Further conflict between Israel and Palestine, higher oil prices and higher than expected inflation all weighed heavily on financial markets in October. The benchmark All-Ordinaries index fell by a further 3.9% in October (after falling 3.6% in September), closing the month at 6,967.5 points.
Global share markets were weaker in October, with the United States Dow Jones Index falling 1.4%, the London FTSE falling 3.8%, the Hong Kong Hang Seng Index falling 3.9% and the Japan Nikkei 225 falling 3.1% for the month.
The Reserve Bank of Australia (RBA) Board kept the official Cash Rate on hold at 4.10% per annum in October, however with higher-than-expected inflation, markets are now pricing a 75% chance of a 0.25% per annum increase in the Cash Rate when the RBA board meets next Tuesday.
The Australian Dollar fell by a further 1.4% in the month against the United States Dollar, with 1 Australian Dollar buying 63.4 United States cents.
Shock geopolitical events inevitably trigger market “volatility” and a short-term sell-off in share values. Commodity prices (especially gold and oil typically increase in value), as do safe-haven currencies (such as the United Stated Dollar) and bond prices typically increase.
Historically, over the longer term, market “volatility” from geopolitical events wanes and share market values recover. We need to look no further to the Russia-Ukraine conflict from early last year as evidence of just how quickly share markets can recover.
Notwithstanding the above, investment markets are currently playing a “tug of war” between stocks and bonds. Traditionally, there is a fundamental relationship between interest rates and asset valuations. This makes sense, as interest rates represent the “price of time” and should be embedded in the value of every risk asset.
The relationship is simple. When interest rates decline, the value of future company cash flows rises and pushes share valuations higher. The reverse traditionally is true when interest rates increase, with the notable exception in the chart below being this calendar year.
We are currently witnessing a breakdown in the traditional relationship between bonds and share values (as evidenced in the above chart which shows United States real yields inverted against the forward United States S&P 500 “price-to-earnings” valuation ratio).
Perhaps this breakdown in traditional relationship is because share market investors think inflation is “transitory”. Their argument is that inflation is largely due to the knock-on effects of COVID-19 lockdowns, supply chain issues, Russia’s invasion of Ukraine and now the Israel-Palestine conflict. Their view (and mine for what it is worth) is that inflation will naturally trend down with the passing of time and increasing the Cash Rate is beyond its current level is unnecessary.
Bond markets indicate a different story. That is, the bond market is currently saying that central banks will struggle to curtail inflation, and that interest rates must continue to increase.
If the bond market is correct, then perhaps share market valuations will be under pressure in the short-term. However, if the share market investors are correct, then bond yields will equally be under pressure. Either way, it appears volatility will be a feature of markets for the time being.
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This article is general information only and is not intended to be a recommendation. We strongly recommend you seek advice from your financial adviser as to whether this information is appropriate to your needs, financial situation, and investment objectives.