Monthly Investment Update — May 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:
Interest rates will rise much faster than markets expected just one month ago.
Central Banks are now playing catchup at a time when economic growth is slowing.
Amazon, the world’s largest retailer is facing significant challenges from rising operating costs.
Apple, the world’s most valuable company is warning that sales may slow due to supply chain challenges.
Despite this, the US Fed expects the labour market to remain strong as they deliver interest rate hikes.
A soft landing is what the Fed wants and what markets need to save still optimistic asset prices.
We are not fully convinced and remain cautious in our investment approach whilst being well diversified owning only liquid high-quality investments.
Have investors already sold and gone away or is there more weakness to come? That is a tough question to answer. What we know is that equity markets are swimming against the tide. Elevated inflation, rising interest rates, fears of recession, and a war in Europe. Let’s pause and unpack some of the drivers behind the recent weakness in equity markets.
A short recap on how we got here. The US Fed incorrectly labelled high levels of inflation as transitory in 2021. US inflation remains stubborn at a multi-decade high, currently 8.5%. Expectations have been for Central Banks to start/continue to raise interest rates in the coming months.
So, what has changed? Central Banks will now be hiking interest rates much more aggressively. They will be doing this into a slowing economy. Recession risk, or the risk of a so called “hard landing” has increased. Equity markets have become increasingly nervous about profit expectations.
Let’s talk about profits. The negative impact of inflation is becoming more notable. US retail sales grew 6.9% over the 12-months ending in March. After adjusting this for 8.5% inflation, US retail sales is flat/negative. To make matters worse, the cost of doing business (goods, freight, wages) has also increased seeing many businesses make less profits. That is the macro-economic data which most investors were happy to ignore until the reporting season started.
Amazon last week reminded investors of this in their quarterly profit update. Investors did not like the reminder as the stock price slumped more than -10%. Sales for the period Jan-Mar 2022 grew by 7% when compared to the same period in 2021. No real growth after we adjust for 8.5% inflation. Insult to injury, sales growth expectations for the upcoming Apr-Jun quarter is 3-7%. Reasons for the weaker profit margins are supply chain disruptions, higher fuel costs, and higher labour costs. Elevated costs are clearly a problem for the world’s largest retailer.
The story at the world’s most valuable company was somewhat improved. Apple’s sales grew by 8.6%, marginally beating inflation. The dominant iPhone category delivered modest sales growth of 5.5%, but the important Services category delivered 17.3% sales growth. Apple CEO, Tim Cook, was quick to remind investors that Apple is not immune to supply chain challenges. The message was highlighted by Apple CFO Luca Maestri warning of materially weaker sales in Apr-Jun quarter. Since the start of the pandemic, Apple has not provided sales or profit guidance for the upcoming quarter which remains the case. The environment is just too uncertain.
Why is this important to us? Last year equity markets chose to ignore what CEO’s and the bond market had to say. Instead, they listened to the US Fed who happened to be wrong. The US Fed now agrees with corporate CEOs and the bond market. Inflation is a problem, and the US Fed will now play catch-up hiking interest rates much faster than initially expected.
This is where things get complex. Could the US Fed be making another mistake? One where they are going to be too aggressive in hiking interest rates.
In mid-March the US Fed raised interest rates by 0.25%. They further outlined their plans to raise interest rates in 22/23. Since then, the US Fed Chairman Jerome Powell has taken every opportunity to inform markets of their intent to raise interest rates “expeditiously” to slow inflation.
Updated US Fed projections for 2022 see inflation (Core PCE) expectations revised upward and economic growth expectations revised downward. One piece of the puzzle does not fit too well. The US Fed expects the labour market to remain resilient. Can the unemployment rate remain at 3.5% through 22/23 in the face of higher interest rates and slower economic growth?
Equity markets are priced for a US Fed outcome in the employment market. Amazon and Apple are unlikely to add employees and contribute to the further strengthening of the US labour market (current unemployment rate of 3.6%).
Higher interest rates are not going to solve all of Amazon and Apple’s challenges. Yes, demand should slow and ease some of the cost pressures. Supply is however a key contributor to current cost pressures and profit uncertainty. There is little the US Fed or higher interest rates can do to change what happens in Ukraine or with COVID-19 lockdowns in China.
The US Fed remains committed to a “soft landing” which they may achieve. In our view equity markets are priced for that outcome. We are not fully convinced.
Investor sentiment is very bearish, and this contrarian indicator could see markets rally in the short term. Looking further out we are still concerned. Earnings expectations are too bullish and current prices do not reflect the possibility that earnings expectations are not met.
Accordingly, we remain cautious in our investment approach whilst being well diversified owning only liquid high-quality investments.
Forget Inflation...It’s About Interest Rates
We have for 18-months been highlighting the risk inflation poses to the global economy. Now everyone is talking about it, so we no longer need to.
What we need to talk about is interest rates. And the fact that Central Bankers are and will continue to raise them aggressively.
Unlike Australia, several Central Banks have already started raising interest rates.
The Reserve Bank of New Zealand raised its official cash rate by +0.25% in Oct21, +0.25% in Nov21, +0.25% in Feb22, and +0.50% in Apr22.
The Bank of England have hiked interest rates +0.10% in Dec21, +0.25% in Feb22, and +0.25% in Mar22.
The Reserve Bank of Canada started its rate hike cycle with a +0.25% hike in Mar21 followed by +0.50% in Apr22.
The most watched US Federal Reserve Bank (US Fed) also joined in with a +0.25% interest rate hike in Mar22.
The bond market tells us that other Central Banks will soon follow.
The European Central Bank has not hiked rates since 2011. The bond market is pricing 3 interest rate hikes for this year taking rates above zero for the first time since 2012.
Similarly, the Reserve Bank of Australia has just raised interest rates by +0.25% to +0.35% and signalled more rate hikes are coming shortly.
Fixed Rate Mortgages have already largely adjusted for these higher interest rates.
Is 0.50% the new 0.25%?
Clearly interest rates are heading higher globally. More fascinating is that both the Reserve Bank of New Zealand and the Reserve Bank of Canada hiked interest rates by +0.50% at their latest meeting.
Similarly, the US Fed last month said they are open to the idea of an +0.50% interest rate hike, something not seen in 22 years.
Fed Chairman Jerome Powell last week said the Central Bank is committed to raising rates “expeditiously” to bring down inflation.
The most hawkish US Fed member James Bullard has been calling for +0.50% interest rate hike for months now. Most recently he said the US Fed should not rule out a +0.75% rate hike.
The below chart illustrates US Fed interest rate changes for the past 30-years together with the recent hike in green and the 12-month expectations in red.
The unknown is whether the economy can absorb these higher interest rates.
How Far Will Central Banks Go?
Central Banks are today focused on inflation. They need to slow the economy to reduce the supply and demand imbalance which currently exists.
The challenge is Central Bankers have missed the window in which they needed to raise rates (2021). Now inflation has become a much bigger problem and policy settings need to play catch-up.
Every speech from US Fed Chair Jerome Powell sends a stronger message. It has become very clear that the US Fed is willing to go all the way. (US cash rate of 3.0% within 12 months).
The bond market has been paying attention as fixed-rate bonds adjust lower. Similarly, bond investors are demanding a greater premium from corporates with a poorer credit rating. Debt is no longer cheap.
Banks have also been paying attention as mortgage rates move higher. The US 30-year mortgage rate has reached 5.0%, back at levels last seen in 2011.
Debt markets clearly think the US Fed will go all the way. Equity markets perhaps still entertaining the thought that the US Fed will change its mind on interest rates like it has many times before.
Australian Equities
The S&P/ASX200 Index declined -0.85% over the month of April outperforming global markets by a healthy margin. The local market has now outperformed developed markets by +13.68% over the last 12-months.
With little surprise the best performing sectors for the month were the defensives. The Utilities sector gained +8.35%, Consumer Staples +3.22% and Healthcare +1.76%. Other positive contributors for the month were the Industrial sector gaining +3.62% and the Energy sector gaining +1.41%.
The worst performing sector for the month is the Technology sector (-12.32%). This is something we have seen repeatedly over the last few months as investors reprice expensive growth stocks.
International equities
The MSCI All World Index declined -9.59% over the month. Australian investors with unhedged International Equities exposure had some protection due to a stronger USD (+5.57%).
Risk asset repricing was broad sending major global exchanges lower. The US S&P500 Index returned -8.72%, the S&P Europe350 Index -5.41% and the S&P Japan500 Index -8.32%.
The sentiment was the same in Emerging markets. USD strength and China COVID-19 lockdowns saw the S&P Dow Jones Emerging Market Index end the month -5.40% lower.
Property and Infrastructure
Australian Property Index followed the defensive sectors ending the month in the green with a monthly gain of +0.57%.
Global Listed Property (Hedged) weakened -5.06% over the month resulting in a marginal +1.39% gain over the last 12-months.
Global Listed Infrastructure (Hedged) slipped back -0.92% over the month and remains a strong performer over the last 12-months gaining +15.36%.
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 -1.49% return for the month of April. This sees the widely followed Australian bond index down more than -10.0% since peaking in August 2021.
The 10-year Australian government bond yield closed the month at +3.24% compared to +2.77% a month ago and +1.69% 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.