As we move through the Australian financial year 2023-24, the second quarter (October-December) brought significant developments in both global and Australian financial markets. Building upon the groundwork laid in our Q1 report and further detailed through our monthly market updates for October, November, and December, this Q2 FY 2023-24 Market Review provides a comprehensive analysis of the pivotal trends and economic signals that emerged. By examining these key movements, we aim to offer valuable insights and forward-looking strategies to navigate the remainder of the financial year confidently.
Key Highlights from the Q2 FY 2023-24 Market Review
Equity Surge: Global and Australian equities soared in Q4 2023, despite a slump in the energy sector.
Bond Rally: Central banks' dovish stance spurred significant bond and credit market gains.
Currency Shifts: The US dollar dipped while the Australian dollar climbed, reflecting rate policy expectations.
Cautious 2024 Outlook: Expect market volatility with a focus on diversified equities and medium-duration bonds.
Sector Performance: Real estate and financials thrived; be selective in credit markets, favouring investment-grade options.
Markets in Review
Christmas came early for many investors in the fourth quarter of 2023, as November brought about the best monthly performance for global equities in three years. Better-than-expected economic data, falling inflation, and a more dovish tone from the Fed fuelled excitement that central banks would cut rates sooner than expected. As a result, all four major share markets posted positive returns in Q4, with the US (S&P500) leading the pack, returning an impressive 11.23%. Emerging Markets performed the worst this quarter with a sizable gain of 7.45% highlighting the strength of the global equity rally in the final months of the year.
With a change in rhetoric from many central banks, fixed income also had an astonishing end to the year, with Government bond yields falling across the globe. This led to both the Australian and global bond markets experiencing some of the best quarterly performance in decades. Credit markets were not excluded and rallied as investors became more optimistic about the idea of a soft landing, and revisions were made regarding the likelihood of a deep financial recession.
Australian Sector Returns
Following poor performance in the third quarter, Australian equities reversed their losses and delivered a return of 8.4% in Q4. Data suggesting economic weakness and a further rate hike from the RBA in November resulting from persistent inflation caused investors to bear caution in the quarter's first half. However, a low unemployment rate, milder inflation data, a more dovish tone from the RBA and a global equity rally all fed into a positive end to the year.
Stand-out performers over the period were real estate and financials, which returned 14.6% and 10%, respectively. The rate sensitivity of these sectors benefitted from the narrative that rates have now peaked, providing a tailwind for these names. Although the rally was broad, with most sectors participating, energy fell short in the final quarter. The energy sector in Australia notably fell by 9.0% because of slower global economic activity and a significant fall in oil, with Brent crude oil falling by 19.4% over the period because of supply/demand concerns.
Foreign Exchange Markets
The US dollar index (DXY) against a basket of currencies weakened by 4.56% in the fourth quarter as investors were given signals that the Fed are done hiking and is now looking towards cutting rates in 2024. This caused a selloff in the dollar against most major currencies, which are seemingly further behind in their rate-cutting programs.
In contrast, persistent inflation in Australia forced the RBA back into action in November, resulting in the Australian Dollar's appreciation by 5.73%. The AUD also strengthened against most major currencies in December with the exception being Japan, where there is speculation that the BOJ will soon pivot from its ultra-dovish monetary policy.
Fixed Income Markets
A dovish pivot in the rhetoric of leading central banks led both the global and Australian bond markets to deliver some of the best quarterly returns in decades, with the global aggregate bond index returning 2.91% and the Australian government bond index returning 5.23%. Improvements in economic data in the US combined with a change of tone from the Fed resulted in US Treasuries, UK gilts and German bunds returning 3.41%, 5.78% and 3.36%, respectively.
Understanding the relationship between market trends and economic health is crucial. Recently, we've seen significant changes in the bond market, leading to what we call a 'flattening' of the yield curves—this means the difference between short-term and long-term interest rates has decreased. Specifically, short-term rates have dropped more than long-term rates. This trend is important because it can sometimes signal economic caution.
In the US, even though there's been some improvement, the yield curve is still 'inverted.' This means short-term interest rates are higher than long-term rates, a situation that historically hints at economic uncertainty. On the other hand, Australia's financial landscape looks a bit different. Their 2-year and 10-year interest rate spread has been positive since July, indicating a more typical, healthier market condition.
It's important to keep an eye on these patterns as they help us understand the broader economic picture and make more informed decisions.
Outlook
After an impressive rally in markets going into year-end, 2024 will likely start slow as annual profit-taking commences. There is likely to be short-term volatility throughout the year as investors scrutinise comments/decisions from the Federal Reserve and eye up key economic data releases.
At the start of 2024, there was a 75% chance of a rate cut in March despite clear comments from the Fed suggesting cuts will come much later, and it is our view that markets have gotten ahead of themselves. The disconnect between markets and the Fed is further highlighted by the market currently suggesting there is a 98.1% chance of rates falling by more than the Powell’s current end of year projection of 75bps, in fact pricing in just over double that. With early cuts priced into equity and fixed-income markets, we see this as the biggest risk in the year's first half.
The possibility of inflation becoming stickier than predicted as we get closer towards the 2% target, coupled with no signs of economic weakness (especially in the labour market), leads us to think something would have to drastically change in the coming months to see a rate cut in March. Although inflation is coming down in developed economies, stickier-than-expected inflation is likely to be a key theme for markets going into the new year. No more so than in the UK where the inflation rate unexpectedly rose to 4% in January providing a stark warning to markets and those set on rate cuts.
As previously mentioned, there is likely to be volatility in equity markets throughout 2024, and a cautious approach should be taken. This is not to say we do not think equities can perform well over the year, but investors should be aware of the downside risk. Given this backdrop, we recommend a well-diversified equity allocation, ensuring you are not overexposed to rate-sensitive sectors whilst also ensuring participation in any market rallies. Signs of a slowing economy here in Australia also point towards a cautious outlook, as it remains to be seen whether the RBA can avoid a recession.
A medium-duration approach would be sensible for fixed income in today’s market environment. Over the last year, investment managers have positioned themselves on the short end of the curve, earning a healthy income whilst taking little to no risk. However, towards the end of 2023, investors increased duration to lock in healthy long-term income and benefit from capital appreciation as rate cuts near. Whilst we believe the time has come to increase duration, a medium duration is likely to be the sweet spot. This allows high short-term income and, hopefully, some capital appreciation whilst limiting exposure to the long end, which will fare comparatively worse should we get any interest rate surprises. A selective approach in credit markets will bode well for 2024. Good opportunities in investment grade credit, however less so in high yield where it appears the returns do not justify the risk.
Conclusion
As we venture into 2024, the financial markets continue to evolve, presenting a complex yet opportunity-rich environment. The past quarter's performance serves as a crucial guide in understanding market dynamics and economic health, especially as we navigate through potential uncertainties and shifts. While the prospect of market volatility remains, informed decision-making and strategic diversification will be key in embracing the opportunities that lie ahead. For those looking to refine their investment strategies or gain deeper insights, our team is poised to provide the expertise and guidance needed to traverse this ever-changing financial landscape.
General Advice Warning
This update is issued by Ventura Investment Management Limited (AFSL 253045), which is a related body corporate of Centrepoint Alliance Limited. The information provided is general advice only and does not take into account your financial circumstances, needs or objectives. Where you are considering the acquisition, or possible acquisition, of a particular financial product, you should obtain a Product Disclosure Statement for the relevant product before you make any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. It is imperative that you seek advice from a registered professional financial adviser before making any investment decisions.
For more information, refer to the Financial Services Guide (FSG) for Ventura Investment Management Limited (available at).
Disclaimer
While Centrepoint Alliance Limited and its related bodies corporate try to ensure that the content of this update is accurate, adequate, and complete, it does not represent or warrant its accuracy, adequacy or completeness. Centrepoint Alliance Limited is not responsible for any loss suffered as a result of or in relation of the use of this update. To the extent permitted by law, Centrepoint Alliance Limited excludes any liability, including negligence, for any loss, including indirect or consequential damages arising from or in relation to the use of this update.