Market & Economic Update – July 2022
by Financial Keys
The Australian equity market (as measured by the S&P/ASX 200) recorded its biggest monthly decline since March 2020, falling (-8.8%) in June to extend its quarterly loss to (-11.9%), its worst loss since the March quarter 2020. Fearing aggressive monetary tightening policy and the risk of recession, every sector bar two (Energy and Utilities eking out small gains) were violently sold-off as fundamentals were tossed aside and indiscriminate selling took control. The June quarter was again dominated by the conflict in Russia and Ukraine which added further fuel to the ever-increasing geopolitical tensions occurring globally; China forcing mass lockdowns of major hubs due to further Covid outbreaks and mounting global recession concerns which do not seem to be abating (quick enough).
The fallout has basically been mass hysteria, with central banks, including the RBA, scrambling to control rising inflation with higher-than-expected rate hikes. This has played havoc with Australia’s most important sector, the housing market where fixed rate mortgages due to roll-over into higher variable rates will potentially increase the downside risk to prices (declines have been steadily increasing) and more importantly the construction sector and consumer spending. Hopefully, the re-opening of Australian borders will pave the way for an increase in net migration of overseas students.
At the sector level, as expected, the Energy sector (+1.7%) and the defensive Utilities sector (+1.7%) were the only profitable sectors for the quarter. Best performing of the rest included Industrials (-1.4%) and Healthcare (-1.9%). The most challenged for the quarter, as longer-duration growth assets were sold-off because of interest rate hikes, was Information Technology (-27.2%). Rising rates and the threat of recession also resulted in Real Estate (-17.8%) and Consumer Discretionary (-14.9%) falling sharply.
The usual advantages of Value orientated companies in rising interest rate environments didn’t quite come to fruition (broadly) during the quarter (relatively outperformed Growth though), as all style factors were hurt. The whole market cap spectrum, from large (-10.6%), mid (-14.7%) and small (-20.4%), also sold-off as heightening volatility and “risk-off” mentality gripped investors.
Global equity markets continued to weaken over the June quarter experiencing the same vicious selling pressures as the domestic market. The first six months of the calendar year was characterised by the fastest rate-hiking cycle in decades, to combat levels of inflation not seen this century; continuing market turbulence and a war that could be drawn out for longer than most people expected, that has spurred spiralling inflation, leaving investors wounded and contemplating what’s in store for the remainder of the year; and beyond. What is arguably the key, is that central bank policy will play a large role in the potential outcomes of global investment markets (and economies) in the second half of the calendar year.
Quarterly performance across various regions suffered significant losses as hawkish central banks implemented aggressive tightening policies, hell-bent on stifling inflation at the cost of economic growth. Prices had continued to be exorbitant (based on the perception of a never-ending zero interest rate environment), and earnings expectations were not being adjusted for the rising risk of inflation; leading US markets continuing on their merry way (US PE ratio, based on forward earnings, measured circa 22 times at the beginning of the year) until reality bit hard, seeing historical weekly losses in mid-June. By June end, we had seen two hefty rate increases by the Federal Reserve, the second of 0.75% being the largest since 1994 and bringing the Feds cash rate to a range of 1.5%-1.75%. The US PE ratio had dropped to 16.5 times by the end of June. The S&P 500 lost (-16.4%), its worst quarter since the March quarter of 2020, whilst the tech heavy Nasdaq slid (-22.4%), its worst quarterly stretch since 2008: both in US dollar terms. In AUD terms, the falls respectively of (-8.5%) and (-15.1%), meant currency movement proved to be a strong attributor for unhedged strategies as the Aussie dollar fell sharply during the quarter.
In Australian dollar terms, the broader global equity market (MSCI World NR AUD) lost (-8.5%); Eurozone equities (STOXX Europe 600 NR) continue to experience steep declines as the war in Ukraine continues and concerns are mounting over potential gas shortages and recession (-7.2%); Emerging Markets (MSCI EM Index) however held up relatively well (-3.3%), mainly due to China, the FTSE China 50 USD TR shot up (+12.9%), as lockdowns were eased, economic indicators and manufacturing metrics picked up, the People's Bank of China (PBOC) kept its key monetary policy rates steady and President Xi reaffirming massive stimulus packages for the second half of 2022. The Asian nations fared much better relative to Latin America, which continues to be dragged down by sovereign uncertainty, trade and currency depreciation (especially in Brazil). US dollar strength continues to be the broader Emerging Market headwind.
Property & Infrastructure
The Australian listed property sector (S&P/ASX 200 A-REIT) continued to struggle, falling a further (-17.7%) to be down (-23.5%) for the six-month period. This is largely due to the ongoing rise in ‘real’ yields and the rising risk of recession.
Global listed property (unhedged) returned (-9.4%), for the quarter, (-15.4%) year to date, considerably outperforming the domestic market. The speed and level of increase in real interest rates over the quarter has de-rated listed Real Estate Investment Trusts (REITs) globally (especially in the US), while the sector also continues to be weighed down by issues surrounding the China property sector. The good news is that most REITS are now trading below the net asset values which will possibly provide positive trading opportunities for the remainder of the year.
Performance trends overall across the REIT sector have been dominated by macroeconomic factors rather than underlying fundamentals. "Quality" appears to be unusually cheap within the REIT sector, particularly given the backdrop of mounting recession concerns. More broadly, with REITs being one of the most domestic-focused and rate-sensitive sectors, the upcoming earnings season could be a catalyst to drive an upward re-pricing of the sector, with a particularly strong rebound from high-quality REITs in the "essential" sectors - residential, technology and industrial.
Global listed infrastructure (unhedged) again provided some respite, recording a positive return of (+1.2%). The sector however is also succumbing, albeit slowly at this stage, to the lift in real yields and weakness in broader equity markets.
Both sectors, although part of the global risk-off thematic, should continue, over the long-term, to provide attractive diversification benefits. Over this volatile period and as we are nearing the end of the current cycle, both sectors again should be well-supported as global economies reopen and by infrastructure-led fiscal stimulus packages, decarbonisation, the ‘green’ transition and importantly, inflation-linked pricing models.
Bonds & Cash
Global bond markets continued to sell off sharply in the June quarter, with yields markedly higher amid still elevated inflation data, hawkish central banks and rising interest rates. Bonds rallied into quarter-end amid rising growth concerns and low consumer confidence, limiting the losses slightly.
Australian bond yields also continued to move higher in the first half of June, reaching a peak mid-month before joining the US bond rally later in the month and benefitting from a reassessment of the RBA cash rate outlook (evidence of softening house prices and declining consumer confidence).
As inflation reached decade peaks globally, central banks feverishly tried to control its acceleration, by scaling up the level of rate increases resulting in yields reaching levels not seen this century and pushing indices further into negative territory not seen for a long time.
Yields on 10-year treasuries, both domestically and globally continued their volatile ride throughout the quarter. The 10-year Australian Treasury yield starting at 2.78%, peaked mid-June at 4.2% before ending at 3.72%. The yield at the start of 2022 was 1.72%.
The 10-year US Treasury yield began the quarter at 2.34% also increased significantly, peaking at 3.49% on June 14 before ending the quarter at 2.98%. The yield at the start of 2022 was 1.52%.
Markets initially priced in at least half a dozen rate rises in most developed markets in 2022 with a further 2-4 in 2023 to rein in inflation. This however might be overshooting as recent key economic indicators show growth decelerating. Major central banks might continue to raise rates over the next few monthly meetings but might temper the level as further evidence of previous hikes filters through. Bond markets though are now pricing an end to hiking cycles, with the Fed now seen cutting rates by half a point over the second half of next year.
Australian bonds (Bloomberg AusBond Govn 0+Yr) returned (-4.0%) whilst global bonds (BBgBarc Global Aggregate TR Hedged) returned (-4.7%). Credit markets sold off sharply during the quarter and continue to be quite volatile. At current levels, markets are pricing in a 60% probability of global recession. Credit spreads indicate that investors are taking precautions and seeking the safety of treasuries and higher-grade debt whilst at the same time taking risk off the table. Unlike the March quarter, Emerging Market debt suffered significant declines. EM currencies weakened as the US dollar performed well, benefiting from broad risk aversion.
With major central banks around the world fixated on slowing growth and cooling labour markets (in what seems at any cost) to rein in inflation, official cash rates have risen considerably. The RBA lifted the official rate in both May (first rate hike since 2010) and June to bring the official rate to 1.35% by quarter end.
Quarter in review
The June quarter was one for records – the lowest Australian unemployment rate since 1974 and the highest US inflation rate since 1981 – all whilst markets shifted from pricing inflation risks to pricing recession risks, with an ever-complicated backdrop including the threat of an escalating war in Europe, increased supply challenges caused by the conflict and covid lockdowns in China, and concerns regarding energy and food shortages globally, as the prices of both skyrocketed.
The rather narrow beneficiaries of an increasingly likely stagflationary environment (i.e. high inflation, falling or low economic growth) continued into the June quarter with higher energy and commodity prices benefiting the resources sector, the prospect of a sharp central bank rate hiking cycle supporting banks and insurers, and utilities benefiting from equity investors seeking out safety and inflation protection.
Increased rhetoric regarding “peak” inflation proved to be premature as inflation continued to rise in many jurisdictions, as wages surged in tight labour markets in trying to keep pace with rising energy, food, and shelter costs. The stubbornness of inflation simply acted to embolden central banks to act more decisively in taking away stimulus, with many central banks moving to increase rates in larger than normal increments. These moves caused increased market volatility with government bonds continuing to come under selling pressure, along with growth stock names including technology stocks. The move in central bank cash rates and the worsening economic conditions in Europe saw the US dollar surge, putting downward pressure on the Australian dollar.
The resultant moves higher in central bank cash rates, coupled with higher costs of living, saw soft economic data start to weaken quite significantly including consumer confidence and sentiment indicators, surging US credit card debt, and weakening construction and housing market data as fixed mortgage rates surged, auction clearance rates nosedived, and construction company stress emerged. In contrast, hard economic data continued to hold up reasonably well including retail sales, manufacturing and services data, and strong employment data. Recession risks began to rise with the market turning its attention late in the quarter to firmly fixate on pricing nearer term recession. This meant economically sensitive equity sectors like resources, financials, consumer discretionary, and real estate, along with riskier small and medium sized companies, came under intense selling pressure as the market moved into a risk-off environment. Credit spreads within bonds also started to widen with largely nowhere to hide. However, the move to a risk-off environment did provide a reprieve to government bonds, with investors seeking out safety and taking advantage of higher yields, whilst investors began to discern good growth stocks from bad growth stocks and more importantly, discern quality from growth, giving good growth and quality biased stocks a reprieve.
Interestingly infrastructure, Asian equities, and emerging market equities (to a lesser extent), were three of the better performing asset classes in the quarter, with investors seeking out safety and defensiveness in infrastructure, whilst seeking relative value in Asian and emerging market equities as the Chinese government stepped away from its aggressive regulatory stance and began to provide both fiscal and monetary stimulus to lift their economy out of the doldrums following a lengthy period of large and quite significant covid-related lockdowns. The risk-off end to the quarter did see oil prices fall but remain high due to continued supply issues and strong demand as post covid reopening continued.
Weakening economic signals along with stubbornly high inflation present a conundrum for central banks, giving them a very small window in which to address inflation whilst increasing the chances of a policy misstep (i.e. over tightening). The Russia/Ukraine complex remains a complicating factor both in terms of geopolitical risks and ongoing supply issues, whist it remains to be seen whether China is done with their covid-zero policy framework.
In contrast, economic conditions remain reasonable (outside of Europe), and corporates and households did come into this environment from a position of strength – i.e. high household savings rates, two years of strong equity and property prices, full employment and rising wages, and very strong corporate balance sheets following two years of raising capital relatively cheaply and extending debt maturities whilst locking in very low borrowing rates.
With rising costs of living starting to hit home and the market pricing significantly more rate rises from most central banks before year end, upcoming company reporting season will be key to watch with forward guidance for earnings even more important. Investors and economists will be looking for signs of peak inflation to gain more clarity, and comfort, on the central bank rate hike path whilst central bankers attempt to engineer a soft landing which is becoming increasingly difficult by the day.
Thankfully, some more positive news has come through since the last quarter and markets have strengthened through July.
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