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Investment Perspective | 28 June

May/June 2022

Global equity markets remained volatile in May after suffering a sell-off in April. Investor sentiment deteriorated with higher inflation and tighter monetary policy moving into focus. The war in Ukraine and widespread lockdowns in China also weighed on sentiment. Central Banks worldwide continued to raise interest rates and signalled they would continue to be aggressive until there were clear signs that inflation was under control. US stocks briefly entered a bear market, defined as a fall of over 20% from the peak. Some weak earnings reports from companies including Walmart, Target, Amazon, Netflix, and Paypal weighed on the market. By the end of May, stocks had staged a partial recovery as sentiment shifted from fears of the Fed overshooting and causing a ‘hard landing’ to hopes that peak inflation is already in. Which would mean the Fed may not hike rates as aggressively as feared.

The US S&P500 index fell 9% over the two months. The index was down nearly 14% in mid-May before staging a recovery over the last two weeks. Thanks to our heavy exposure to commodities, the Australian share market proved more resilient. The market outperformed global peers by falling just 3.5% over the same period.

The US 10-year bond yield jumped from 2.4% at the beginning of April to 2.84% by the end of May, pulling back from the intra-month high of 3.12%. As investors reacted to the RBA's hawkish tilt, the Australian 10-year has also increased from 2.84% to around 3.35%. The market is pricing in further aggressive rate hikes over the coming months. With financial conditions tightening significantly and evidence that the peak of inflation is already in for the US, some commentators believe such aggressive moves will be unnecessary. Though Central Banks said they would do what is necessary to bring inflation back to their target ranges.

Commodity prices cooled over the period. Iron ore finished May at USD$133 (China futures pricing), falling from USD$160 with China lockdowns and slow economic growth negatively impacting demand. Oil and gas rose due to further sanctions imposed by Western countries on Russian exports. Brent crude now sits at roughly USD$120 per barrel. Copper fell to US$4.30 per pound. The Australian Dollar weakened against the US Dollar to 72 cents by the end of May.

Economic overview

The RBA lifted rates in May by 0.25%. Further hikes are expected over the coming months. Australian Q1 GDP beat expectations at 0.8% quarter-on-quarter and 3.3% YoY. Overall, the Australian economy remains resilient. The unemployment rate fell to 3.9% in May, with the participation rate falling slightly. Wages rose less than expected through the March quarter. However, the RBA expects the tight job market to increase wage growth in the coming quarters. Australian manufacturing and services PMIs remain in expansionary territory. National house prices have started to decline with higher rates increasing servicing costs and reducing borrowing capacity.

In the US, the Federal Reserve raised rates by 0.5% at their May meeting as widely anticipated. They signalled 0.5% hikes in both June and July. Economic data has tended to be positive. Retail sales and industrial production were better than expected. Healthy US job growth supports a reasonably favourable outlook for the consumer. The economy added 390,000 jobs in May, exceeding consensus expectations of 322,000. The most significant gains were in the leisure and hospitality sector, which supports the view that consumption is shifting back to the services sector. US Consumer Confidence is holding up better than expected but remains on a downward trajectory.

The war in Ukraine continues with no end in sight. EU leaders agreed to cut 90% of oil imports from Russia by sanctioning Russian crude oil delivered by shipments by the end of the year. Additional sanctions raise the prospects of Russia retaliating by cutting off Europe from critical gas supplies, potentially exacerbating the energy crises. The energy shock and soaring food prices have seen EU inflation reach 8.1% YoY and 9% in the UK. The Bank of England raised interest rates from 0.5% to 1%, and the European Central Bank flagged that they would start lifting rates for the first time in a decade in July. Labour markets continue to tighten, and consumer confidence improved in May.

China's widescale lockdowns continued in key cities, including Shanghai, causing further havoc on supply chains. The impact of lockdowns was clear in China's April data, with industrial production, retail sales, and unemployment worse than consensus estimates. In response to weak sentiment, the People's Bank of China cut the five-year loan prime rate by 15 basis points to 4.45% to support the country's ailing property sector. Additional stimulus came with a $120b line of credit for infrastructure projects. Pleasingly, there were positive signs that lockdowns were easing towards the end of May.

Outlook

Our view to the end of 2022 and early 2023 is for a bearish outlook for equity and growth assets, and selective allocations favoured into fixed income, defensive assets and cash.  This is driven by our view of the slowing economic cycle globally brought about by higher inflation, and accelerated central bank rate rises.  Equity and credit markets are likely to reprice reflecting a negative outlook for company earnings declines brought about by lower top line sales and declining margins from materials and labour price inputs.  Selected alternative asset markets will have opportunities arising from higher volatility in asset markets, and between individual investments, so we expect some styles of long/short and global macro strategies to benefit.  Private markets favoured by wholesale investors and institutions will provide opportunities for those who can tolerate locking up some capital, while still maintaining higher cash weights for further opportunities. 

Our framework for tactical asset allocation is based on fundamental, valuation and technical factors which consider the current economic, company earning and market cycle regimes. Of the fundamental factors, we see evidence for a slowing pace of GDP growth amidst inflation that is still high despite the commencement of central bank cash rate rises.  We believe that persistent inflationary pressures and higher interest rates will negatively impact consumer demand and pressure company sales and margins, leading to earnings downgrades.  Valuations in equity markets have not fully reflected the earnings downgrade cycle to come, pricing in some economic slowing but not the full extent of earnings downgrades.  While there is a risk of recession, this is not fully priced into markets yet despite the large falls in markets following the high US inflation data in mid June, and at a minimum we expect a company earnings recession even if a full economic recession of GDP does not eventuate.  Technical factors include reducing money in circulation (lowering liquidity) as central bank conditions increase policy rates and starting quantitative tightening– that is a reversal of money flow back to the central bank by allowing bonds to mature and not repurchasing them.

In this environment we see bond yields rising to price in central bank cash rate rises, which once fully priced in within the next month or so, are likely to reverse as the gravity of the economic slowdown and potential recession comes into focus in the second half of 2022.  We don’t expect central banks to ease up their rate hikes until either they get past a neutral rate into restrictive conditions, there is evidence that inflation is slowing materially, or an economic recession looks more likely.  This will require economic data to be released to show this, rather than a forecast of a slowing in the economy.  Central banks have a history of over-tightening cash rates to ultimately cause a slow down or recession, and we think the likelihood of a soft landing is low.

A combination of geopolitical and political risks also contribute to technical factors tilting our view towards a slowdown.  The oil, materials, food and fertiliser shortages arising from the Russia-Ukraine war, political miscalculations in the US restricting new domestic oil exploration and pipeline transportation, and a persistent China COVID zero policy don’t show much signs of being resolved in the next few months while the slowdown and recession risk is highest.

Our asset allocation position in this environment is to trim equities and growth assets further, position towards value and away from growth equities styles, and reposition fixed income to take advantage of higher yields and government bond protection in broad market fixed income strategies. We believe a higher cash weighting is prudent to protect portfolios given these uncertainties and higher chance of downside risk in the economy and equity markets.  On the other side of this cycle once the worst of the cycle is priced and green shoots of the economic cycle are more likely than further downside, we will look to deploy back into equities and risk assets.  For clients with an appetite for alternatives, we expect to see better opportunities in property, venture capital, private equity and private debt still to come.  We see evidence of the best returns in these areas when bought cheap after periods of stress such as 2001-2002 and 2009-2010 and the shorter COVID market shock in 2020.

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