Most global equity markets have been selling off due to rising bond yields which have been reacting to high inflation, not seen for decades, and a very aggressive US Fed. Both the US and Australian 10-year bond yields rose by over 1.5% year-to-date, to trade at around 3.0% and 3.5% respectively. This has resulted in large price falls in common fixed interest benchmarks., including the Australian and Global fixed interest benchmarks down 7.28% and 9.26% respectively in the first 4 months of 2022. Bond yields have since pulled back somewhat from their recent peaks.
The other major event is the Russian invasion of Ukraine. Quite apart from the humanitarian disaster, this has led to elevated oil and commodity prices, adding to inflationary pressure, and resulting in global growth estimates being revised down.
The RBA, along with many other central banks, underestimated the underlying level of inflation and is now scrambling to bring it under control. Interest rate hikes are well ahead of initial predictions. Only a few months ago the RBA conceded a rate hike was “plausible” this year, but it was prepared to be “patient”. On May 3, the RBA joined central banks in the US, UK, NZ, and Canada, which had already lifted rates. The RBA raised the Cash rate by 0.25% to 0.35%, the first increase since November 2010.
Based on a 30-year principal-and-interest monthly repayment loan with a 3.5% interest rate, increasing by the full May RBA increase.
|Interest rate increase
|3.5% to 3.75%
|3.5% to 3.75%
|3.5% to 3.75%
The RBA’s forecast for 2022 is for headline inflation to be around 6% and underlying inflation (core) around 4.75%. It also forecast that inflation would fall back to its target range of 2-3% by mid-2024.
Headline inflation is currently 5.1% in Australia, but this is still well below 8.3% in the US and around 7% in Europe, the UK, Canada, and NZ. The RBA’s assumption is that the cash rates
would reach 1.75% by the end of this year and 2.5% by the end of 2023. However, markets are currently pricing in a Cash rate of 2.5% by December 2022 (RBC Capital Markets, AFR), although we believe this is on the high side. While the US Fed is tightening by also reducing the size of its balance sheet, the RBA has indicated it has no plans to sell the $617 billion bonds it currently holds.
Australia is a special case for the moment. The war in Ukraine has boosted the price of many commodities such as oil, nickel, and wheat, and boosted the Australian dollar earlier this year. However, the Australian dollar has pulled back sharply lately, likely due to the COVID lockdowns in China, as we are so dependent on China for our exports. UBS and JP Morgan recently downgraded their GDP growth forecasts for China in 2022 to 3.0% and 3.7% respectively, well below the official target of 5.5%. Our market is seen as a hedge against inflation, so has been one of the best performing markets this year.
The main issues right now are how high will interest rates need to go to get inflation under control, and how much will growth slow, and whether that leads to a recession in the US. We believe the Fed would like to rapidly get the cash rate to a neutral level (around 2.4%) before possibly pausing. Market expectations change from day to day, but the cash rate is expected to exceed 3% eventually.
It is an open question whether projected rate hikes will be enough to tame inflation. The Fed is so far behind the curve with CPI inflation over 8% and PPI (wholesale inflation) around 11%. Historically, the Fed has had to raise rates to a level matching wages growth (over 5%) or the level of inflation (over 8%). However, it is very hard to see that happening given the enormous levels of debt post-pandemic.
This is probably the most complex investing environment we can remember. We do not know how far interest rates will rise and this makes it very difficult to value markets. What we can say is that we would expect equity price to earnings (PE) multiples to fall as interest rates rise. This is exactly what has been happening, with the higher PE Nasdaq index in the US pulling back over 30% in the year-to-date, and the broader S&P 500 index down around 19%. Australia is trading a little above the long-term average of 14.7x for the ASX 200, while Europe, Japan, and China are now all trading below their long-term PE averages, something we have not seen for a while.
We continue to believe you should hold a mixture of equity styles such as Value/Cyclicals and Growth. Value has done much better than Growth this year, but this could reverse as markets worry about future growth, in China and the US in particular. The case for overweighting Value stocks is more difficult now since the valuations of most growth stocks have come down substantially.
There has been a string of high-profile US companies warning about the strength of the consumer lately. There is no question that growth is slowing in the US. We believe the market will fluctuate between concerns about inflation and slowing growth, and there will be more talk of a possible recession in 2023. We also believe markets have priced in a slowdown in growth resulting from normalised, higher interest rates. However, they would have another leg down if there was a US recession, or if company earnings were to be revised down significantly. The risk is that falling company profits due to increasing costs arising from persistent inflationary pressures have not been fully priced into equities.
We still believe it is too early to start increasing the duration in fixed interest portfolios, as we think there is a risk that central banks may need to raise rates by more than current expectations to tame inflation. However, we would probably not be reducing duration yet as growth concerns will tend to pull bond yields lower. At some stage in a rate hiking cycle, markets will be more concerned about growth outlook rather than inflation.
In our view, it is important to continue to be patient in this market and hold higher cash levels than normal to take advantage of opportunities that will likely arise in a very volatile market.
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