Markets marked time over October, with the consequential US election over-shadowing the investment environment. The one asset class which moved decisively over the month was the bond market, with US 10-year Treasuries rising from approximately 3.81% at the end of September to around 4.28% at the end of October, reflecting increased concern about risks from fiscal deficits, election promises, and increased uncertainty. Hopefully, a peaceful and clear outcome to the US election will see some reversal in November.
In the US, sharemarket indexes ended October mixed to lower, with the benchmark S&P 500 down -0.99%, the Dow Jones down -1.34% for the month, while Nasdaq rose 1.03%. Other global markets were lower: Germany’s DAX was down -1.28%, the French CAC fell -3.74%, Britain’s FTSE was down -1.54%, and Japan’s Nikkei was also lower. China’s key index fell almost 8%, giving back some of the previous month’s gains.
The ASX 200 fell -1.33%, with the 5% fall in Resources a key drag. Gold was the best performing sector, as central bank buying, and geopolitical tensions continue to support the gold price. Consumer Staples was a laggard, largely driven by weak earnings guidance from Woolworths.
Banks returned to strength, partly reversing the rotation to mining that occurred in late September. As we head into their reporting season, banks are still one of the rare parts of the market seeing consensus earnings upgrades as Reserve Bank of Australia (RBA) rate cut expectations are pushed back and bad debts remain low. Banks have risen substantially over the last 12 months and are now priced well above their long-term average valuations.
The ASX 200 is up 20% over the last year. Valuations for Australian stocks are stretched, with the forward Price Earnings ratio (PE) around 18.2x versus a long term average around 14.5x.
As noted above, US and global bonds ended the month with yields sharply higher. Global bond yields had been in a downward trend on the back of softening economic data, with markets enjoying lower inflation readings and rate cutting policies amongst most developed economy central banks. But that trade reversed during October, with anxiety over the US deficit outlook and amidst election uncertainty.
The AUD fell against the USD, reflecting USD strength as a safe haven during times of uncertainty. We think the AUD could rise in the months ahead, boosted by the Chinese stimulus package and higher commodity prices, and it remains under-valued longer term. Resources were mixed over October with iron ore down, gold up, and oil (Brent Crude) flat.
As we have previously reported, the US Federal Reserve (Fed) in late September slashed its short-term rate target by 50 basis points and signalled more cuts to come. Since then, investors have pushed the yield on Treasury notes steadily higher. Why would long rates rise while the Fed’s cash rates fall?
The Fed sets interest rates for the immediate future. Investors in bond markets are betting on the path of those rates for the next decade or longer. For many reasons, interest rates are likely to be higher in the coming decade than in the prior one.
One of those reasons is relatively benign: inflation and growth are unlikely to be as low as they were in the post-GFC period and before the pandemic. A second reason is more worrying with the US federal debt is on an unsustainable path, which might become even more unsustainable after the election, regardless of who wins.
Meanwhile, it is possible US economic growth will surprise with a robust 2.8% to 3.0% pace over the calendar year. That would suggest that the US economy has become less vulnerable to higher interest rates. Using the jargon employed by economists, the “neutral rate,” which keeps inflation and unemployment roughly in balance, has apparently risen. As recently as last December, Fed officials thought neutral was 2.5%. By September this year, they had raised that to 3.0%, and some officials now see neutral at 3.5% or higher. By itself, a higher neutral rate is not especially worrying because it signals a return to normalcy.
But there are increasing risks for bond markets that cannot be ignored – one of which is the soaring US federal debt. Since 2007, the federal debt has climbed from 35% of gross domestic product to almost 100%. Much of this was a result of the 2008-09 global financial crisis and Covid-19. The borrowing did not initially put much upward pressure on bond yields because inflation and the neutral rate were so low. Low rates, in turn, made the debt relatively easy to service.
Yet in the past fiscal year, concerns have started to rise. The US budget deficit is now projected at 6.4% of GDP, a record outside of war, recession or crises such as the pandemic. Interest expense is climbing steadily. The Congressional Budget Office projects that under current law, publicly held debt will hit 122% of GDP in 2034. Whereas the effect on long-term rates had been largely invisible thus far, the rising US Treasury yield is now garnering investor focus.
At this stage at least, the US economic soft landing has been achieved. Yet prudence would suggest noting that positive sentiment is stretched, valuations are high, geopolitical/economy risks are elevated, and uncertainty around policy and politics as the US votes in a new administration is growing. We think that a defensive stance remains sensible, even as positive market momentum appears to be the path of least resistance.
Some key observations from this year to date and which will likely persist into the year ahead:
- Inflation has peaked and is now falling in a steady trajectory.
- Cash interest rates are being adjusted down by central banks. The RBA will follow next year.
- Global economic growth is moderate, no world recession has occurred and nor is one likely.
- The USD and gold have been strong, and the AUD and crude oil weak.
- Sharemarket valuations are generally expensive.
- The US economy is growing in robust fashion while Australia’s economy remains subdued.
- Bond markets are at risk from highly elevated debt levels in many developed economies.
