Monthly Investment Update — June 2022
This month’s newsletter looks at the latest market and economic developments and what they mean for investors.
The main points are as follows:
Investors have welcomed the recent relief rally on equity markets. We are not getting too excited just yet.
The equity market game changed in November when the US Fed conceded that inflation was not ‘transitory’.
Central Banks are on a mission to slow inflation and showing no signs of changing course.
So too is inflation not showing any signs of easing with US inflation holding near 40-year highs.
Share markets are under pressure, and that could intensify should earnings forecasts be downgraded.
We remain cautious on equities until we have more certainty that inflation has peaked.
We are optimistic on fixed income as the income potential is much higher today.
This year has been a challenging year for share markets. Of the 22 completed trading weeks of the year, 15 have ended in the red with only 7 ending in the green. The momentum has clearly shifted with some investors heading for the exit.
Those who have been watching markets closely have enjoyed the recent relief rally. Following 7 consecutive down weeks, the US S&P500 index posted a +6.6% gain last week. We experienced a similar relief rally in March when the US S&P500 index posted a +6.2% weekly gain.
Investors are now asking whether this is just another relief rally within a bear market. Probably. It is difficult to know with certainty. What we have seen over time is the sharper the rally, the less we should trust it. We are not buying the dip just yet.
The experience for most Australian investors has been much more pleasant. Our market has been one of the better-performing markets globally. That is mostly due to higher commodity prices benefiting our materials and energy companies. So too have higher interest rate expectations supported our insurers and banks.
The pain has been felt mostly in expensive stocks. Yes, many of them are great businesses. Yes, we agree with the “bright future” story. The prices were wrong. The enemy of high stock prices is higher interest rates and that once again proved to be the case.
In this newsletter, we discuss in more detail why we think investors should remain cautious. Central Banks have influenced the direction of share markets for the last 14 years. They find themselves in a difficult position today. They need to choose between saving share markets or controlling inflation. Controlling inflation is now their top priority.
The Fed changed tact in November 2021!
A key part of the economic puzzle investors had to wrestle with in 2021 was the outlook for inflation.
Consensus was for inflation to be temporary/transitory. The biggest supporter of this narrative was Jerome Powell and the US Fed.
Wall Street also firmly backed this narrative. Perhaps influenced by its self-interest, as persistent inflation would not be good for asset prices.
Cracks however started to appear in November 2021. Jerome Powell was before Congress and stated, “the Fed believes that ‘transitory’ means that inflation will not lead to permanent economic damage”.
He went on to add that “I think it’s probably a good time to retire that word”.
That clearly meant the US Fed now believed inflation could lead to permanent economic damage. Action had to be taken. The bond market swiftly commenced with the repricing of interest rates (higher).
It was around the same time when high-flying assets were met with selling pressure. Despite still having a great story, any strength was matched by a new wave of selling. This trend continues to this day.
The game clearly changed in November last year. Some long-duration bonds have declined more than -10%. High-growth innovation stocks have declined more than -50%.
We have warned against this. Advocating our preference for shorter-dated bonds and cheaper value-style economically sensitive sectors and regions.
Consensus View is Expect Higher Interest Rates.
Interest rate markets are now positioned for much higher interest rates in the next 12-months.
The official US cash rate is +0.75% and the yield on a 2-Year US Treasury Bond is +2.56%.
The RBA cash rate is +0.35% and the yield on a 2-Year Government Bond is +2.72%.
Yes, cash rates will move higher and resemble something like the 2-year Government bond yields.
The question remains whether the economy can handle those higher interest rates.
In March the market thought it could handle higher interest rates. In April and May the market has clearly become more concerned. The selling pressure has extended into high quality large cap stocks.
Will interest rates move even higher than what the market currently expects?
Equity market bulls would argue interest rate expectations have peaked as higher interest rates will slow price inflation.
Equity market bears will argue that inflation will not ease as expected as the price pressure is from the supply side. This could see Central Banks raise interest rates even further killing demand.
The consensus view may be for higher interest rates. It is not yet the consensus view that higher interest rates, persistent inflation, and higher energy costs could negatively impact earnings.
Contrarian view is Expect Weaker Earnings.
As we know, equity markets trade on a multiple of corporate earnings.
A basket of US S&P500 Index shares generated $198 in earnings over the past 12 months.
The S&P500 Index traded at 4,800 in December – That is 24 times the $198 = 4804
In May the Index is trading at 3,960 – That is 20 times the $198 = 3960
We have been arguing for some time that the higher interest rates go, the lower the multiple needs to be.
Should interest rate expectations march even higher, 16 times multiple could be appropriate.
That is $198 x 16 = 3,168 on the US S&P500 Index. That is another 20% downside!
The repricing of asset markets is well underway. Initially companies with no profits. Now companies with profits.
What has not yet started is the adjustment of future expected earnings. Analysts expect earnings in a year from now to be 15% higher at $227.
A perfect story to fill the valuation gap left in Wall Street models forced by using a lower multiple.
Taking the $227 times 20 is 4,540 on the S&P500 Index (10% upside). These are just rough numbers, but probably the best we can come up with in terms of a bullish case.
More realistically a multiple of 16 ($227 x 16 = 3632). How about adjusting earnings growth lower to compensate for higher operating costs and weaker demand? ($210 x 16 = 3360).
The market has not yet adjusted for the prospect of lower earnings. We believe this is the biggest risk facing investors today.
What Could Pressure Earnings?
For more than a decade, Central Banks have been highly supportive of financial markets.
Any hint of an economic slowdown was met with demand support through money printing or low interest rates.
The challenge today is that Central Banks have already caused an awakening in demand. There is however a supply shortage.
Adding more money to fuel demand will not solve the supply challenges. These supply challenges are only resolved by investment which will take years.
Reaching a balance where demand no longer outstrips supply is what is critical. The US Fed knows this.
Any strength in the demand is likely to be met by pushback from the US Fed. Faster rate hikes and reverse money printing.
What investors have come to know over the past decade as the Fed Put, has now become the Fed Call.
Earnings will be pressured by capped demand (sales) and rising operating costs.
Aligning our expectations for earnings to that of the US Fed makes sense at this point.
Australian Equities
The S&P/ASX200 Index declined -2.60% over the month of May. Relative to other global exchanges the local market has delivered much stronger returns over a 12-month period.
There is however very little to celebrate over the last month. The Materials sector was the top performing sector delivering a modest gain of +0.05%.
The worst performing sector for the month was the Technology sector declining -8.71%. Investors continue to reprice expensive growth stocks as interest rate expectations move higher.
International equities
The MSCI All World Index traded in the red for most of the month. A strong rally into month end saw the index post a positive gain of +0.08%.
Europe and Japan led the rally with the S&P Europe350 Index gaining +1.20% and the S&P Japan500 Index gaining +2.67%. The US S&P500 Index posted a modest gain of +0.18% whilst the US Nasdaq Index gave back -1.65%.
Emerging markets ended the month -0.22% weaker resulting in -19.82% drawdown over 12-months. China’s deteriorating economic outlook remains a concern for investors.
Property and Infrastructure
Australian Property Index had one of its worst months on record weakening -8.73%. The key reason for this was the -14.30% decline in the share price of index heavyweight Goodman Group.
Global Listed Property (Hedged) gained +1.23% over the month. Whilst positive, there is little to celebrate over a 12-month timeframe with the index down -5.98%.
Global Listed Infrastructure (Hedged) gained +3.14% over the month and remains a strong performer over the last 12-months gaining +19.20%.
This asset class has provided great diversification benefits to multi asset portfolios during the recent period of high volatility.
Fixed income
The Bloomberg Australian Bond Index posted a -0.89% return for the month of May. This sees the widely followed Australian bond index down -8.54% over the past 12-months.
The 10-year Australian government bond yield closed the month at +3.35% compared to +1.64% 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.