ASX 200: now in high-risk territory?

The ASX 200 is down 2.7% over the past month, and 12.5% year-to-date to 6,643 points. It’s fair to say that the Australian economic benchmark, comprised of the country’s largest 200 companies by market cap, is not enjoying 2022.

ASX 200: financial services

However, context is vital. For perspective, the US’s S&P 500 is down 25.4% year-to-date, with further falls expected.

The key reason for this performance divergence is that the largest US stocks are tech-focused; top companies including Apple, Microsoft, Amazon, Alphabet and Tesla rely on cheap debt to fuel growth.

But after fourteen years of ultra-loose monetary policy, rising interest rates are putting huge downwards pressure on the sector. The Federal Reserve has even warned it is still fearful of doing ‘too little’ to calm inflation. Further rises appear inevitable.

And inevitably, globalisation means that Philip Lowe, Governor of the Reserve Bank of Australia, will be forced to further increase domestic rates in response, both to temper the Australian dollar’s fall against the US, and to keep a lid on CPI inflation, currently at 6.1%.

In addition, the ASX 200 is a different John Dory. Packed with financial services and materials stocks, the way the index responds to rising rates requires more nuance.

For context, the cash rate is already at 2.6%. And Lowe has warned that the bank’s aim to return inflation to within the range of 2% to 3% means that ‘further increased are likely to be required over the period ahead.’

Rising net interest margins will at least initially benefit the larger ASX financial services stocks, including, Commonwealth, Westpac, National Australian, ANZ, and Macquarie. I

Indeed, the only ASX market sector to post a sizeable gain today is the ASX 200 Financials Index, up 1.4%, driven by positive Bank of Queensland FY22 earnings, which were lifted in Q4 by rising net interest margins.

But higher interest payments will only benefit banks in the long term if the majority of consumers can afford to make debt repayments, and retain enough discretionary income to prop up the wider economy. This is starting to look doubtful at best.

Markets are currently pricing in 7%+ mortgage rates in 2023, double the average 2021 mortgage repayment for a standard 20% deposit mortgage. For context, Australia has the second most indebted consumers in the world by most metrics.

CoreLogic research director Tim Lawless notes that Sydney homes have already seen a 9% price fall year-to-date, the equivalent to $100,000 off the median price.

Could a global recession crash the ASX 200?

Of course, a strong US and Australian dollar helps the largest materials stocks in the ASX 200, including Fortescue, BHP Group, and Rio Tinto. But materials stocks are intrinsically cyclical, and their ability to generate profit hinges on high hard commodity prices.

Iron, copper, nickel, aluminium, and lithium all saw record or near-record highs earlier this year in the wake of the Ukraine war. But they have since come off their highs as concerns grow that globally out-of-control inflation and the attached rising interest rates will cause a 2008-style meltdown.

The overriding problem is that the cost of living is becoming unaffordable, not just in Australia, but across the western world. This leaves governments straining fiscal policy to help citizens cope, and central banks tightening monetary policy to rein in inflation. The resulting volatility, as UK investors can attest, could become the spark that lights the global recession.

As the IMF notes in its World Economic Outlook report, ‘the worst is yet to come,’ and 2023 will at the very least ‘feel like a recession.’ It predicts more than a third of the global economy will contract next year, with the US, EU, and China all set to stall.

China’s diminishing economic prospects are particularly problematic for ASX 200 materials stocks. The country accounts for roughly a third of Australia’s two-way trade, and the lion’s share of these exports are in materials used in China’s housing and auto markets.

And with widespread power problems, increasingly tense Sino-US relations, and a wavering housing market, demand for Australian resources could be set to fall.

And with it, the ASX 200.