Spooktober frightener for markets

Markets struggled in October as stronger economic data kept central banks hawkish adding fuel to the budding higher for longer narrative. The shocking events in the middle east added to market concern given the unknown market impact and implications for energy prices. Government bond yields marched higher, and the U.S. 10-year Treasury yield breached 5% as investors priced out recession and potentially higher interest rates, negatively impacting equity markets as both bonds and stocks sold off. The MSCI World index fell 2.6% on the month, while the EM index was down 2.9%. The Global Aggregate Bond Index fell 1.2% on the month (total returns in local currency).

In a case of good news being bad news, the better 3Q GDP report for the U.S. (+4.9% quarter-over-quarter (q/q) annualized) suggested that the U.S. Federal Reserve (Fed) may have to leave rates higher to curb growth and inflation. However, the tightening in financial conditions, as government bonds yields have risen, could see the Fed stand pat on further rate hikes if the market does the tightening for them. However, the U.S. economy is likely to slow markedly in the months ahead as both business investment and household spending starts to wane.

The Australian economy has also been beating expectations and the firmer economy has meant inflation has been slower to fall, keeping the Reserve Bank of Australia (RBA) and the new Governor on the edge of another rate hike. This has driven the same dynamic in the Australian market as in the U.S. regarding the volatility in the bond market and unease in equities.

The only place that more growth and more inflation are being welcomed is Japan, where the Bank of Japan is loosening its grip on yield curve control and allowing the 10-year bond yield to float higher. This should lead to the Bank of Japan moving away from negative interest rates in 2024 and support the Japanese equity market.

Europe is heading in the other direction as the economy contracted in the third quarter. The silver lining is that the economic weakness and large move in energy costs compared to a year ago means that inflation has fallen to 2.9%, easing the pressure on the European Central Bank to do anything further with the policy rate.

The mixed picture on growth and inflation leaves us cautious on risk assets. While a better growth picture should be supportive of equity markets, it comes with the risk of tighter monetary policy in response, which may weigh on corporate profitability. We retain a neutral view on equities given the potential for the Fed and others to raise rates, investors may be better to add duration in weakening economies, such as the eurozone and keeping a shorter bias in the U.S. and Australia.

Australian economy:

• The quarterly inflation print reinforced what the monthly series had been pointing too—stickier inflation. Prices were 1.2% higher q/q in third quarter, driven by higher fuel prices, rents and insurance costs. While the year ago prices comparisons continue to fall (5.4%) the momentum may not be slow enough for the RBA given it recently outlined its “low tolerance” for a protracted return to the inflation target.
  (GTM AUS page 7)
• Retail sales were up 0.9% in September and prior months figures were revised higher. Spending was relatively broad based. The retail sales figures focus on good spending and suggest that broader indicators of consumption that include services will be stronger still. However, we anticipate that a trough in the savings rate and lagged impacted of higher mortgage rates will weigh on discretionary spending.
  (GTM AUS page 5)
• The labour maket is not showing any strong signs of loosening but the October labour market report was a mixed bag. The unemployment rate declined to 3.6% but was the result of a fall in the participation rate rather than strong employment growth. The breakdown in hours worked, slowing pace of employment growth and decline in vacancies suggest the unemployment rate is likely to rise in the months ahead.
  (GTM AUS page 8)
• Housing data is turning. Housing loan commitments rose 2.2% in August and the volume of new commitments also rose 2.2%. These figures are lower than a year ago but corroborate the pickup in other sales metrics. CoreLogic house price data recorded a 0.9% month-over-month rise in October, and a 7. 6% rise from the January 2023 low.
  (GTM AUS page 10 and 11)

Equities:

• The ASX 200 had another poor month falling 3.8% and follows the negative September month. Small caps posted a very large 5.5% decline. 10 of 11 sectors were in the red as utilities managed to stage a rally (1.7%). The worst performers were IT (-7.6%), health care (-7.2%), industrials (-6.4%) and real estate (-6.1%) (total returns in local currency). 
• Australian equities underperformed the broader global indices as the MSCI World Index was down only 2.6%, but few equity markets escaped the weak performance. The S&P 500 fell 2.1%, Japan -3.0% and Europe -3.4%. The saving grace was the offsetting move in the Australian dollar which marginally improved returns for unhedged global equity returns.
  (GTM AUS page 32)
• Earnings outlook remains a headwind to Australian equity performance as the market is now in a small decline for the year (-0.2%). However, the weak market performance has led to falling valuations across the the board. The ASX 200 is trading just shy of its long run average and European and Japanese markets well below on a forward price-to-earnings basis. Even the S&P 500 has seen something of a valuation reset.
  (GTM AUS page 33)

Fixed income:

• Government bond yields crept higher in October. The U.S. 10-year bond yield moved through 5% for the first time since 2007 although it ended the month at 4.90%, 33bps higher. The Australian 10-year bond yield experienced a much larger 44bps move to 4.92%. Inflation in Australia is slower to fall than in other markets and well above the RBA’s target band supporting the expectations for another hike in November.
  (GTM AUS page 49)
• The rise in longer dated bond yields meant that yield curves have steepened. The difference between the 10-year and 2-year bond in the U.S. Treasury market has narrowed to just -16bps. For Australia, the spread is still positive (46bps) indicating a steep rather than inverted curve. This is important when considering adding duration and perhaps adding more in Australia where carry on longer dated bonds compensates for risk, while in the U.S. it may not.
• Credit markets suffered as both U.S. investment grade and U.S. high yield fell by 1.2% and 1.0%. This put investment grade into negative territory for the year.
  (GTM AUS page 48)

Other assets:

• The oil market was rattled by developments in the middle east and growth risks around the world. While prices stabilised, a risk premium may remain in the price given the unknowns around how things may develop.
  (GTM AUS page 62)
• In China, crude steel production is holding up supporting the iron ore price at USD 122 a ton.
• Meanwhile, gold has benefited from safe haven flows and more so than other traditional safe havens, such as core government bonds, given uncertain rates outlook. Gold ended the month at USD 1,997 an ounce.
  (GTM AUS page 65)
• The Aussie dollar fell against the USD by 1.9% and 1.8% on a real effective exchange rate basis.
  (GTM AUS page 67)