August Market Review
Since the end of June, equity markets have staged an impressive rally, with the S&P/ASX 200 accumulation index rallying over 6.5% off its lows heading into the end of August and MSCI World ex Australia over 8%.
Interestingly this rally flies in the face of rapidly deteriorating macro data, especially on an international basis, as key indicators such as global PMI’s continue to roll over, indicating a likely recessionary environment. Electricity prices also continue to climb to stratospheric levels, especially in Europe.
One redeeming feature has been employment data (particularly out of the US) which continues to outperform expectations.
The ultimate reason for the recent market rally is not fundamentals, but rather sentiment. This has been the most telegraphed slowdown in economic metrics in recent memory, and the majority of investors, particularly “hot” or shorter-term investors such as hedge funds, have been positioned accordingly. This matters, because it means an outsized positive reaction eventuates to even the mildest piece of good news. In this case, a very slight moderation in the market’s expectation of Fed rate rises has catapulted equities higher, particularly in tech and other long duration assets such as government bonds.
Where to from here? There are two key parameters we are watching closely.
Firstly, Powell’s statement at Jackson Hole on Friday stayed true to the course taken over the last year, with a focus on the data, and little to suggest any adjustments to counter potential structural inflationary trends. Had a focus on structural inflation factors been evident in the speech, then we would likely have changed our positive leaning view on bonds. We’ll continue to keep a close eye on inflationary pressures.
Secondly, corporate earnings, which have been strong enough to support this rally, but remain vulnerable into year-end as individual company earnings start to mirror the macro data (such as PMI).
The recent counter trend rally has taken many by surprise, with deteriorating macro data, valuations, and earnings all appearing as headwinds for further price gains.
Let’s look at these individually and take stock of where we are at as head towards the second half of 2022.
Valuations remain reasonable in all markets except the US.
Our modelling calculates a medium term expected return based on valuations, profitability, growth outlook and forward cash rates. On this basis the US sits around 3% above cash, which is historically associated with poorer equity market outcomes.
Australian equities on the other hand, look relatively healthy with a 5% return premium over cash on the same basis. This becomes even more the case when you consider franking benefits to domestic investors.
Much of this outlook however depends on earnings.
Globally we are seeing a slowdown in the data as consumers crowd out spending faced with rising cost of living pressures. We are yet to see too much of this phenomenon feed through to company earnings just yet which continue to grow here and overseas:
Whether or not cost of living pressures bite into consumption will be key.
The outlook for inflation is mixed, on the one hand, we have a slowdown in many macro indicators, which typically portends a slowdown in inflation. On the other hand, we have increasing price pressures from key inputs such as oil.
Overall, we think there are risks to earnings over the next twelve months, but more so globally than locally, where the data has been stronger and inflation pressures more moderate. Local employment data has also been strong, and unlike the US, has been driven by full time employment.
Despite deteriorating macro data, Australian companies generally reported very upbeat earnings relative to expectations, with companies outperforming analyst earnings forecasts by a ratio of 3:2. This is an impressive showing given the headwinds faced by companies over the last six months.
Investor positioning running into reporting season had been far too bearish, with investors hiding in defensives such as consumer staples. Over the last few weeks, investors have been forced to rebuild their positions in domestic cyclicals, a sector they had aggressively sold in the second half of June as global recessionary fears grew.
Rising costs, be it energy input or labour were a recurring theme. Labour is not just a wages issue, but a lack of supply issue, with many businesses suggesting that there are simply no suitable candidates for positions at any price. That said profit margin resilience has been impressive across much of the index, with businesses largely able to pass costs to consumers. Energy input costs have been especially acute amongst building materials companies, which are also dealing with a softening residential property market.
Trading statements for the first few weeks has shown consumers are still spending, suggesting no demand destruction visible at this stage, though we do expect higher interest rates to start to bite in FY23.
Fixed Income Markets
Fixed income duration exposure (“duration” representing bond sensitivity to interest rates) serves a dual role in portfolios. Firstly, as a source of return when the bond markets overly aggressively factor in rate rises. Secondly, in a recession, as one of the few financial assets that typically generate a positive return.
For these two specific reasons, we believe in running higher than usual duration in portfolios as we head into the next twelve months.
The rates implied by Australian fixed income investors suggest a terminal interest rate of around 4%, and no recession. This means that should a global recession eventuate, which unfortunately is a possibility over the next twelve months, Australian bonds are now offering some downside protection. Something which they largely lacked prior to the recent bond sell-off, when interest rate expectations were much lower.
Contrast the chart above for Australia with the chart below, which shows the situation in the US. As you can see, the US is already factoring in a significant slowdown from 2023. This implies that US bonds are offering far less downside protection in the event of a global recession than domestic bonds.
The supply side shortages in key commodities such as oil, gas, and coal in particular, have been well documented.
Looking ahead it is the demand side that will determine the price of key commodities. Typically, a global PMI of 45 suggests a significant softening of the global economy, inconsistent with ~$90 oil.
The reason for the recent rally in oil has been some optimism around a China re-opening. We have seen attempts from authorities to stimulate the economy by encouraging real estate investment, at direct odds with the focus only 12 months ago.
Our sense is that in the short term, we could see appreciation in key commodities as the Xi looks to shore up his economic credentials pending his re-election in November. Beyond that we are more pessimistic. We have not seen any significant consumer response to stimulus in China yet, the re-opening trade has been muted, even as the focus on COVID Zero has waned somewhat.
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