2 key lessons from 2022

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2022 will go down as the year in which central banks finally got serious about inflation.

Having slashed interest rates during the 2020 COVID crisis, central banks sat back over 2021 and watched as the excess demand they created caused a surge in inflation. By late 2021, concerns over ensuring a solid post-COVID economic recovery gave way to the worry that high inflation may become entrenched, especially given the strong wage and pricing power both households and business were starting to exercise.

Russia’s surprise invasion of Ukraine only added to inflation concerns, due to actual and feared energy and food supply disruptions from these two important global producers.

In March, the US Federal Reserve began the process of lifting interest rates from near-zero levels. Two months later, the Reserve Bank of Australia followed suit, raising interest rates for the first time in over a decade.

Having started the year at relatively high valuations, equity markets wilted under the onslaught of higher interest rates. The price-to-forward earnings ratio for America’s S&P 500 index started the year at a lofty 22, but sank to below 16 by the market lows of mid-October.

Thanks to the underlying momentum in the economy, and solid company pricing power, corporate earnings held up for much of the year, though there are signs they may now start to wilt.

Perhaps most surprising with hindsight has been the resilience in economic growth in both Australia and the United States in the face of higher interest rates. While the housing sector in both countries started to slow, consumer spending and employment growth remained firm – which in turn reflected an unleashing of pent-up demand for services as most remaining COVID restrictions relating to travel and recreation were removed.

In fact, while the 2021 surge in goods inflation began to unwind this year, this was largely offset by a pick-up in service sector inflation which left overall inflation rates stubbornly high.

As a result, market expectations for how high central banks would need to raise interest rates to reign in demand were revised ever higher. Markets now expect the US Federal Reserve to lift the Fed funds rate to around 5% by mid-2023, and the Reserve Bank of Australia to raise rates to around 3.5%.

A ratcheting up in central bank tightening expectations led to a large rise in bond yields and one of the biggest bond market sell-offs in history. With equities also down, 2022 was an especially tough year for investors in diversified portfolios covering both bonds and equities – the safest and best returning major asset class was cash!

That said, Australia’s equity market has so far managed to hold up relatively well. Higher interest rates were especially troublesome for highly priced global technology and growth stocks, which tend to have a lower weight in the Australian market. At the same time, our relatively conservative banking sector was less negatively affected by the upsurge in global financial market volatility compared to their global counterparts. Higher commodity prices also supported the resources sector.

Australia’s relative resilience was all the more impressive given China didn’t provide us with too many favours this year. In fact, China’s economy slowed notably as it battled both a property sector bust and on-again off-again lockdowns as part of it’s persistent ‘Zero-COVID’ strategy.

Europe also suffered from surging energy costs due to cutbacks in the supply from Russia.

In currency markets, the relative strength in the US economy and relatively more aggressive interest rate hikes by the Federal Reserve saw the US dollar rise against most other major currencies – including that of Australia. The Australian dollar, however, held up better against other currencies such as the British Pound, Euro and Japanese yen.

Lessons for investors

For investors, one critical lesson we’ve been reminded of over the past year has been: “Don’t fight the Fed”. When central banks are hell bent on raising interest rates and slowing economic growth, it’s usually a negative for equity markets – however much we wish the good times could simply roll on.

It’s a lesson that we may well need to remember next year given the Fed still seems determined to raise interest rates and slow US economic growth.

Another key lesson is that what’s popular in markets can often change – and the risk of abrupt change can intensify the more popular a certain theme becomes. The past year, for example, has seen a major shift in investor interest from long-popular growth/technology stocks to long-unloved and relatively value/cheap energy companies, as rising interest rates and energy prices favoured the latter over the former.

As and when interest rates and energy price trends change, fortune may again favour growth stocks over value, so investors need to be attuned to shifting macro-economic forces.

Looking forward

Heading into 2023, the biggest question facing markets is whether the United States can manage to get inflation under control without triggering a recession. Given America’s red hot labour market and high wage growth, that won’t be easy – as it will likely mean service sector inflation will be sticky unless there’s some rise in unemployment.

Thanks to lower wage growth, Australia’s Reserve Bank appears more patient than the Fed in waiting for inflation to hopefully fall without a recession. But as the saying goes, if the US sneezes we often catch a cold – our economy and equity market won’t be immune should the US economy suffer a hard landing.

The ongoing war in Ukraine and China’s problems with debt and COVID present other global challenges.

That said, while equity markets likely face further downside risks, one bright spot in 2023 could be bond markets – as slowing economic growth and inflation inevitably brings the period of aggressive central bank rate hikes to an end. For the first time in a long time, bonds are offering relatively attractive income returns – with scope for capital gains if central banks switch to cutting interest rates later next year, resulting in lower bond yields.