Inflation, interest rates and geopolitics represent dilemmas for investors

With the geopolitical landscape changing quickly, there will likely be continued flow-on effects to the global economy. In times of uncertainty, it’s natural to be concerned about your investments, but maintaining a long-term view and controlling risk through a broadly diversified portfolio is still the best course of action, in our view.

Rates and inflation

It is widely expected that the RBA will lift the official cash rate in June for the first time in over a decade. Financial markets are currently pricing in a cash rate of 2 percent by December 2022 and 3 percent by mid-2023. This represents a significant change from the RBA’s stance late last year that the cash rate would remain on hold until early 2024.

Many developed nations have already begun normalising rates in response to a rapid rise in inflation. Facing the highest inflation rate in 40 years, the US Federal Reserve lifted rates in March and the US Federal Funds interest rate is expected to reach 2.5 percent by the end of this year, hitting 3.25 percent by mid-2023. New Zealand was one of the first countries to lift interest rates this cycle, with three hikes since November last year also attributed to multi-decade high inflation.

If market expectations for the cash rate are realised, discounted variable mortgage rates in Australia could reach 5 percent by mid-2023. The good news for borrowers is that many economists believe mortgage rates will not reach this level, partly because of higher sensitivity to interest rates given high household debt levels.In any case, according to the RBA’s Financial Stability Review this month, most households are well-placed to absorb higher repayments over the next couple of years, due to savings accumulated in mortgage offset and redraw accounts.

Economic growth outlook

The outlook for domestic and global economic growth remains positive, although the Ukraine conflict has caused the International Monetary Fund (IMF) to revise down its forecast for global GDP growth to 3.6 percent p.a. for both 2022 and 2023.  The IMF expects Australia to outperform, with growth of 4.2 percent this year, falling to 2.5 percent in 2023. 

The strength of the local economy can be seen in the unemployment rate of 4 percent - the lowest since 2008. Company balance sheets are in good shape with businesses generally well-placed to cope with higher interest rates. According to the latest available RBA data, aggregate business cash holdings as at June 2021 were approximately 30 percent higher than before the pandemic. Higher commodity prices are boosting Australia’s terms of trade.

Consumer sentiment

Despite a strong labour market, consumer sentiment has fallen in Australia over recent months, although this is more pronounced in the US, where consumer sentiment is at an 11-year low - according to the University of Michigan’s sentiment index. This mainly reflects cost of living pressures, however with the fall in retail gasoline prices (which appear to have peaked in March), consumer sentiment improved slightly in April. This is a positive sign for the US economy although the trend over the coming months will confirm this.

Financial markets

Higher long-term interest rates have been particularly negative for the technology sector. In the US, the NASDAQ Composite Index is down 17 percent from the November 2021 high. The Australian share market was the only developed market to post a positive return in the March quarter, due to the higher exposure to raw materials, energy, and financials.

Rising interest rates mean the outlook for share markets is more challenging. Given a growing global economy, however, selective exposure to shares should still provide decent long-term returns. In particular, we favour exposure to high-quality companies (i.e. high return on equity, stable earnings, and strong balance sheets) due to the tendency for companies with these attributes to act as a ‘safe haven’ when markets are volatile. On the other hand, with the quality universe dominated by US large-cap technology companies, it is important to ensure appropriate diversification in portfolios. In our view, global small-cap companies look attractive given their valuation relative to large-caps.

BDO Comment

In summary, while we expect volatility to remain high as markets adjust to higher interest rates, investors should remain focused on their long-term investment strategy and look to control risk through appropriate diversification. 

Against this backdrop, we have begun introducing new strategies to client portfolios, including diversifying away from traditional asset classes into alternative assets (e.g. absolute-return hedge funds), which have the capability to generate positive returns regardless of the direction of the market. Private debt (such as corporate loans) is another opportunity for diversification, with this asset class offering attractive yields together with inflation protection as the underlying loans are usually structured as a floating rate.

Should you wish to discuss how your portfolio is positioned in the context of your investment objectives and market risks, please speak to your local BDO Private Wealth adviser.

This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact the BDO member firms in Australia to discuss these matters in the context of your particular circumstances. BDO Australia Ltd and each BDO member firm in Australia, their partners and/or directors, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.

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