It’s not Called the Lucky Country for Nothing

Will Australia once again live up to its billing as the lucky country? The year ahead poses the twin challenges of low growth and sticky inflation. However, in terms of market returns, things may not be as gloomy. We looked at historical negative return years to see what 2023 could have in store for investors.

When Donald Horne came up with the phrase “the lucky country” back in 1964, few would have expected it to be relevant almost 60 years later. However, looking back at the year that was, Australia’s economy, financial markets and central bank managed to navigate the challenges better than global peers. Some of this can be put down to sheer luck, but there is evidence we have contributed to making our own luck.

2022 was a year dominated by inflation. The inflation spike has been attributed to the perfect storm of the Russia-Ukraine war, pent-up demand and supply chain backlogs. This curbed the post Covid growth spurt and prompted central banks around the world to hike rates aggressively to check the historic high prices. The Australian economy digested 300 bps of rate hikes by the Reserve Bank of Australia (RBA) yet it remained resilient.

Australia’s GDP growth was steady in 2022, likely coming in at 3.7%.¹ This was on the back of robust consumption and exports. Additionally, the Australian inflation uptick was not as pronounced as global inflation. This growth resilience was in contrast to global peers that saw at least one quarter of negative growth, with the US having a technical recession on the back of a hawkish Fed that raised rates by 425 bps.

The repercussions from higher inflation and central bank hikes weighed heavily on markets as volatility increased. Fixed income indices suffered their worst return on record as the Bloomberg Global Aggregate Index had losses of -10.2%², the Ausbond composite was a little better, posting a return of -9.7.² Equities also suffered big losses with their worst returns since 2008. US equities posted a -12.2%² return in 2022 and global equities -12.1%.² Australian markets again outperformed their global peers as the S&P/ASX 200 Index recovered somewhat in Q4 to return -1.1%² for the year.

The year ahead poses the twin challenges of low growth and sticky inflation. However, in terms of market returns, things may not be as gloomy. We looked at historical negative-return-years to see what 2023 could have in store for investors. The chart below shows the average returns for the years following a negative-return-year. The observed market performance shows healthy average bounce-backs across all major indices. While this was an interesting exercise, we would caution against placing too much faith in these averages given the variability in the individual outcomes and the low number of observations. The S&P 500 Index has had 10 negative return years since inception (1970-2021). In seven of those 10 times, the S&P 500 Index has had a positive return the following year. The average return in the following year post a negative-return-year is 12.2%.³

In keeping with the theme of Australian outperformance, the S&P/ASX 200 Index has only had five negative return years since inception (1992-2021). It has never had two consecutive negative years and the average return post a negative-year-return is 23.3%.³

Despite this rosy forecast based on historic bounce-backs, we do not expect such strong performance this time round. Overall, we still remain cautious on equities in 2023, and expect volatility to persist for at least the first half of the year. Our 2023 outlook does foresee an upside move in the second half of the year. This prognosis is dependent on the rate-hike peak which could be influenced by either an inflation downtrend or a material economic slowdown. We have seen some evidence for both of these circumstances.

Our outlook is for a disinflationary episode in 2023 with inflation falling from peak levels as supply side pressures are easing across the board. After accelerating 28.8%⁴ in the first 9-months of 2022, commodities then moderated -3% in Q4. Further deceleration in prices is seen in the January ‘23 reading for the Drewry World Container Index Composite (an indicator of freight fares) which is now lower than its 10-year average.⁵ Although the November ’22 inflation number came in at 7.3%⁶, higher than consensus and the previous month, we still expect a moderation through 2023. We expect inflation in Australia to be 4.2% in 2023 versus the expectation of 6.6% 2022.

On growth expectations, we have seen a recent downward trend in global economic indicators with the Composite Purchasing Managers’ Index (PMIs) for both US and Global now below 50⁷ (contraction territory). Australia business sentiment is weak and consumer spending is softening, although not quite to recession-like levels. While global growth conditions look anaemic, our outlook for Australian Gross Domestic Product (GDP) growth is for a comparatively rosy 2.1%. While below trend, this is still the highest in advanced economies with our expectations for the US only 0.4% and advanced economies overall 0.6%.

With such low growth and uncertain economic outlook, there is a material risk of a recession. Yet central banks continue to be hawkish and laser focussed on fighting inflation. An area that seems to justify this hawkishness is the historically tight labour market both here and in many advanced economies. The Australian unemployment rate was 3.4%⁵ in both October and November, matching the historic low of July ’22. The tight labour market threatens an acceleration in wage inflation so a central bank pivot is unlikely till we see signs of slack in the labour market. Therein lies the risk of excessive policy tightening halting economic growth.

Australia also faces an additional risk, the housing market weakness. This could be exacerbated by the large chunk (45%⁵) of the present fixed rate mortgages that will rollover to floating rates in 2023. There is an estimated interest rate rise of 2.15-2.65%⁸ for an average Australian borrower.

Despite these risks, we are relatively bullish on Australian financial markets. First, the inflation rate is high but is on a downward trend, notwithstanding the November ’22 figure, as global supply shocks soften. Second, job vacancies and advertised jobs have fallen sharply in the latest numbers⁵, easing some of the labour market tightness. Third, Australia’s growth over the last year has been fuelled by the high savings rate post-Covid. The last recorded savings rate (September ’22)⁵ is still over the long-term average and this should provide relief from the increase in borrowing costs. Fourth, China’s re-opening will boost exports for Australia.

Lastly, the RBA’s more cautious hawkishness relative to global peers also provides comfort. We still expect the RBA to raise rates by another 75 bps but, the reduction in the size of rate hikes last quarter highlights their understanding of the fine line between restricting economic activity and pushing the economy into a recession.

Against this backdrop of macro and policy uncertainty there are still opportunities in the markets. In equity markets we favour defensive securities. The short duration earnings and lower market risk allows these securities to withstand high market volatility. Specific sectors that benefit from this theme are 1) health care 2) food and staples, and 3) telecoms. In Fixed Income we favour a barbell strategy. Fixed Income yields are at a decade high and provide decent income. Additionally, the volatility can be managed by balancing the higher duration with very short duration exposure.

Australia may not have fully lived up to Horne’s lofty ambitions but, as the saying goes, it’s better to be lucky than good.