The last two months have again been volatile in markets. In February, the war in Ukraine and associated sanctions led to a broad risk-off sentiment. Equity markets have staged a strong recovery over March. Investors are betting that Russia and Ukraine will reach a peace deal, and Central Banks will successfully tame raging inflation. However, there has been a mismatch between how equity and bond markets assess the economic climate.
Bonds have performed poorly in recent weeks, with yields surging across the globe as investors price in central bank tightening to fight generationally high inflation. The yield on the US 10-year bonds has jumped from 1.51% at the beginning of the year to around 2.40%. The Australian 10-year has also increased from 1.67% to around 2.8%. The sell-off in bonds (yield moves inversely to price) accelerated with the surge in commodity prices after the war began. The US yield curve has flattened significantly. Bond investors are concerned that rising interest rates will hurt growth, edging closer to inverting with 2-year yields rising faster than ten years. Analysts closely watch inversion as a predictive signal of a future recession which often follows on average 18 months later.
The US S&P500 index is now less than 4% below the all-time high in early January. The index was down over 12% in early March before staging a remarkable recovery over the last three weeks. The Australian share market has proven to be more resilient in 2022, with the broad ASX200 index essentially flat over the previous three months.
Commodity prices surged after the breakout of the war. While many have pulled back from highs seen earlier in March, they still sit higher than pre-invasion levels. Oil and gas surged due to sanctions imposed by Western countries on Russian exports. Brent crude now sits at roughly USD$105 per barrel, up over 40% from where it started the year. Iron ore is currently approximately USD$150 (China futures pricing) after previously hitting US$160 earlier in March. Copper now sits around US$4.70 per pound.
The Australian Dollar strengthened against the US Dollar to 75 cents by the end of March, supported by surging commodity prices.
Cost of living concerns are starting to bite in Australia. While retail sales had a strong month in February, consumer confidence levels have dropped to the lowest level since the height of the first wave of the pandemic in 2020. Household inflation expectations rose to a decade high of 6.4%, led by a surge in grocery and petrol prices and talk of interest rate hikes. On a positive note, unemployment dropped to a 14-year low of 4% in February and will continue to fall. The labour market is strong with a rising participation rate, hours worked, and an improved underemployment rate. The Federal budget will offer some near-term cost of living relief, and the RBA has stated they are ‘prepared to be patient’ with hiking rates and wait for wage growth to pick up. Further, the Australian economy stands to benefit from the prevailing high commodity prices.
In the US, the Federal Reserve raised rates by 0.25% at their March meeting as widely anticipated. They signalled six more hikes in 2022 and three in 2023, largely in-line with bond market pricing. Chairman Powell admitted the Fed had “widely underestimated” how long inflationary pressures would last. Still, he remains confident the Fed will be able to engineer a ‘soft-landing’. Powell does not see the risks of a recession as ‘particularly elevated’. Economic data has tended to be positive. US employment data is again robust, with the unemployment rate falling from 0.2% to 3.8%.
Europe’s economic recovery slowed after the outbreak of the first war on European soil in 70 years. The war will hit economic growth in the region, with analysts meaningfully lowering 2022 GDP growth forecasts. Europe is particularly reliant on Russian gas and oil. Therefore, they are more exposed to higher energy prices impacting pricing and consumer confidence. The Bank of England is facing further pressure to continue its path to raising interest rates with inflation hitting a fresh multi-decade high of 6.2% on surging energy and food prices, deepening the country’s cost of living problem.
Chinese economic data relating to fixed-asset investment, retail sales, and industrial production surprised the upside. Positively, the Chinese government has signalled a willingness to deploy further support to boost the economy and calm jittery investors in the real estate and technology sector. The country has stuck to its strict COVID containment measures, which has seen millions of residents and businesses impacted by lockdowns and will be a headwind to growth.
Outlook for the remainder of the year
The trajectory of investment markets for the rest of year is influenced by where we have been over the last couple of market cycles, and the changed nature of some longer term mega-trends, in particular deflation to inflation and globalisation to de-globalisation.
Our framework utilises a view of the fundamentals, valuations and technical. The fundamentals driving markets and their shifts are guided by leading indicators of the economic cycle. We view the rate of change as more important than the level of economic data. Therefore, we follow the acceleration or deceleration of economic growth, inflation, and government policy settings. Many leading investors use this framework to shape their long term portfolios by adapting their portfolio mix to changing economic regimes.
2022 was always going to be a year vulnerable to shocks given the reversal of stimulus to more restrictive settings by central banks and government budget spending. Markets are more vulnerable to these settings at turning points and will price in ebbs and flows of trajectories of the economy in the market sentiment priced into investment assets. Valuations are important at turning points and extremes, which are guided by technical indicators that include market breadth, rotations in sector leadership, fund flows, and investor sentiment.
We expect the short term rally in equity markets and risk assets to continue for a while but run into overwhelming headwinds of higher inflation and contractionary policy within a quarter or two. This is because central banks will keep on their cash rate tightening path while inflation remains high. There needs to be another quarter or two of GDP growth and inflation data for the central banks to adjust policy and slow the pace of cash hikes if we see growth falter quicker.
We have also seen that unforeseen shocks such as the war between Russia and Ukraine can prompt a further adjustment to market expectations. Curiously markets are now following a positive narrative that the war effects will be resolved with a peace deal soon, inflation will be manageable, businesses and households can absorb higher interest rates, and equities are a hedge for inflation. This has reversed some of the January narrative when the markets adjusted to price a rapid pivot in Federal Reserve positioning to multiple cash rate hikes hiking into the year end.
We believe that some of the higher inflationary impulse will become more permanent, and adjustments to investment expectations will coincide with a slowing economy that becomes much more prevalent by year end. A hint of this is in more cautious company earnings guidance. The highest growth and inflation impact is mostly a US and European phenomena, while Australia is likely to be shielded from the worst growth impacts due to our commodity exports and positive net export contribution to GDP. A remarkably robust Australian labour market with the equal lowest unemployment rate in 45 years may be challenged by an expected influx of imported migrant labour throughout this year.
While we do believe that some degree of inflation hedging should be undertaken, there should be some selectivity in the assets chosen as there is a lot of money chasing real assets such as property, agricultural land and commodities. We expect some further volatility this year in investment markets, and the combination of slowing growth and inflation peaking later to be headwinds. That said, further events such as the paths to resolution or stalemate in the Russia-Ukraine conflict also impact oil and gas prices, key exports of fertilisers important for food, and metals important for industrial development of the new energy economy.
In conclusion, we expect opportunities on both the positive and negative side this year. Given the range of outcomes possible, we will take a risk management approach first for client portfolios and look for return enhancement opportunities when we see cheaper valuations combined with catalysts for recovery.
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This month’s perspective highlights that market sentiment on all asset classes is constantly changing. It is important for us to quickly recognise any threats, to preserve your investment capital or to identify early investment opportunities to maximise any return advantages. At Partners Wealth Group we don’t get complacent with the current state of play and constantly monitor investments and your portfolios.
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This article contains information that is general in nature. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider you financial situation and needs before making any decisions based on this information.