Financial markets and central banks are now on the same page
A meeting of central banks in Jackson Hole, Wyoming (U.S.) provided a pivotal moment for financial markets in August.
It was clearly apparent from the statements by central bankers that they were committed to a program of lifting interest rates further until inflation was brought back under control.
The challenge for the Europeans continues to grow with the lack of any resolution to rising energy prices and the associated Russian supply constraints.
In response to the statements made by central banks, bond yields increased sharply, and equity markets sold off around the globe. This reaction suggested that markets were surprised by the magnitude of interest rate increases implied by the central banks. At least now, however, markets have a clear understanding of what central banks are thinking. Potentially, this lowers uncertainty and market volatility in the period ahead.
Notwithstanding some clearer visibility around the likely future path of cash interest rates, the impact of tighter monetary conditions on the real economy and future company earnings remains up for debate.
The uniqueness of this current cycle is undeniable.
Never before have the major global economies entered a tightening phase with such strong labour markets and excessive job vacancies. This, combined with the flexibility of gaining additional employment in the “gig economy” for those households with financial constraints, separates this cycle from those that have preceded it. Optimistically, this creates a potential path for higher interest rates to wind back inflationary pressures, with household spending showing more resilience because of the uniqueness of conditions in today’s labour market.
The so-called “soft-landing” remains a likely scenario, in which case company earnings and therefore equity valuations may hold up well as a result.
There are some signs equity markets are starting to be more discerning in determining which companies and sectors will be most impacted by the economic cycle ahead. Recent earnings results have also provided additional guidance. Last month’s sell-off of global and local property trusts was a good example, whereby higher interest rates were seen to have more significance for property than other sectors.
If continued, this trend may see fundamental active management of equity portfolios becoming more rewarding than passive indexed-based management.
Although there may be more clarity as a result of recent central bank commentary in major developed markets, the outlook for the Chinese economy is an area of increasing concern. Economic growth is clearly being impacted by domestic COVID management policies and the fall-out from the “clean-up” of the property sector. The significant decline in the growth of the globe’s second-largest economy will have wide-reaching impacts and should be a key focus on investment strategies in the months ahead.
For portfolios, the case for an Australian bias may be growing - as economic, inflation and interest rate-related risks appear to be lower here than overseas.
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