June saw extreme market volatility across most asset classes, and interest rate increases in multiple jurisdictions including Australia, Switzerland, the UK, and the US. New Zealand printed a negative GDP number for the March quarter, with its interest rates having so far been raised to just 2.0 per cent.
Given the extent of the volatility, we are dispensing with our normal end of quarter summary and instead we will be discussing the extent of this volatility, why it has occurred and what it means for portfolio construction.
Whilst the Reserve Bank of Australia (RBA) increased the official cash rate in June by 50 basis points or 0.50 per cent to 0.85 per cent, the big move was by the US Federal Reserve (the Fed) which raised the Fed Funds rate by 0.75 per cent to a range of 1.5 to 1.75 per cent. The Fed is determined to lower inflation, whatever it takes. The risk of this strategy is that as they raise rates above neutral, it also raises the risk of recession.
Bond markets have experienced their largest sell off since records began and we discuss this in further detail below, as both cash rates and policy are starting to normalise.
Inflation is the top concern in the minds of investors however there is now a focus on the consequences of inflation or, to put it another way, if inflation is not brought under control, then the risks of a recession rise. Central bank messaging is clear that they will raise interest rates as much as necessary to bring inflation under control.
Macquarie Bank is expecting the US to enter a recession in the second quarter of 2023, lasting 2 or 3 quarters, but the jury is still out amongst many other forecasters including Capital Economics. Macquarie feels the data is moving in the direction of a recession and the Fed will not stop hiking until a recession occurs in the US.
This year’s sell off was reasonably orderly until June, when a higher than expected US inflation number caused both inflation and interest rate expectations to ratchet up further, causing a downgrade in global GDP forecasts and the sell-off in risk-based assets to accelerate.
While inflation is showing no notable signs of abating, global GDP estimates are being revised down, with the IMF downgrading global GDP growth in late April from 4.4 per cent to 3.6 per cent in 2022 and again in 2023. In our opinion these estimates look too optimistic.
Whilst some commentators are forecasting cash rates in Australia to rise above 4 per cent and cause a new financial crisis, it’s important to step back and look at everything in perspective.
The shift globally amongst central banks to lift interest rates has seen the bears fall out of the top of cupboards.
The speed or degree of an increase in the short term has little bearing on where rates will end up. Yes, many economies seem to be running hot and central banks are working hard to dampen demand but supply, which is tight, looks like becoming more accommodative and this can rebalance without the need to increase rates to the excessive levels being projected.
Last month New Zealand GDP contracted for the March quarter by 0.2 per cent, the RBNZ having commenced tightening 9 months ago and interest rates now at 2% there. The New Zealand economy has already fallen over (this is not directly comparable to Australia but is significant).
Inflation is naturally a concern. According to Capital Economics in London, “Energy and food prices have directly caused 4.1 percentage points of the 7.9% rise in consumer prices in the major advanced economies over the past year. We expect oil, gas and agricultural commodity prices to start falling later this year, so inflation should drop back sharply”.
As many investors focus on the negatives, remember both consumers and corporates appear in markedly better health than in the last cycle in 2008.
In Australia, corporate balance sheets are in good health, the employment market is strong and even if it weakens, we doubt you will see soaring unemployment. What we produce and export is in strong demand, therefore whilst the US has a 80 – 90% probability of a mild recession, there is a strong probability Australia will escape a recession yet again.
During the quarter we reduced A–REITs to underweight along with Domestic Australian Equities to Neutral.
With A–REITs there is an inflation hedge however, with bond yields increasing this puts downward pressure on REIT valuations and therefore the listed value of the underlying securities.
Our concern over Australian equities has been the lag in the effect of interest rate increases and the index composition.
Approximately 20 per cent of the domestic Australian index is financials. The focus on increasing interest rates has been on households and the increasing interest rate payments on mortgages. We feel the outperformance gap between Australia and other developed markets as per the table below must close, so whilst we see Australia outperforming in the medium term, we do predict short term under performance from the domestic Australian market.
It is important to remember that markets will always react in advance of economies. What we have witnessed since the start of this year is markets falling in anticipation of economies slowing and the increased possibility of an economic recession.
The equity market falls to date have priced in an 80 to 90% probability of a moderate recession in the US so, if this were to eventuate, then based on history, we would expect the majority of market falls to have already occurred. There is the possibility that economies experience a greater than moderate recession, in which case equity markets will fall further.
Our Tactical Asset Allocation (TAA) changes are based on probabilities and have helped cushion portfolios during 2022. Furthermore, what we have historically observed during recessionary periods is that a focus on asset selection via managers that hold investments in quality businesses, with strong balance sheets, is that these types of businesses gain market share and come out of the downturn in a better position than they went in, thus creating greater long-term value for shareholders.
The performance of equity managers during 2022 has predominately been driven by their sector exposures, as per the table below. We will not chase short term sector performance and will continue to support equity allocations to quality businesses with through the cycle balance sheets.
Source: Koyfin / Hamilton Wealth Partners
Bond markets have experienced their worst year since records began, the main Australian Composite Bond Index down more than 15% from peak to trough. The extent of the moves in the Australian market is shown in the charts below. As inflation expectations have risen, and central bank messaging has further raised interest rate expectations, bond markets have sold off accordingly.
Capital Economics points out that 10-year bond yields normally peak at around the same level as official cash rates peak, and within a few months of the final rate hike. The market is currently pricing in a cash rate of close to 4% in Australia by the end of this year and 3.75% in the US. 10-year bond yields in both countries have briefly traded at these levels but have started to fall as we approach month end. As interest rate increases begin to slow GDP growth, the big question is how soon inflation expectations begin to fall and at what level inflation starts to settle again. If it is somewhere around these levels, then arguably bonds are starting to look like reasonable value. If inflation falls more slowly and/or looks like settling at higher than current bond levels, then the bond market will have further to sell off yet.
Capital Economics thinks that the yields of 10-year developed market (DM) government bonds will peak earlier and, in some cases, at higher levels than they previously forecast. That reflects a view that tightening cycles in many DMs will be more front-loaded and aggressive than we previously thought. They expect the US 10-year bond to reach 4% by year end before falling in 2023.
We are watching the bond market closely and preparing to add duration to our portfolios at the appropriate time. This will be through Government bonds rather than corporate bonds. Whilst corporate credit spreads have widened as interest rates have risen, we have not seen corporate defaults yet and, as the economy slows, this is a risk that means caution is still warranted in the corporate bond market, particularly outside of the major bank issuers.
Australian Government Bond Yields – Year to date
We have entered the mature stage of the economic cycle. Central bank tightening of interest rates will have negative implications if they go too far, as New Zealand has shown, with a cash rate of just 2% being sufficient to cause a March quarter GDP contraction -0.2 per cent already.
The past few months have demonstrated that policy tightening is painful for most asset classes but there will continue to be areas of relative resilience, including parts of the stock market where valuations are comparatively low and that are therefore less sensitive to rising interest rates, such as financials.
Quality will bounce back and bounce back well, whilst companies without earnings may not even survive.
Investors need to be patient, with strong asset allocation disciplines to protect their portfolios, remembering that whilst markets hate uncertainty, they always look ahead.
How far interest rates will rise and how our economy and corporate earnings respond is what we need to look for and monitor. We are of the view it may not be as bad as the pessimists are making out.