Monthly Investment Update — August 2022
This month’s newsletter focuses on the latest US macroeconomic developments, Fed policy and corporate earnings season.
The main points are as follows:
The S&P 500 bounced back in July with its strongest month since November 2020.
The initial driver of the bounce was better than expected US corporate earnings.
The markets then interpreted comments by US Fed Chairman Jerome Powell’s as being net positive further fuelling the bounce.
The risks however remain plentiful and even more so when we include geopolitical tensions.
We remain focused on the trajectory of long-term earnings as this is ultimately what investors own.
At this stage we remain cautious and not as optimistic around earnings as Wall Street analysts.
The US S&P500 Index posted a +9.11% return for the month of July. This is its 6th best month since January 2000 and 13th best month since January 1980. Whilst impressive the market is still trading -14.13% off its January record highs.
Why have markets rallied? We should not overlook the fact that investor sentiment has been weak over the last few months. History does show that a positive change in sentiment can result in a powerful share market rally. Let’s take a closer look at what changed the mood/sentiment on Wall Street.
The first key event was the US reporting season which kicked off in July. The good part is earnings have been better than what analysts expected. The not so good part is earnings growth is much lower than the last few quarters. The bad news is future earnings expectations are swiftly being lowered. For now, the market is focused on the good news.
The second driver was the July meeting of the US Federal Reserve Bank. Chairman Jerome Powell hinted in his Q&A session that the US Central Bank may be nearing the end of their interest rate hiking cycle. Or maybe that was what the market heard amongst many other comments. Since then, several committee members have tried to remind markets they will continue raising interest rates until they see compelling evidence that inflation is falling.
Whilst Central Bankers are talking tough, the market is not buying it. Central Bankers are backward looking arguing the labour market is strong enough to handle more interest rate hikes. Wall Street is forward looking and trimmed future earnings expectations and at the same time lowered future interest rate expectations. Is Wall Steet correct? Will Wall Street’s interest rate expectations be what the US Central Bank actually delivers?
The complexity only increases when we include geopolitics in the conversation. Russian gas supplies to Europe are highly uncertain with winter fast approaching. The relationship between the US and China is once again under the spotlight as Nancy Pelosi, the Speaker of the US House of Representatives visits Taiwan.
Investing always comes with an element of uncertainty. What is different today is the variability of outcomes is much wider. Interest rates could well rise slowly into year end and decline in 2023 as Wall Steet expects. Interest rates could also move higher into year end and continue to move higher in 2023 as inflation remains stubbornly high. The outcome for share markets would be much different.
This is what keeps us focused on preserving capital. Whilst swinging for the fences could have a great payoff, it certainly does carry a higher level of risk. We continue to concentrate our investments in high quality, highly liquid, and well diversified investments. A higher cash weighting also provides additional portfolio defence and optionality.
EARNINGS WILL LEAD STOCKS!
EQUITY MARKETS ARE STRUGGLING TO FIND DIRECTION
Markets sold off in the first half of 2022 on a combination of high inflation, rapidly rising interest rates and growth concerns.
These factors remain in play as the second half commences. Central Banks are focused on defeating inflation at all costs. Expect more aggressive rate hikes over the coming months.
Markets are sensing the cost will be weaker growth and weaker earnings but to what extent?
A US recession is now being widely talked about. The question is how bad will it get?
Markets are struggling for direction trying to decipher the unknowns.
EARNINGS ARE TODAY’S FOCUS
As we know, equity markets trade on a multiple of corporate earnings.
Most of the focus over the past 6 months has been on the multiple. The higher interest rate expectations are, the lower the multiple needs to be.
We believe this multiple ‘compression’ has now played out. The result has been lower prices particularly for higher growth sectors such as technology.
The focus today is on the second part of the equation, earnings.
THERE IS MUCH EARNINGS UNCERTAINTY
There is a growing divergence between analysts and investors on the US earnings outlook.
Analysts expect robust earnings growth to continue. Consensus forecasts have S&P500 companies delivering +9.0% earnings growth in calendar year 2022 and +8.7% in 2023.
Analysts are clearly not in the US recession camp.
Investors are less optimistic, seeing downside to analyst forecasts and selling into bounces on equity markets.
The recent Q2 earnings season did provide some direction:
Companies are facing cost pressures as expected, they are however successfully navigating them.
Companies are still growing revenue and earnings but flagging that earnings growth rates will slow.
Company profit margins are shrinking but remain well above the 5-year average at this stage.
Supply chains remain a challenge for many companies but there are signs of improvement.
For companies that have issued Earnings guidance, 58% have been negative which is marginally below the 5-year average of 60%.
We expect to have a better line of sight over Q3 earnings in the coming months as earlier rate hikes have had time to work through the economy.
THERE ARE GOOD REASONS TO BE CAUTIOUS
As we have been arguing for some time, there are many good reasons to be cautious on the earnings outlook:
US consumer confidence is weak.
Elevated inflation (energy prices, labour costs etc) is driving higher operating costs.
Borrowing costs have increased.
Key markets such as Europe and China are experiencing economic downturns.
Then there are currency impacts. Most US behemoths are multinationals.
About 30% of S&P500 company revenue is generated from outside the US.
This is worth less when the $US is strong (like now). Several corporates have cited currency headwinds in recent earnings updates.
AUSTRALIAN EQUITIES
The S&P/ASX200 Index gained +5.75% over the month of July. The local market continues to outperform International Equities over a 12-month timeframe.
Lower bond yields/lower future interest rate expectations make the technology sector the go-to trade, so it is with little surprise seeing this sector being the top performer gaining +15.23%.
Most other sectors posted strong results with Real Estate gaining +11.93%, Financials +9.28%, and Consumer Discretionary stocks +8.22%.
The only sector to end the month in the red was the Materials sector which gave back a modest -0.67%.
INTERNATIONAL EQUITIES
The MSCI All World Index ended the month +7.94% higher making up most of June’s -8.66% loss.
The technology heavy US S&P500 Index led developed markets gaining +9.22%. S&P Japan500 Index followed with a +6.31% gain for the month with the S&P Europe350 Index gaining +4.85%.
Emerging markets struggled to gain traction ending the month -0.40% weaker. Weighing on the index was the Chinese market which gave back most of June’s gain with the S&P China500 Index weakening by -8.05%.
PROPERTY AND INFRASTRUCTURE
Australian Property Index gained +11.93% making it the best performing asset class for the month, albeit from heavily oversold levels. Global Listed Property (Hedged) gained +8.43%.
Global Listed Infrastructure (Hedged) gained +4.40% for the month. Infrastructure is the best performing asset class over a 12-month timeframe gaining +15.36%.
FIXED INCOME
The Bloomberg Australian Bond Index posted a +3.36% return for the month. This sees the widely followed Australian bond index down -9.10% over the past 12-months.
Key for investors to note is the monthly performance of equities and bonds are highly correlated which is unusual and somewhat concerning.
The 10-year Australian government bond yield closed the month at +3.07% much lower than the +3.69% a month earlier.
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.