Rally riders beware! The numbers don’t add up

The conditions are not in place for any extension of the recent share market rally.

Many commentators have been calling the recent market strength the start of a new bull run. It isn’t. What we just witnessed was a relief rally.

Relief rallies – the ASX rose almost 9 per cent from its lows before stalling in recent sessions – are a central part of a bear market.

In fact, investors need to fasten their seat belts and be prepared for more volatility ahead.

They should be aware that tighter monetary policy, seen in higher interest rates, led to a sell-off at the beginning of 2022.

Now we are in the middle of a more sustained sell-off with a year-end target on the US S&P 500 of 3600 points: it is currently closer to 4000.

At the end of July 2022 it looked like Australian equities were the place to be. They showed a relatively strong rolling 12-month performance to the end of July of -2.16 per cent with marginal outperformance against the MSCI All Countries World Index ex Australia in $A of -4.39 per cent.

It is even better when you consider currency adjustments: the S&P 500 in $A for the same period was +0.44 per cent (in $US it is -7.1 per cent).

So, it’s clear our local market has outperformed but is that going to be sustained?

I would argue that the “old” structure of the Australian index is a positive with good performance over the last 12 months to the end of July in consumer staples, energy, financials, industrials and utilities.

Then there’s the reality of inflation. It seems to have been accepted by markets and will eventually settle at lower levels, (albeit higher levels than originally expected in the 3-4 per cent range).

Still, the market must absorb two key factors.

The first is the lack of growth in economies generally as a result of lower corporate earnings. Look at history: we see an average decrease in corporate earnings of 10-15 per cent after peak inflation.

The second is what’s driving the slowdown in growth.

The main cause of inflation has been supply-side issues, causing higher food and energy prices to name two of the reasons. Central banks are trying to solve this supply-side issue with a demand-side solution being monetary policy, by increasing interest rates. That’s a very blunt instrument which will arguably have a negative impact on economic growth.

Traders work during the opening bell at the New York Stock Exchange. Picture: AFP

After the relief rally, it’s time for investors to consider equity valuations.

A further decrease in weightings in developed market equities makes sense, particularly the US and the bounce in technology – the growth area of the market.

In contrast, now is the time to maintain a weighting in Australia equities and consider a “relative overweight” position compared with developed market equities.

Developed market economies look certain to enter a mild recession – especially the US, the UK and Europe. I believe Australia will avoid a recession due to record low unemployment, economic structure and excess cash still in the system.

Interest rates will continue to dictate the direction of equity markets. The challenge is to increase rates to contain inflation expectations but at the same time ensure that households and financial markets can cope with the pace and degree of these increases. This is a very delicate balancing act.

In August, there were signs of reaching a turning point in global inflation.

Commodity prices and shipping costs are now down year on year, and product shortages are alleviating, with fewer bottlenecks.

Despite this, central banks are intent on raising official cash rates – and aggressively so. This will cause growth to slow. Although inflation will continue to fall, it will not fall below the upper target band of 3 per cent for quite some time yet. Employment is still strong and wages strength will grow, limiting the pace of the fall in inflation.

Investors will know that, while our domestic Australian market has outperformed on a year-on-year basis, its participation in the relief rally was more constrained. We can expect its downside participation to be less than the high growth markets such as the US.

On the positive side, later this year or early in 2023 a long-term buying opportunity will present itself. You will never pick the right time to find a market bottom as timing markets is difficult, but be aware that the bottom in equity markets will likely come before the low point in the economic cycle.

Will Hamilton is the managing partner of Hamilton Wealth Partners, a Melbourne-based wealth manager.

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