January 2023 Quarterly Market Update: Unravelled by a common thread

Some investment markets leapt back into life in the December quarter, but for most of 2022, inflation was the common thread, dominating economic debate and unravelling investment returns.

The January 2023 Perpetual Private Quarterly Market Update reviews the performance of investment markets in the tail end of 2022 and assesses what themes we see driving investment returns in 2023. You can download our full report - or read our concise review

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December Quarter 2022: What happened?

• With inflation soaring to 7.3% (in the third quarter), the RBA lifted interest rates eight times in 2022. However, inflation may now be easing and the RBA's October, November and December rate rises were trimmed to 0.25% from the previous half a percent pattern.
• Thanks to a December quarter rally worth over 9%, Australian shares ended the calendar year down just 1.8% (counting dividend income).
• Most major international equity markets had a cheery December quarter. Hong Kong's Hang Seng Index was buoyed by the end of China's 'COVID Zero' obsession and rose 15%. French and German indices were up over 12%.
• In the battle of investment styles, Value continued its run of wins, returning 13.8% vs 5.6% in Australia in the December quarter. After a decade where Growth shares soared on a diet of low rates, Value now outpaces Growth over time periods out to five years.
• In 2022, local and global bond markets fell sharply - down around 10%.

^{(Indices referenced: S&P/ASX 300 Accumulation index, Hang Seng Index, German DAX index, French CAC 40, MSCI Australia Value index, MSCI Australia Growth index, Bloomberg Global Aggregate (AUD Hedged), Bloomberg AusBond Credit (0+Y), Bloomberg AusBond Composite (0+Y). All performance numbers for December quarter unless otherwise stated).}

Whoever you are, in 2022 inflation was busy unravelling your best laid plans.

Consumers suffered sticker shock wherever they shopped. Central bankers were in catch-up mode, frantically raising rates to slow entrenched inflation they once thought transitory. Politicians sought to soften the impact of rising prices - but found that difficult because vast government debts are no longer cheap to fund. And investors lost money in shares and property as higher rates reshaped how assets are valued.

The usual suspects

So what was it that brought inflation, the curse of the 70s, bubbling back to life? There are some obvious culprits:

• Lockdowns and border closures broke fine-tuned supply chains.
• They also drove thousands out of the workforce and dammed the flow of migrants that could have replaced them. Labour costs increased.
• Stimulus measures put extra money in consumers' pockets, driving excess demand.
• Russia's invasion of Ukraine sent commodity prices soaring.
• Attempts to 're-shore' manufacturing - whether for geopolitical reasons or to reduce dependency on overseas suppliers - meant consumers lost the cost-cutting benefit of comparative advantage.^[1]

QE and its questionable effects

To this list of suspects, Andrew Garrett, Investment Director at Perpetual Private, adds a long period of loose economic policy - specifically Quantitative Easing (QE) (policies designed to make money 'cheaper' to stimulate demand in the economy and encourage investor confidence).

"The Federal Reserve, along with other central banks, would return to the QE spigot time and time again," says Andrew. "Low interest rates, a direct result of QE, became the gift that kept giving."

Andrew's thesis is that early caution about QE's inflationary effect was dulled over time. And that complacency had seeped into investment markets.

"By 2022 investment markets had become foolhardy," he says. "The dramatic reaction to rising interest rates shows that markets had become complacent and begun to believe ''this time is different.' While the pace of rate increases was truly historic, the impact was so severe because our addiction to low rates had pushed too many investors up the risk curve. Investors had begun to believe that markets could defy gravity. But they never do."

And now what?

In his December Monetary Policy Statement^[2], RBA Governor Philip Lowe predicted Australian inflation would peak at around 8% but then decline in 2023 due to "the ongoing resolution of global supply-side problems, recent declines in some commodity prices and slower growth in demand."

But will moderating inflation shift the investment environment back to pre-COVID harmony? The Perpetual Private view is that this is unlikely.

• Volatility will persist as markets continue to adjust to a higher inflation, higher rate environment and global economies deal with higher energy costs, geopolitical turmoil and more post-COVID restructuring.
• The overwhelming force of 2022's rate rises mean growth will be lower. In the Statement quoted above, the RBA predicted Australian economic growth of just 1.5% in 2023 and 2024.
• Inflation will moderate and the pace of interest rate rises likely slow. But labour costs and the inefficiencies of deglobalisation means central banks will have less room to cut rates than they would want. So rates are likely to settle at higher levels.

Implications for investors

While the above economic prognosis appears negative, Andrew Garrett says a tough macro environment doesn't mean investors can't make money.

If they act both carefully and decisively, smart investors can use volatility to sell into peaks and buy in troughs. Value shares should continue to outperform as investors prefer companies with what Andrew calls "clear and present cashflows" to those with attractive but uncertain growth prospects..

A clear view of the economic data will be crucial. "In this new and still evolving investment environment many investors will be caught over-reacting to the latest information drop," says Andrew. "What is needed is steady, cool-headed decisions, the ability to look through the noise, avoid over- and under-confidence and focus on long-term goals."

Perpetual Private's Quarterly Market Update for January 2023 covers the Great Inflation debate in more detail and looks at the outlook for equities, fixed income, real estate, currency and alternatives.

^{[1]Broadly speaking, countries have different cost advantages in producing different goods (e.g., Australia is an efficient producer of wheat and many resources). So it makes sense for countries to trade with each other to capture those efficiencies.
[2] See https://www.rba.gov.au/media-releases/2022/mr-22-41.html}