October Market Update

October market view: growth holds up as central banks tighten

Looking back at September’s dataflow and what it may mean for portfolio positioning.

Introduction

September’s growth data was better than many had feared. US employers added 162,000 jobs in August, retail sales rose 1.2%, euro area business activity grew at its fastest pace in almost three and a half years, and Australia’s economy grew slightly ahead of expectations. India expanded 7.8%.

Central banks moved the other way. The ECB, the Fed, the Bank of Japan and the RBA all raised rates within three weeks of each other, and longer-term US interest rates reached near 19-year highs. Much of today’s inflation comes from supply problems rather than excess demand, which leaves rate rises a blunt tool.

Growth held up in September, but the inflation central banks are fighting is coming mostly from supply problems that higher rates do little to fix.

What moved the dial

Supportive signals

• Australia’s economy grew 4% in the June quarter, slightly ahead of the 0.3% expected, and 2.1% over the year. Household spending rose 0.4%, the same pace as the March quarter, as the economy kept growing despite higher interest rates and fuel costs.
• US employers added 162,000 jobs in August, far more than the roughly 55,000 expected, while unemployment held at 4.1%. It eased concerns that the world’s largest economy is heading into recession.
• US retail sales rose 2% in August, ahead of the 0.8% expected. The gains were broad rather than a product of higher petrol prices, with sales excluding autos and fuel also up 1.2%.
• Euro area business activity grew at its fastest pace in almost three and a half years in September, with manufacturing at a 55-month high and services at a 10-month high. The region is coping with higher energy costs better than many had assumed.
• India remained the world’s fastest-growing major economy, expanding 8% in the April to June quarter, with strong domestic demand cushioning it from the global slowdown. Alongside other emerging economies in Asia, it remains a bright spot for global growth.
• Japan’s factory sector expanded for a ninth consecutive month in September, with export orders rising at one of the fastest rates since 2018. Growth eased to a six-month low, but demand is holding up as the country manages higher interest rates.

Watch-outs

• The RBA raised the cash rate to 60% on 29 September, its highest since 2011 and the fourth increase this year, with underlying inflation stuck at 3.6%, above the 2 to 3% target. Borrowing costs rise for households and businesses.
• The Fed raised rates for the first time since 2023, to 75-4.00%, and its projections point to one more increase this year. A rate-rising Fed removes the support that the prospect of cheaper money had been giving markets.
• Longer-term US interest rates rose to near 19-year highs, lifting the average 30-year mortgage rate to 7.28%, the highest since November 2023. Higher borrowing costs squeeze households and weigh on almost every kind of investment.
• Euro area inflation climbed to 8% in September, its highest since September 2023, after the ECB raised rates again on 10 September. The region is grappling with rising prices it cannot easily control.
• The Bank of Japan raised rates to 25% on 18 September, its highest since 1995, citing upside risks to inflation, with a weak yen adding to price pressures. Faster rate rises in Japan can ripple through global markets.
• China’s economy stayed weak. Retail sales grew just 4% in August and house prices remain well down on recent years. Factory activity only just returned to growth in September, with the official manufacturing PMI at 50.1 after two months of contraction.

Macro overview

September’s data split in two. Growth held up better than expected: US hiring and retail sales beat forecasts, euro area business activity reached its strongest pace in almost three and a half years, India grew 7.8% and Australia’s June quarter came in slightly ahead of expectations. China was the exception, with weak consumer spending and factory activity only just back in growth.

Policy tightened regardless. Four major central banks raised rates within three weeks, and long-term government borrowing costs rose around the world. The difficulty is that much of today’s inflation comes from supply problems, including the conflict around Iran and the war in Ukraine, rather than from excess spending. Rate rises work mainly by cooling demand, so they are a blunt tool against a supply-driven problem. The risk we watch most closely is an economy showing early signs of cooling while inflation stays high, because the usual fix for one makes the other worse.

Asset class outlooks

Equities: Company profits have held up well and we expect them to keep growing into next year, which is the main reason we remain broadly positive. The pressure is on valuations. Higher long-term interest rates lower the price investors are willing to pay for each dollar of profit, and P/E ratios are already coming down across the market, with the most expensive companies feeling it most. We have tilted portfolios toward businesses with strong, lasting growth that are less exposed to supply disruption.

Fixed income: Long-term government borrowing costs are rising around the world, with longer-term US rates near 19-year highs. In the US, Chair Kevin Warsh has signalled the Fed will keep rates higher for longer and gradually withdraw liquidity from the financial system, a flow we watch closely because markets need it to function smoothly. Our base case is that policy stays tighter than markets had hoped, without derailing the recovery.

Alternatives and real assets: Energy remains the key swing factor. The conflict around Iran has pushed energy prices higher and disrupted the supply of essential goods such as fertiliser and industrial chemicals, and the war in Ukraine adds further strain to global supply chains.

FX: The yen remains weak, one of the pressures behind the Bank of Japan’s latest rate rise.

Implications for asset allocation and portfolio positioning

We remain positive but are holding a little extra cash for now. September and October are historically the choppiest months for shares, more so in a US mid-term election year, and we would not be surprised by a bumpier ride.

Practical implications:

• Keep the tilt toward businesses with strong, lasting growth that are less exposed to supply-chain disruption.
• Hold a little extra cash, ready to act if volatility creates opportunities.
• Expect tighter policy for longer, with four major central banks now raising rates.
• Watch valuations. Rising long-term rates are compressing P/E ratios, and the most expensive companies are most exposed.
• Watch liquidity as the Fed gradually withdraws money from the financial system.

Scenarios and probabilities

Scenario probabilities reflect our current assessment and are reviewed as new data emerges.

Base case: 75% probability

The global economy remains on solid ground. Company profits to hold up well, governments are still spending and money is relatively easy to borrow, and we expect profits to keep growing into next year. That gives markets a firm base and is the main reason we stay broadly positive. The risks are building, however. The conflict around Iran has pushed energy prices higher and disrupted the supply of essential goods such as fertiliser and industrial chemicals, and the war in Ukraine adds further strain to global supply chains. We have tilted portfolios toward businesses with strong, lasting growth that are less exposed to these disruptions.

Inflation had been easing, but higher energy prices have pushed it back up. Because much of it comes from supply problems, rate rises are a blunt tool, and if high prices persist the bigger danger is that households cut back their spending. Fed Chair Kevin Warsh has signalled he will keep rates higher for longer and gradually withdraw money from the financial system. Long-term government borrowing costs are also rising around the world, lowering the price investors pay for each dollar of profit, and P/E ratios are already coming down, with the most expensive companies feeling it most. Our base case is that policy stays tighter than markets had hoped, without derailing the recovery.

The big growth themes remain in place, with investment in AI, manufacturing and energy expected to lift profits across many industries. We are watching the rising cost of building AI. Our base case is that this raises the bill without breaking it: the companies leading the spending can afford it, and competition may bring costs down, spreading the benefits to the many businesses that use AI. In short, resilient profits, government spending and available credit give markets a reasonable foundation, though in a more volatile setting than in recent years. We remain positive but are holding a little extra cash, ready to act if volatility creates opportunities.

Bear case: 13% probability

The main risk is a real pullback in spending by households and businesses, especially in the United States, the main engine of global growth and profits. With share prices already high relative to profits, a slowdown in AI investment at the same time could make the downturn sharp, and with stubborn inflation and high interest rates, margins and share prices could fall together. Large, sustained oil price rises and worsening supply-chain disruption from the wars in Iran and Ukraine would make this more likely. Because much of the inflation is supply-driven, central banks may be unable to cut, while high government debt limits fiscal support. Rising long-term borrowing costs would squeeze valuations further, so share prices could fall even if earnings stay strong. If the cost of building AI keeps climbing while the payoff is delayed, a sharp fall in the expensive technology leaders could drag the whole market down.

China adds another risk. If its property market weakens further and government support fails to restore confidence, Chinese growth could slow sharply, directly hitting Australian national income and company profits given our reliance on Chinese demand for resource exports. In this scenario we would take a more defensive stance: more cash, less exposure to shares, and a tilt toward healthcare, consumer staples and utilities.

Bull case: 12% probability

In the bull case, tensions with Iran ease and the pressures on markets turn supportive. Falling energy prices, easing supply-chain strains and better diplomatic relations, including progress in Ukraine, would support stronger global growth while keeping inflation in check. If trade disputes also resolve, profits could grow strongly as costs fall and consumers keep spending, and wider use of AI would lift output across industries without the widespread job losses many fear. At best, ceasefires hold, the Strait of Hormuz reopens fully and a period of recovery follows.

The two pressures we are watching could then turn in investors’ favour. If markets trust that inflation will stay under control, long-term borrowing costs can fall even while the Fed holds rates steady, lifting the price investors pay for each dollar of profit, the reverse of the pressure now weighing on the market. Cheaper energy and rapid technological improvement could also bring the cost of building AI down faster than expected. For Australia, government spending and the end of the current run of rate rises would support stronger growth, with relatively low public debt giving policymakers room to act. If interest rates stay below inflation, we would favour a growth-focused portfolio with less cash and more exposure to industrials, materials and financials.

Closing perspective

September showed a global economy holding up better than expected while central banks kept tightening, with the ECB, Fed, Bank of Japan and RBA all raising rates within three weeks. With much of the inflation coming from supply problems, and long-term borrowing costs rising worldwide, valuations are under pressure even where profits hold. We remain positive, tilted toward businesses with strong, lasting growth, and are holding a little extra cash through a seasonally choppy period.

This publication is prepared by Akambo Pty Ltd (ABN 16 123 078 900) AFSL 322056.

The information presented in this publication is general information only, and is not intended to be financial product advice. It has not been prepared taking into account your investment objectives, financial situation or needs, and should not be used as the basis for making an investment decision. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and financial circumstances.

Some numerical figures in this publication have been subject to rounding adjustments. Akambo Pty Ltd (including any of its directors, officers or employees) will not accept liability for any loss or damage as a result of any reliance on this information. The market commentary reflect Akambo’s Pty Ltd’s views and beliefs at the time of preparation, which are subject to change without notice.

Past performance is not a reliable guide to future returns.