Quarterly Economic & Market Commentary – December 2022 

Economic & Market Review

The final quarter of 2022 started with a bang as shares roared back in October and November on signs that price pressures had peaked and central banks would soon slow the pace of interest rate hikes. However, financial market woes returned in December after the US Federal Reserve (the Fed) reiterated its willingness to fight inflation throughout 2023. 

US equities

In the wash-up, the US benchmark S&P 500 price index narrowly avoided the -20% bear market mark that only six other calendar years since 1928 have seen. The Dow Jones Industrial Average finished nearly 9% lower for the year, while the tech-heavy Nasdaq shed close to a third of its value as investors abandoned long-duration growth stocks. Across the S&P 500, more than 70% of constituents finished the year lower. Volatility was the order of the day throughout 2022, as 219 of the 251 trading days had at least a 1% intraday high/low spread, compared with just 95 days in 2021.

Australian equities

In domestic shares, after accounting for dividends, the benchmark S&P/ASX 200 gained nearly 10% in the December quarter. But, over the calendar year, the key domestic index lost 1.1%. After adding back franking (at an assumed 75% for the index), the grossed-up return crept into the black at around 0.2%. Small caps lagged most of the year, with industrials bearing the brunt of the damage. Listed property also had a forgettable 2022, as A-REITs shed more than 20%, followed closely by global peers.

Cash and fixed interest

While cash, in relative terms, performed well in 2022, fixed interest failed to mitigate losses in growth assets as bonds posted some of the worst returns in modern history. While domestic bonds fell nearly 10% over the year, US bonds plummeted 16% as the 10-yr Treasury yield surged to 3.83% from 1.52% a year earlier. The Reserve Bank continued to lift interest rates in December. The 0.25% hike took the official cash rate to 3.1% after commencing the year at 0.1%.

Currency

Elsewhere, the Australian dollar posted gains against most currencies in the December quarter but fell 6.5% versus the greenback across the twelve months. This weakness partly insulated domestic investors exposed to US shares. The reversal of the strong US dollar dynamic in the December quarter was a welcome relief to emerging market economies as this helped stem outflows of financial capital. 

Commodities

Meanwhile, crude oil prices were flat over the quarter as weakening growth in developed economies was offset by the prospects of China’s reopening. The latter was reflected in iron prices, which rose strongly in November and December.

Economic data

September quarter GDP was released in early December, revealing that the economy expanded by 0.6% in the period and 5.9% throughout the year. The household saving ratio declined from 8.3% to 6.9% as of 30 September 2022, returning to levels seen before the pandemic. 

Households continued to run down their savings rate in the December quarter, with a strong retail spending surge in the November’ Black Friday’ sales event. Elsewhere, unemployment remained near multi-decade lows, and total employee costs continued to increase above the inflation rate. By the end of December, the proportion of workers in full-time employment had returned to the 70% mark, and hours worked continued to increase.

Among global economies, the US economy rebounded in the second half of 2022, driven by sustained consumer spending on the back of booming labour market conditions. Across 2022, GDP expanded by 2.1%, down from the 2021 Covid-rebound of 5.9%. Final figures for Europe are yet to be released and are expected to show a weak second half, albeit likely to have avoided recession.

Outlook

The 2022 calendar year was dreadful for multi-asset investors as bond market normalisation more than nullified the usual cushion provided when equity markets are selling off. But, investors are generally an optimistic lot, and at the beginning of 2023, markets have simultaneously discounted the likelihood of a global recession while pricing-in multiple rate cuts by global central banks. 

The growth part of this equation appears to be predicated on a sustained rebound in China. At the same time, the rate cuts are more a function of lower price pressures via supply-chain repair and the removal of base effects in some components of the inflation data (such as rents and utility costs). 

Further adding to the upbeat mood, the IMF signalled that it was poised to upgrade its 2023 global forecasts due to expected improvements in the year’s second half. Better-than-expected data from Europe and the US, along with rising sentiment surveys, lower natural gas prices and the dismantling of zero-Covid policies in China, are the key drivers.

So where to from here? 

We believe that global growth will slow further in 2023 and that a shallow recession cannot be ruled out in the US and Europe. These regions have enjoyed buoyant labour market conditions, but the impact of higher interest rates is yet to be fully felt on activity. Industrial sectors in many developed economies have stagnated in recent months, and underlying capital expenditure has been flatlining. This is despite efforts to reduce reliance on China and could reflect that higher input costs are proving more difficult to pass on to the end user. 

The Fed Beige Book remains sombre reading and the Conference Board’s Leading Economic Indicators index has breached levels that have always resulted in some degree of recession. At the household level, there has been a clear spending switch favouring non-discretionary items. A sharp drawdown in personal savings rates and a spike in credit card debt has accompanied this.

In bond markets, US 10yr Treasury yields remain well below the 2yr yield (this is known as a yield curve ‘inversion’). Historically, steep inversions have been a sign of impending recession. But, this instance is unusually accompanied by positive real yields and tight credit spreads, which are inconsistent with expectations of recession. Perhaps the current inversion is signalling that investors anticipate significantly slower inflation. While we see the latter as a likely outcome in the first half of this year, without more muted wage growth and increased spare capacity, it will be difficult for inflation to reach the 2% level often targeted by central banks, let alone stay there.

On the domestic front, strong consumer spending has been supported by solid wage growth and high rates of employment. The initial impacts of the Reserve Bank’s efforts to slow inflation have been felt most strongly in the housing market. But, with a significant proportion of mortgage holders set to come off ultra-low fixed rates in the June quarter, Australia is increasingly vulnerable to an economic shock in the second half of 2023. It is not our base case for a domestic recession, but If the China rebound dissipates and a sharp global downturn comes to the fore, then a slump in local activity will be tough to avoid. We anticipate at least one, but at most two, official interest rate increases in early 2023. Our base case does not see the Reserve Bank cutting the cash rate this year.

We are encouraged by the solid start for the year in financial markets but remain wary about the outlook. Earnings growth has turned negative in the world’s largest economy, and economic conditions have been considerably looser than expected at the beginning of the year. Unless planned central bank balance sheet reductions (quantitative tightening, QT) are slowed or placed on hold, then we will likely see a return to a more liquidity-constrained environment and further bouts of market volatility. 

In addition, the periodic debate about the US debt ceiling is back on the agenda, though the chances of a US debt default remain trivial at the present time. 

Overall, the risks for significant market moves (both positive and negative) remain elevated, and we have retained a cautious stance in portfolios.