Thinking about what this means for Central Bankers in each country who are trying to control inflation, the Australian Central Banker is going to have a greater near-term influence over the level of spending and consumer confidence than their American counterpart.  Why?  Well, the RBA knows that variable rates will immediately feel the impact of higher rates.  They can also see the near-term impact of fixed rate expiries (which become variable) in their datasets.  In the US, there is zero incentive for 30-year borrowers who locked in a long-term fixed rate to change their arrangements as rates rise.  As a result, their disposable income is not immediately impacted – they have certainty over rate and the number payments they need to make.
 
This goes some of the way to explain why we have had the fastest interest rate increases in history. The Fed must increase rates faster and by more (everything else being equal) to get a corresponding impact on consumption (in an economy where circa 85% of GDP is internally generated).

Low Unemployment, an Opportunity for a Central Bank Near You 

As discussed, Central Bankers only remit is to provide price stability and full employment.  Plentiful supply of money and near zero rates have created strong (nearly full) employment outcomes and strong economic growth figures post the pandemic.  This buffer allows Central Banks to create a margin of safety by increasing interest rates, which can then be decreased (at the right time) to fight the next recession.
 
Looking to history, interest rates drop 2.5% - 5% to combat a recession.  In 1990-91 the US recession required a drop of 2.5% in interest rates to get back to growth, in 2001-03 it took 5%.   The US Fed tried to build a buffer during Trump’s presidency, but eventually ran into political headwinds that forced them to change direction in 2019.  With a more hands off administration and low unemployment now is the time.
 
In the next few months rates are expected to stabilise (or possibly fall if there is a recession), the political climates in the US and China become known, and inflation figures are tipped to fall.  Markets love certainty and they love rate cuts even more.  Currently we hold elevated levels of cash, with the best dollar we invest for the next decade likely to be invested in the next 3-6 months. 

What Are We Expecting

• In the near-term, we could see more downside in equity markets if corporate earnings report a material fall.
• The current consensus expectation however is that on average, corporate earnings will increase +6%.  If this occurs, combined with falling inflation, there is a clear path for markets to get back to flat for the year at 15-25% up from current levels. 
• Further opportunity lies in the currency effect with the Aussie dollar being sold off significantly since March, to the tune of 15% down, approaching 30yr lows.  A reversal could see hedged international positions climb a further 5-10%. 
• Finally, the sectors seen as proxies for the bond market will be clear value plays.  Long dated annuity revenue streams, revenue linked to inflation and well hedged debt positions will be in high demand as rates plateau or fall (e.g.: infrastructure and real estate)