This month has been a significant period for central banks. The Reserve Bank of Australia (RBA), increased its policy rate 0.25% to 4.10%. at the same time, the US Federal Reserve (Fed), left its policy rate unchanged between 3.50% and 3.75%. However, the message from each central bank was different.
What was announced?
The RBA indicated that further rate increases may be required to offset growing inflationary pressures. The Fed retained a cutting bias, subject to the impact from the current Middle East war. Both banks said that they will proceed with caution as oil prices remain elevated and growth slows.
Inflation remains critical for the outlook
The RBA and Fed would prefer to look through the inflationary pressures created by higher oil prices, as long as inflation remains anchored around their targets. Currently, this remains the case in the US, where inflation break-evens have increased, but levels are still well short of those reached at the start of the Russian war on Ukraine. In Australia, consumer expectations for inflation have surged. Inflation could push higher, if oil prices remain above $100/barrel for more than a month.
What are the markets currently pricing in?
US markets are pricing one more rate cut in 2026. Conversely, the RBA is priced to increase rates twice over the same period. Also, don’t forget that Australia already had inflationary pressures prior to the Middle East war. It should also be noted that market pricing has been very fluid since the war in the Middle East started. Higher oil prices are a risk to inflation, but also a risk to economic growth. Central banks have the difficult task of managing this tension. This is why they will likely proceed with caution.
What does it mean for markets?
In simple terms, if the Fed reduces interest rates, it will likely create some level of growth within the US equity markets. By default, some of this may trickle through to global indices, including the ASX. Domestically, if the RBA increases the domestic cash rate, this will dampen any growth from the ASX. At this time global equity markets, including the Australian All Ordinaries index, have continued to largely look through the impact of the war. They assume a short conflict with limited impact on growth and inflation. Only time will tell if the markets are correct.
In reality, we do not have any accurate insight into the duration of the war. That said, there are probably three scenarios that we can use to manage portfolios.
- There is contained escalation. There continues to be tit-for-tat, more symbolic strikes, which create a near-term oil spike. However, over time the current volatility fades.
- There is a wider regional conflict. This escalation means that additional Gulf states are drawn into a broader conflict. This would lead to a sustained oil price above $100/barrel.
- Shipping though the Straight of Hormuz is disrupted for an extended period. This will likely create severe global inflation and a wider growth shock.
How will we manage portfolios going forward?
In reference to this article and future interest rate movements, we aim to retain our current agreed asset allocations. At the same time, we would like to take advantage of the likelihood of interest rates increasing over time. We will be focusing on duration for any term deposits and, where appropriate, restructuring some of our wider fixed income exposure. For the more growth orientated allocation within portfolios, we will continue to monitor the underlying investments. We regularly speak with, and review, our managed fund and active ETF (Exchange Traded Fund), investments. Potentially, when markets are a little less volatile, we will look to increase passive exposure to indexes such as the All Ordinaries. We can then hopefully participate in any ongoing market recovery.
Our three overriding goals are to try to protect your capital, generate a reasonable level of income and, if possible, maintain growth in line with or above inflation. In the current market, an increasing interest rate cycle can help achieve these goals. Importantly, how we manage your portfolio does not change. We will not be making ‘knee jerk’ reactions and will prioritise holding long-term quality investments which provide good liquidity.
In addition to this article, we would encourage clients who haven’t already done so, to read “https://www.w2wealth.com.au/manage-portfolio-volatile-times/“.