July Market Update
The financial markets had the unusual situation during the past year where equities and interest rates have experienced significant price reversals at the same time, and for similar reasons. During this period the S&P 500 was down -12%, the Nasdaq -24% and the Australian S&P/ASX 200 -9%, while the traditional ‘defensive’ assets such as the AusBond Composite Index provided a -10% return and the Global Aggregate bond index provided a -15% return, as 10-year bond rates increased circa 1.5% and 2% in the US and Australia. The unusual positive correlation between bonds and equities has been directly caused by the overly accommodative monetary policy provided by central banks. Now we enter the unwind phase of hiking interest rates and quantitative tightening, clearly articulated by the Federal Reserve, the macro environment has become more challenging and will be very difficult to predict.
Global markets are now encountering a period of consternation, not appropriately understanding asset valuations which broadly became very expensive as a result of the extended period of fiscal and monetary support, following the GFC and COVID crises. Central banks excessively stimulated, provided poor guidance to markets, and seemed to be asleep at the wheel having developed the view that inflation was transitory, while green inflation from climate change policy was fully ignited under the surface, as a result of underinvestment in old and new forms of energy. Fed Chair Powell recently said, “The bigger mistake – lets put it that way – would be to fail to restore price stability”. Inflation control is now seen as more important than economic stability.
Along with inflation, the abnormal levels of liquidity have created abnormal asset prices. Low interest rates and high levels of liquidity from fiscal and monetary support, along with grossly bloated central bank balance sheets and global government debt started to become an issue for markets during 2021. This set of factors aligned to set the stage for a perfect storm, which was further accentuated by the development of the Ukraine War in February 2022. Since then, many facets of investment markets have been like the deer in the headlights, with a wide range of views on potential impact and outlook.
Central banks have suddenly pivoted from providing ‘whatever it takes support’ to ‘whatever it takes to fight inflation’. Of note, central banks generally have three fundamental tools available to achieve policy – interest rates, money supply and jawboning. In our opinion, the latter having seriously misled financial markets, individuals and corporates during a fragile period in the cycle to the extent that may cause widespread damage. To dwell on the point, we consider the most critical issue currently facing global markets is the tipping point between reducing inflation to the stated target of 2% (in the US) and the degree of acceptable backwardation of economic growth, because reversing the support policy of the last 10 years will take away the tailwind that has driven equity and interest rates to abnormally high levels and the adjustment may have a serious impact on financial stability. Media commentary has been narrow and uninteresting over the last couple years as it has shifted from COVID to recovery, then inflation and now starting the shift to recession. All these aspects have different impacts on the wide matrix of equity and interest rate valuations.
Of further concern and a direct result of the cheap and easy money policy is the rate at which non-bank financial assets have grown when compared to bank financial assets, since the GFC, while the credit quality has also deteriorated. As with the GFC and in other periods of market meltdown it only takes one or two collapses to bring the house down. Bear Stearns was the Jenga block of the GFC when they collapsed on 31 March 2008.
Financial market risks remain elevated and broad views on the outlook are confused, and therefore our view is to remain exposed to central lower risk themes with the objective to avoid the risk of being on the wrong side of possible binary outcomes and aim for reduced volatility. While the economic and market recovered at record speed following the COVID crisis, we are not so sure this will be the case during the next phase. While the medium-term market outlook is rather opaque, adversity does create opportunity.
Unfortunately, the use of jawboning by central banks has misled all and sundry to a very uncomfortable position. The RBA has finally admitted ‘the market was correct, and they were wrong’ (about holding rates low until 2024). The central bank has lost a lot of credibility and corporates and individuals are now facing potential hardship.
Inflation projections have increased significantly between December 2021 and June 2022. ECB President Lagarde was quoted “I don’t think we are going back to that environment of low inflation” at a recent ECB forum. The consensus view is evenly balanced between inflation being lower than present a year out, and the other camp of the view that it will be difficult to tame in the near term. This issue will drive policy rates, bond rates and economic conditions, and therefore we expect a period of elevated uncertainty in financial markets when looking forward over the next year.
With risk of a shift to a regime of higher inflation now increasing, the central bank playbook of the last 20 years may need to be re-considered. Energy, which flows through into almost every pricing factor, was a key component of higher inflation during the 1970 and 1980’s. More recently, the climate change and policy conversation which pre-dated available alternative solutions resulting in under-investment in traditional energy resource development, coupled with the Ukraine War, has resulted in significantly higher energy prices. Energy and supply constraints have been the main influences on the recent and sudden spike in inflation.
Development of civilisation
As a side thought about inflation. Take a moment to think about the major developments that have extended life and comfort. Think medicine and energy; and consider how most of the global population are affected. The availability of medicine continues to improve for the poor, with the help from developed nations. How would the majority be affected without the energy sources that have developed over the years? We accept available energy sources are changing and need to change, but the gap between traditional and renewable will remain for some time. The early triggers of inflation, termed green inflation, came from climate policy and will affect the broader global population in emerging countries significantly more than the developed countries.
We noted in our March Economic Update that we considered inflation (and management of) would be single most important factor during 2022, which has been correct, however, the discussion is now shifting to an impending global recession. Global GDP growth is now projected to slow to 3% in 2022 and 2.8% in 2023; US growth projections are reduced to 2.5% for 2022 and 1.2% in 2023; UK 3.6% in 2022 and 0.0% in 2023; Eurozone 2.6% in 2022 and 1.6% in 2023; and Australia 4.2% in 2022 and 2.5% in 2023. The view remains pessimistic with some economists noting that global GDP growth for 2023 at 2.8% which is borderline recessionary. The OECD graph below shows the recent revision to GDP growth forecasts in 2022.
Even the chart below from the RBA indicates the possibility of recession in Australia, albeit a low probability.
Confidence – consumer and corporate
The two charts below, showing consumer and corporate CEO confidence, are a strong indication of the expectation of difficult times ahead. Future confidence data can often be self-fulfilling however these are key leading indicators. Of interest, one of the roles of a corporate CEO’s is to be upbeat so that indicator should be read as caution ahead.
Source: ASR Ltd
The Ukraine War has accentuated the upward movement on commodity prices as can be seen from the chart below.
Source: IMF, Ausbil
Commodity and related equity prices are often volatile, reflecting the balance of supply and demand in narrow markets. Again, the inflation trend was impacting several commodity groups when the Ukraine War caused pricing and supply constraints to shift to a higher level. In addition to the upward trend for many commodities, the broad renewable energy requirement has increased demand on several metal groups used in wind, solar and battery products, while the stockpile of several of these key components are at cycle lows (see chart below). As a passing observation, in an obscene way the increased prices for oil, gas and grains are providing a financial benefit to Russia.
Source: Ausbil, Bloomberg
Policy interest rates
As inflation emerged, and appeared to surprise central banks, the focus has rapidly shifted to price stability and aiming to reduce inflation back to the policy levels of 2-3%. Central banks will materially increase interest rates, to pull demand down, and in turn the expectation that inflation will fall. As noted earlier by the ECB (an opinion also held by others) the risk is elevated that higher levels of inflation become embedded in the system. But will the rise in the oil price reduce purchasing power sufficiently and reduce the need for Central Banks to lift interest rates? The answer is an unknown but something to consider.
Source: Munro Partners, Bloomberg
The US Federal reserve has indicated that want to see inflation rates back at 2%, sooner than later. The chart above shows the shift in FOMC views on future rate policy of the Federal Reserve. Interest rates are a blunt instrument and historically a recession has followed significant rate hikes.
The chart below shows the movement in the 10-year US Treasury yield over the last 5 years. The rise in rates explains the negative returns in bond funds, which have been the traditional defensive asset. The price sensitivity for upward and downward movements of rates is much greater when the yields are low, which helps explain the higher negative returns experienced by bond funds, without considering factors such as credit margin expansion.
The yield curve chart below shows the upward adjustment of policy and longer-term bond rates over the last 6 months. It is interesting to consider the yield movements on the chart above with the yield curve movements on the chart below. The blue line on the chart below and the falling 10-year rate on the chart below has adjusted lower as recession fears have surfaced in the media.
The chart below shows the 10-year US Treasury Bond from 1970, with rates and inflation peaking in the early 1980’s. There were quite different circumstances behind interest rates and inflation in the 1970’s and we are unlikely to head back to the rates experienced during the 70’s and 80’s, however, we do consider over the medium term long term rates are likely to normalise at higher than current levels as demand for capital becomes more concentrated and question if the quantitative easing experiment is used to the same extent as it has been over the last decade. 40 years of falling interest rates has been a significant tailwind for equity market pricing and credit expansion, and we now question whether this period of financialization will be repeated.
The quantitative easing support provided by The Federal Reserve following the GFC was considered to be a temporary measure, however, was kicked down the road and it was never unwound. When the COVID crisis unfolded the QE program of printing money was turbo charged.
The textbooks had us believe that money supply expansion (QE) creates inflation. Inflation didn’t appear pre or post the GFC, or even post COVID. It wasn’t until higher energy prices filtered into the system along with supply constraints brought on by COVID that inflation emerged, and then accentuated by the Ukraine War. Now we have an inflation problem, a money supply problem and an abnormally low interest rate problem. We assume quantitative tightening is most likely achieved by the Federal Reserve allowing bonds purchased to mature and not re-invest. Alternatively, they could speed up the process by selling bonds. The net effect is that the financial market system liquidity will reduce and that is likely to have the effect of dampening asset prices with the worst quality being affected the most.
Mortgage rates and house prices
Immediately following the COVID crisis the concern was that house prices would collapse as the epidemic created mass unemployment (amongst other reasons). However, the opposite transpired as government support and emergency interest rates were provided en masse across the community. Recent data provided by CoreLogic (see below) shows house prices are reversing as interest rates head higher.
Banks are lifting fixed and variable mortgage rates and more so for fixed rates. This is likely to continue as the RBA adjusts policy rates to higher levels. The terminal policy rates are forecast to be circa 3% over the next year, and at that level mortgage rates could reach 5%. This is a long way from circa 2% mortgage rates during 2H 2021 when the RBA stated vehemently policy rates would remain at 0.10% until 1H 2024. Not a good outcome for people who have recently taken out variable rate mortgages. This will put a lot of pressure on the consumer disposable income and demand.
When we note the chart above showing the US 30-year mortgage rate, the borrowers now face a similar problem in the US with their mortgage rates close to 6%.
Interest rates – summary
There is no doubt the outlook for assets, interest rates and financial markets remains unclear. However, when we try to bring components discussed above together, the ‘on-balance’ likely outcome does start to become clearer. Many would suggest the central banks over-stimulated, which is easy to say with the benefit of hindsight. If that is the case, then unwinding support and low interest rates (normalising) becomes important so that the central banks are in a better position in the future if the need develops.
When we think about what might be normal in this highly indebted society, it is difficult to envisage that rates can go back to the average of the last 40 years. However, to contemplate a scenario of how this may play out, the normal policy rate could be 3% to 5%, which puts 10-year bonds at 3.5% to 6% respectively in a positive growth environment, and 2.5% to 4% (using the base policy rate assumptions) if the economies fall into a negative growth environment. Variable mortgages are generally 2% above policy rates, therefore the range could be as wide as 5% to 7%. We note the regulators are likely to push policy rates to at least 3% and if a recession is perceived to develop then bond rates are likely to fall, however, over time we expect the regulator would prefer to see the complete yield curve normalise, which is probably higher than current levels. So, without taking this scenario any further, this puts a lot of pressure on the consumer, corporates and government debt programs, which suggest future growth and company earnings are likely to somewhat constrained in the future.
Also, note the chart below showing the growth of non-bank financial assets. We consider credit and paper issued by this sector to be extreme risk. In some regards this reflects the excesses that evolved prior to the GFC. Sub-investment grade, high yield and low quality credit may face significant margin expansion as central banks soak up the liquidity released post GFC and COVID.
Source: ASR Ltd / Datastream
In our view, financial markets including equities, both public and private, to be driven by interest rates. No one can say for certain how this will all unfold, and history tells us negative periods are followed by positive periods. We have made observations and put forward a range of possible outcomes.
The equity market (S&P 500) has steadily slipped back into lower valuation levels; however, it remains 47% above the long-term average, with future with earnings under pressure. The higher PE sectors such as the Nasdaq are likely to remain under pressure from PE compression.
The chart below compares the S&P 500, Nasdaq and Australia for the calendar year.
There is no doubt that equities are now more compelling compared to valuations from the start of the year, but interest rates are likely to provide a significant influence on earnings and pricing. We suspect that we are entering a period of corporate earnings cuts as we move into a recessionary phase.
As interest rate yields rise relative to dividend yield, the bond market becomes more attractive as can be inferred in the chart below. In short, interest rates look more attractive than equities when comparing rates and dividends. This does reduce the attractiveness of equities until sentiment improves and investors consider the upside of equities outweighs the benefit of the yield gap. Complexity develops when we try to decipher and unpack the central bank’s desire to tackle inflation and normalise interest rates and balance sheets.
Source: Jamieson Coote Bonds
On balance, while equity pricing is more attractive than the start of the year, we are concerned how equity earnings and market pricing will react to a continued upward adjustment of policy rates, the commencement of quantitative tightening, and a potential recession further dampening company earnings. There will always be companies benefiting during negative growth periods and therefore active management is the preferred approach during these periods.
Currency is generally a USD story and influenced by the outlook for relative interest rates and commodity prices.
The regime controlling financial markets has shifted from falling interest rates, dormant inflation, monetary and fiscal support being strong tailwinds for equities and other growth assets. We are now faced with an inflation spike, interest rates increasing back to normal levels, and monetary and fiscal support being withdrawn. Under this circumstance the macro environment has become significantly more challenging and will be very difficult to predict.
Under these circumstances and the well documented geo-political issues, we feel it prudent to be cautious on equities and more centrally focussed style, over-weight property, infrastructure and alternatives. We have been under-weight long duration fixed interest versus the benchmark. As talk of a recession has become more prominent, long duration interest rates have rallied from highs and our short-term view has shifted to a more neutral duration exposure. However, there is the potential for another leg up for long dated interest rates as policy rates push higher, supply increases as a result of quantitative tightening. The lack of clarity surrounding the macro has led to a more neutral view to longer duration. We are also concerned with lower quality credit and consider high yield and low-quality credit to be at high risk of margin expansion and to be avoided. Higher levels of cash would be prudent in such a market environment.
Index Returns – 30 June 2022
|Sector Returns (%)||FYTD||1-month||3-month||6-month||1 year||3 years||5 years|
|International Shares (unhedged)||-6.52||-4.64||-8.42||-16.13||-6.52||7.83||10.12|
|International Shares (hedged)||-12.51||-8.10||-15.10||-19.37||-12.51||6.36||7.33|
|Australian Listed Property||-12.26||-10.33||-17.68||-23.53||-12.26||-2.75||4.41|
|Global Listed Property (hedged)||-10.49||-7.82||-15.62||-18.59||-10.49||-1.36||1.93|
|Global Listed infrastructure (hedged)||5.36||-5.05||-5.49||-2.55||5.36||3.70||5.91|
|Australian Bank Bills||0.10||0.05||0.07||0.08||0.10||0.33||0.95|
|International Bonds (hedged)||-9.33||-1.64||-4.66||-9.41||-9.33||-1.63||0.78|
|CRB Commodity Index USD||36.44||-8.02||-1.37||25.29||36.44||17.16||10.75|
|Aust CPI (at previous quarter)||5.16||0.41||2.40||3.45||5.43||2.93||2.46|
Source: Lonsec, Bloomberg
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