Monthly Investment Update — April 2022
This month’s newsletter looks at some of the key issues facing markets and recent asset class performance.
The main points are as follows:
The past month has seen equity markets find some support after several months of weakness.
We now know that the US Central Bank is serious about fighting inflation using higher interest rates.
Where do we go from here? Deep bear markets coincide with recessions. We are not there yet but the warning lights are flashing.
Companies are today operating in a different environment which Wall Street seems to be brushing aside.
The next few months will reveal the impact of higher interest rates and quality of company earnings.
We remain patient as we are not yet convinced the future looks like the past.
The last few months have proven to be increasingly challenging for investors. Initially worried about persistently high levels of inflation, coupled with concerns about how Central Banks will respond, and then the complexity around the Russia/Ukraine conflict.
Going into March the US S&P500 Index had posted 4 negative months out of the last 6. By mid-March it was down another -4.59%. Like many times before, the market can however have a mind of its own, shake off bad news, and climb the wall of worry. The US S&P500 Index rallied over the last 13 trading sessions to close the month out with a +3.71% gain.
We today know that the US Central Bank (the US Fed) is serious about addressing inflation. We also know their primary tool to slow inflation is raising interest rates. US Fed Chair Jerome Powel on 21Mar22 said, “the Inflation outlook has deteriorated significantly”. He also flexed his inflation fighting muscles by adding “the Fed is prepared to raise rates by half percentage point if warranted”. The tone has clearly changed, and in a meaningful way.
Strangely the market welcomed this news, perhaps because higher interest rates were expected, and the announcement was well overdue. These comments now provide a clearer path for investors. Whilst the interest rate path may be clearer, the economic outlook remains uncertain.
The market may be enjoying the rally but many are asking the question, where to from here? Is the bull market correction over and are markets about to post new highs? Or are markets just experiencing a short-term bear market rally, soon to move lower again? Possibly too early to know.
Past experiences tell us bear markets are a result of negative profit growth. We are not there yet. One recession warning light has however started flashing red (bond market yield curve inversion). The recession clock has started ticking and paying close attention to what businesses are saying is most important.
Companies and management teams are now dealing with the realities of higher operating costs. Yes, some are able to raise prices to protect profits, but not all. Companies will soon also be dealing with much higher interest rates. Once again, some will manage to navigate this and limit the damage to profits, but not all.
Markets tend to presume future profit expectations will look like past profit realities. We know past realities were supported by low-interest rates and massive stimulus programs which have now ended. Inflation may also be masking the quality of earnings currently being generated. We are not yet convinced the future looks like the past.
Inflation risks have accelerated
We have repeatedly written about the risk inflation poses to the economy. These risks were well noted by Central Bankers around the world.
Groupthink amongst global Central Bankers has however seen interest rates remain at emergency low levels well beyond their expiry date.
Low interest rates are intended to support a weakening economy. We have however experienced a global economic boom. Tight labour markets, robust wage growth, strong demand, booming asset prices, etc.
But Central Bankers erroneously believed this would be transitory, then hoped for things to settle in 2022. Now they are being dealt some additional bad luck from Russia.
Supply constraints due to the Russia/Ukraine conflict has seen commodity prices appreciate materially. The Commodity index is up +9.63% over the last month and +64.55% over the last 12-months.
These higher commodity costs are currently being absorbed by businesses and will soon be passed on to consumers. Unfortunately, these consumers are already facing elevated rates of inflation.
The bond market is not convinced
Central Banks have played with the inflation tiger’s tail. They unfortunately now find themselves staring at the white of the tigers’ eyes. US Fed Chairman Jerome Powell however remains well composed.
“We will use our policy tools as appropriate to prevent higher inflation from becoming entrenched while promoting a sustainable expansion and a strong labour market”.
What he means in Fed speak is; We agree with what bond markets have been saying for some time. We are well behind where we should be with interest rates and will therefore raise interest rates.
The US Fed ended their two-day FOMC meeting on 16 March, announcing their first interest rate hike since 2018 (0.25%) and laid out a more aggressive interest rate hiking path.
Most policy makers now see the US Fed raising interest rates at each of the 6 remaining meetings in 2022 taking them to 1.75-2.00% by year end. Interest rates are expected to reach 2.80% by year end 2023.
So, what does the bond market think? The above projections set by policy makers are conservative. Neither is the bond market fully convinced that the US Fed succeeds in engineering a soft economic landing.
The narrowing gap between 10-year and 2-year US bonds (shown below) is common leading into recessions (grey shaded area).
The bond market has waning confidence in the ability of companies to service their debts (the widening gap between corporate and government bond yields).
The bond market could however be wrong. The counter argument is that the bond market has run ahead of itself. Elevated inflation will slow the economy reducing the need for aggressive interest rate hikes.
Whilst we acknowledge this argument, we retain our view that the economic outlook remains challenging.
Even higher inflation on the horizon?
The outbreak of war between Russia and Ukraine has thrust the global inflation problem to a new level.
Russia is a commodities superpower and globally significant exporter of energy (oil, gas, thermal coal), agricultural products (wheat, fertiliser), industrial metals (nickel, aluminium, copper, cobalt, steel) and precious metals (palladium, gold, platinum).
The economic sanctions imposed on Russia and Russia’s retaliatory export restrictions represent a significant global supply shock.
Energy and food prices have particularly surged since Russia’s invasion of Ukraine on 24th Feb. They are now well off their highs but still materially higher than prior levels.
Crude Oil +8%
European Gas +26%
Thermal Coal +20%
Wheat +26%
The US consumer price index (CPI) hit a 40 year high in February of +7.9%. With pending increases in producer prices (chart below) yet to flow onto consumer good prices this looks set to rise further in the coming months.
There are renewed calls for US President Biden to shift policy to encourage an expansion of domestic fossil fuel production to allow the US to reclaim its energy independence. After all, the US has vast untapped oil and gas resources.
Europe is more vulnerable. Geographically situated at the epicentre of current events, has fewer quick fixes available and is therefore likely to bear the brunt of soaring energy prices.
Higher for longer commodities prices increases the risk of stagflation. The combination of high inflation and slow growth which is negative for share markets.
Australian Equities
The S&P/ASX200 Index posted a +6.89% gain for the month of March and up a respectable +14.97% over the last 12-months.
The best performing sector for the month was the Technology sector gaining +13.15%. Arguably rallying from oversold levels rather than any positive catalyst. Energy once again posted a strong performance gaining +9.59% over the month.
Stocks delivering strong gains in the Technology sector included Wisetech Global Ltd +17.21%, Xero Ltd +9.67%, and Computershare Ltd +14.01%. In the Energy sector Woodside gained +12.52% followed by Santos +6.61%.
Defensive sectors underperformed over month but still posted positive returns. The Healthcare sector gained +1.89%, Consumer staples gained +3.28% and the Communications sector gained +3.47%.
International equities
The MSCI All World Index gained +2.74% over the month. Currency hedged international equities remain a strong performing asset class over a 12-month period (+10.12%) despite underperforming the Australian market.
Regional relative strength over the month favoured the US S&P500 Index which gained +3.71%. Out of favour were economically sensitive sectors such as the S&P Europe350 Index declining -0.17% and the S&P Japan500 Index declining -1.17%.
The S&P Dow Jones Emerging Market Index gave back -2.70% over the month. The Russian market is once again open (limited trading) with the S&P Russia BMI Index gaining +35.44% over the month.
Weighing on Emerging Market performance was the Chinese market with the S&P China BMI Index ending the month -8.34% weaker.
Property and Infrastructure
Australian Property Index continued to underperform the broader domestic equity market gaining +1.24% for the month.
Global Listed Property (Hedged) gained +5.61% over the month. Global Listed Infrastructure (Hedged) continued its strong performance gaining +5.81% over month.
This asset class has provided great diversification benefits to multi asset portfolios during the recent high levels of volatility.
Fixed income
The Bloomberg Australian Bond Index had one if its worst months on record slipping -3.75%. Clearly a sign of some capitulation by nervous investors. This asset class is becoming increasingly attractive.
The 10-year Australian government bond yield closed the month at +2.77% compared to +2.12% a month ago and +1.83% a year ago.
GENERAL ADVICE WARNING
The advice contained within this document does not consider any person’s particular objectives, needs or financial situation. Before making a decision regarding the acquisition or disposal of a Financial Product, persons should assess whether the advice is appropriate to their objectives, needs or financial situation. Persons may wish to make their assessment themselves or seek the help of an adviser. No responsibility is taken for persons acting on the information within this document. Persons doing so, do so at their own risk. Before acquiring a financial product, a person should obtain a Product Disclosure Statement (PDS) relating to that product and consider the contents of the PDS before making a decision about whether to acquire the product.