Interest rates continue to pose headwinds to the global growth outlook

Global

The US equity market retreated during the September quarter as upward pressure on core inflation raised expectations for interest rates to remain ‘higher for longer’. The recent rally in the oil price, related to OPEC production cuts, has also added to inflation concerns.

While the US Federal Reserve (the Fed) has remained on hold for the last two meetings, it recently reiterated a tightening bias. Of more immediate concern is the persistent rise in the US 10-year bond yield, which has rallied from 3.6% to 4.7%, over the past six months.

A rising bond yield is problematic in many ways, including raising the cost of debt for government, companies and households and increasing the discount rates used to value growth investments. US investors can now get close to 5% in essentially ‘risk free’ cash and bonds (if the bond is held to maturity), which is raising the hurdle rate for all other investments.
The persistent rise in bond yields seems to relate to a number of factors, including rising real yields, increased issuance of bills and bonds (to fund the US budget deficit), dysfunction within Congress, a recent US credit rating downgrade and reduced investor demand for bonds (from the Fed, China and Japan).

It seems growth and inflation will need to fall sharply for bond yields to retreat. One also wonders at what point the Fed will switch from QT (quantitative tightening or selling bonds) to QE (quantitative easing or buying bonds). This is not out of the question, the Bank of Japan is already intervening in bond and currency markets and the Bank of England had to intervene in the bond market in 2022, in response to the Liz Truss government mini-budget shock. However, it would be hard for the Fed to switch its position, without some sort of crisis.

Most other developed countries are also experiencing rising interest rates, but China is going in the opposite direction in an effort to stimulate its lumbering economy. However, China is limited in its ability to act as it must support a sharply depreciating currency (related to US/China interest rate differentials) and it also doesn’t want to encourage leverage in an oversupplied and already overleveraged property sector.

Australia

Australia is in a similar situation to the US, where the RBA has remained on hold for the past three meetings but is also worried about core inflation rising. Futures markets are still pricing in one more 0.25% rate rise to go this cycle to take the peak rate to 4.35%.

Elevated Chinese steel production is keeping bulk commodities (iron ore and coal) buoyant for now, but the downside risks seem to be increasing, due to rising evidence of excess steel production and low steel margins. In addition, there has been a recent surge in Chinese migration to Australia (seems to be related to a mistrust of government and a depreciating currency) which has helped prop-up Australian house prices. Although, this is now feeding into core inflation via dwelling shortages and higher rents.
The main positives are that growth and employment remain resilient to date and the Federal government is in a relatively strong financial position with a budget surplus of $20bn and a Debt/GDP ratio below 40%, which is close to the lowest in the developed world. In addition, the Australian Banking system is in a strong position, in terms of liquidity, provisions and capital.

Outlook

Interest rates continue to rise, and investors are now receiving attractive returns on cash, deposits and bonds (for new money). However, we remain cautious on growth assets, as earnings growth is likely to slow and market valuations will also be under pressure from higher bond yields.

This is a direct result of the short-term tightening cycle and will reverse when Central Banks get closer to easing, as growth and inflation retreat. Timing this event is very difficult and there are likely to be many ‘false dawns‘ along the way.
We expect FY24 to be a challenging year for growth assets, but this will lead to great opportunities to buy quality equity, property and infrastructure assets, on a long-term view. Investors should ensure their portfolios are appropriately diversified and accept that volatility comes with investing in assets that offer growth, income and liquidity, such as listed securities.