Market & Economic Update – July 2023

Australian equities

The Australian equity market returned (+1.01%), for the quarter, to end the financial year at (+14.8%).

The Australian equity market (S&P/ASX 200) started and ended the June quarter well with a slight bump in May as an unexpected rate increase caught the market by surprise. Investor resilience continued through until mid-May when momentum shifted to the downside as further rate hikes - off the back of strong labour data and services inflation - coupled with US debt ceiling concerns, started to take their toll.

Although ending the quarter in the green, the Australian equity market underperformed global equities as inflationary pressures and the risk of recession played heavily on investor minds. Unlike 2022, banks and materials, the two biggest sectors by market capitalisation, have been a drag on performance due to rising recession risk and weaker commodity prices whilst a rotation back into “growth” stocks, and Australia’s lack of a deep growth/quality market, e.g., IT, was also a key factor behind the underperformance.

At the sector level, Information Technology surged ahead, unsurprisingly, riding off the back of the global A.I. phenomena, recording a quarterly return of (+21.1%). The steadiness and rising interest rate advantages of Utilities (+5.5%) and Energy (+3.8%) also provided solid returns. Healthcare (-3.2%), off the back of CSL's surprise earnings downgrade, Materials (-2.5%) and Consumer Discretionary (-1.7%) lagged during the quarter as soft demand for commodities and the lagged effect of rising rates provided the dampener on sentiment.

Across the market spectrum, the mid-sized companies outperformed both large and small companies, whilst large companies outperformed small.

International equities

Global equities led Australian equities for both the quarter and the year, with the broader global equity market (MSCI All Countries World NR AUD), gaining a very solid (6.83%) for the quarter and an impressive (+20.4%) for the year.

The June quarter started in a much more sanguine nature as the flow on effect of the banking crisis, which engulfed the previous quarter began, to a degree, to subside, steering the monetary policy outlook to be slightly less hawkish. Technology and Artificial Intelligence (AI) induced market rallies, some have labelled a “decoupling from reality”, pushed the S&P 500 into a technical bull market in mid-June. The rotation was at extreme odds with analyst consensus for the steepest drop in company quarterly profits for the sector since at least 2006 and the bounce in the shares had nothing to do with earnings expectations. With approximately 90% of the index's gain coming from 7 companies: Apple, Amazon, Meta, Microsoft, Nvidia, Tesla, and Alphabet – now known as the “magnificent 7”. The return of the Japanese market, closing at 33-year highs on 6 June, added further fuel to the notion that central banks have come to the end of their tightening cycle and are pricing in rate cuts as early as late 2023.

The S&P 500, rose a healthy (+8.61%) for the quarter (1-year: +18.98%), in local currency, whilst the tech heavy Nasdaq, produced (+13.1%), (1-year: +26.1%). Both indices benefitting from the A.I surge in June but also the resilience from the consumer which fed through to greater than expected company earnings. Technology (+15.4%) and Communication Services (+12.3%) led the way. In AUD terms, both indices outperformed for the quarter, S&P 500 (+9.3%) and Nasdaq (+13.8%) respectively, which reflected further depreciation of the Australian dollar (-0.37%).

Eurozone equities (STOXX Europe 600 NR), continued its upward trajectory although economic data indicated the region is slowly running out of steam, posting a solid (+3.33%), (1-year: +25.6%); UK equities hung in there helped by relative currency strength, the FTSE 100 TR adding a further (+3.14%), (1-year: +18.0%). Japan equities finally provided some light, surging to a near 40-year high during June. The Nikkei 225 Average TR ended the quarter up (+9.3%), (1-year: +24.9%). A mixture of re-inflation and financial reform being the key drivers.

Emerging Markets (MSCI EM Index) posted muted returns for the quarter as U.S and China tensions seemed to have affected the broader asset class along with the anaemic economic recovery in China. The index finished the quarter up (+1.5%), (1-year: +5.1%); MSCI China TR fell sharply, losing (-9.2%) for the quarter, (1-year: -14.1%); broader ASEAN followed China, with the MSCI AC ASEAN NR falling (-4.1%), (1-year: +9.3%); MSCI EM Latin America NR surged (+14.8%).

Property & Infrastructure

Global listed property continued to suffer at the hands of rising real rates and especially sentiment as bank failures, bad debts, delinquencies, and inflated vacancy rates all made the headlines during the quarter. The benchmark index, (FTSE EPRA Nareit Global REITs TR), still managed a positive unhedged quarter return of (+1.6%), (1-year: +1.0%). The sector however continues to underperform broader global equities. Valuations (in the listed sector) continue to remain at significant discounts to book/carrying values and unlisted property (circa 15-20%).

The infrastructure sector continues to benefit from its defensive characteristics however was not immune to the volatile and jittery nature of the June quarter. The FTSE Global Core Infra 50/50 index (unhedged) was up slightly (+0.5%) for the quarter and a moderate (+3.5%) for the year. The hedged equivalent fell (-0.7%) and (-2.2%).

Bonds and Cash

Global bond market volatility continued to recede in the early parts of the quarter as 10-year treasuries traded in a much tighter range. The month of May however saw an increase in bond yields - more evident at the shorter end of the yield curve - as the U.S debt ceiling issue caused volatility to pick up and markets reassessed the outlook for rates as central bankers continued to fight rising inflation. This was evident in the MOVE Index, which tracks market volatility. Falling from the highs in March only to rise in mid-May and trade violently throughout the rest of the quarter.

The 10-year Australian Treasury yield started the quarter at 3.24%, and steadily rose to end the quarter at 4.00%. The Australian yield curve inverted for the first time since 2008 in June, significant in that it’s usually a fairly good recession predictor.

The 10-year US Treasury yield started the quarter at 3.49%, and whilst briefly hitting a low of 3.36% in early May, rallied to end the quarter at 3.85%.

Australian bonds (Bloomberg AusBond Composite 0+Y TR) fell (-2.95%) whilst Global bonds (BBgBarc Global Aggregate TR Hedged) remained stagnant, falling slightly (-0.3%). Both indices falling off the back of rising yields due to higher expected terminal rates and further inflation uncertainty.

Most currencies depreciated against the US dollar during the quarter. The AUD peaked at 0.69 in mid-June before trending lower easing down to 0.66 by quarter end. Risk aversion however will see the USD appreciate should global conditions continue to come under pressure.

Economic Update

The June quarter was a stark reminder that markets can defy economic logic in the short term with data all but confirming looming recession locally and globally whilst most asset classes saw reasonable to strong positive returns.

Central banks grew more hawkish as the quarter went on as inflation remained persistently high in most countries. Whilst headline inflation has peaked and continues to fall due to easing energy & food prices and repaired supply chains, core or underlying inflation is falling at a much slower pace and reaccelerated higher in some countries during the quarter. Demand remains more resilient than most expected given the extraordinary amount of stimulus provided during covid still providing consumers with spending capacity whilst labour markets remain very tight with unemployment still extremely low and wages growth remaining elevated. As such, central banks have brought back their tough talk on the fight against inflation to ensure that the inflation trajectory continues a downward path and does not reaccelerate higher like it has in some jurisdictions.

In contrast, leading economic indicators continue to highlight the possibility of recessions, with Australia joining the party in the quarter as the government bond yield curve finally inverted (i.e. shorter-dated bond yields higher than longer-dated bonds). Retail sales data continued to weaken. Manufacturing production and services remained in contractionary territory and weakened further. Consumer and business confidence & sentiment remain well below their covid peaks, whilst continuing to weaken in some countries. Bad debts are beginning to rise but off a very low base. Economic growth continues to contract globally with Germany and NZ entering technical recessions in the quarter, and others expected to follow over the next 6-9 months.

Around the grounds, the US finally patched over their US debt ceiling debacle with a last minute and very odd agreement to extend the ceiling until after the 2024 elections with no upper limit. US banking system stress seemed to stabilise during the quarter, but regional banks are not out of the woods just yet.

China growth continued to disappoint with weak export data, elevated levels of youth unemployment, soft manufacturing data, with consumers and domestic investors remaining overly cautious. Foreign investors grew more impatient with the China reopening efforts, wanting to see significantly more stimulus from Chinese authorities with only minor stimulus provided in the quarter.

Europe remained under pressure from a cost-of-living perspective as energy and food costs remained high given the ongoing impacts of the Russia/Ukraine conflict and central banks obliged on the inflation fighting front with more rate rises. China’s slow reopening also heavily impacted Europe given demand and export/import headwinds.

Japan performed well in the quarter with the country finally having what looks to be a more sustainable inflation and economic growth outlook.

Closer to home, we saw a surprise Federal Budget surplus, higher than expected increase in award and minimum wages, and Australian residential property prices moving higher yet again as “fear of missing out” crept back in following the RBA’s April rate pause and the misguided talk early in the quarter that the rate hiking cycle may be done.

Geopolitical risks rose as China and the West continued with trade and economic sanctions / restrictions whilst Taiwan, semiconductors (chips), and military exercises in the South China sea risked further escalation in tensions. The Russia / Ukraine conflict continued with still no end in sight, whilst social unrest in France worsened with violent street protests.

Outlook

Whilst we remain cautious on the short-term outlook given central bank action clearly aimed at crushing excess demand, we remain constructive on the medium-term outlook as higher interest rates punishes speculative behaviour whilst rewarding patient, selective, and valuation-focused behaviour. Tougher economic backdrops do bring about both risks and opportunities, with the latter usually playing out through the demise of weaker companies and strengthening of quality companies.

Diversification is pleasingly working again and correlations (relationship) between individual stocks is falling at rapid pace presenting great opportunities for active investing yet again.

We remain watchful of evolving data and overreactions by investors, and central banks for that matter. Now is not the time for unnecessary risk taking nor is it the time to stretch for returns. But it is also not the time to check-out of markets.