Market Commentary – May 2022

It comes as no surprise that the elevated level of volatility in both equity and bond markets in recent weeks has unsettled many clients as they experience capital declines in both their share and fixed interest investments. These recent declines are not without cause, as we appear to be transitioning through a period of regime change within markets and economies.

If Covid wasn’t enough—what is going on with markets? It started earlier this year with the United States (US) reporting an annualised inflation rate of 7.0% in December 2021. This came about because the developed world was reopening post the supposed Covid peak and required an increased supply of manufactured components and goods from the developing world, largely China. However, because supply chains take time to restart and due to China’s zero Covid policy, both production and logistics (shipping) have not been able to respond to increased demand. This has resulted in price increases, leading to higher inflation, particularly in the US, but also in Europe and the rest of the developed world. Inflation has also been magnified and prolonged by the Ukraine War which has driven energy and wheat prices much higher. The April read for US inflation came in at 8.3% p.a. down slightly from the 8.5% p.a. reported in March. Encouragingly, the monthly number for April of 0.3% is well below the March level of 1.2%.

The increase in the rate of inflation now looks to have caught central banks on the back foot, after initially believing that inflation was ‘transitory’ and would decline as global output rose post the Covid peak. This has not eventuated as a result of the outbreak of the Omicron variant which has taken hold in China and authorities there have persisted with their Covid zero policy – and continue to do so to this day. Currently in China, 27 cities and circa 185 million people remain in full or partial lockdown, so supply problems have continued largely unabated from late 2021.

While some central banks have been increasing interest rates from their lows, the US Federal Reserve (the Fed) has had a significant change in its appreciation of inflation and is no longer prepared to say it is transitory. This being the case, the Fed has responded with a substantive policy change choosing to quickly wind back the bond buying program (reducing stimulus) and embark on a rapid tightening of monetary policy, increasing interest rates by 0.25% in mid-March and then 0.50% last week, the largest single increase since the year 2000. Markets have responded and are now expecting that, by the end of calendar year 2022, the US cash rate will be in the range of 2.75% to 3.00%. Similarly, in Australia, RBA chair Philip Lowe had a mea culpa last week admitting their view that official rates would not rise in Australia until at least 2024 was wrong. As we write this, the RBA has already increased rates by 0.25% earlier this month, well ahead of the previous expectations.

This change of heart by the US Federal Reserve, Reserve Bank of Australia and others has happened reasonably quickly (in about the last 8 weeks) and has been quite dramatic. So, fundamentally it is the abruptness and magnitude of this change of attitude of the central banks that has seen market interest rates take off. The US 10-year bond yield has risen from 1.7% on 7 March 2022 to 3.14% on Monday this week. That means a US 10-year bond purchased for $100 on 7 March is now worth $93.84, a fall of 6.16% in 63 days. The Australian experience is similar, starting from the recent low on 2 March of 1.98% closing out on Monday this week at 3.51%, the price impact being a fall of $6.96 per $100. This recent experience highlights the driver of negative performance of many traditional bond funds over the past 12 months.

Equities, which had benefited from accommodative monetary policies and low interest rates, also got caught in the down draft of the swift change in interest rate expectations. The MSCI Global Share Index has fallen 14% in the 35 days to Monday 9 May as markets react to factor in expectations of higher inflation and higher interest rates. Australia fared relatively better, the ASX 200 falling just 6.3% over the same 35-day period. By contrast the US NASDAQ Index which lists the world’s largest technology stocks who were the market darlings during the first year of Covid, fell 19.6% over this same 35-day period to Monday 9 May.

So, where to from here? The simple answer is we are not sure, but we do anticipate continued volatility as markets adjust to a higher inflation rate, exacerbated by higher energy prices courtesy of the ongoing Russian invasion of Ukraine and a higher interest rate environment. While the Omicron outbreak in China seems to be waning, there does not appear to be any marked improvement to disruptions in global supply chains. As a result, inflation is likely to stay elevated and support continued upward pressure on interest rates and ongoing volatility in equity markets.

We are encouraged by the corporate earnings results from the latest US reporting season with many companies exceeding broker estimates and reporting higher earnings. However, for the moment investors remain firmly focused on inflation (which remains high but is showing signs of peaking) and interest rates, the outlook for which is heavily biased to the upside. That said, if corporate earnings continue to hold up then, at current prices, there are some attractive opportunities within equities, but that is not what is driving investor sentiment and markets in the short term.

While the combination of these macro forces are driving inflation concerns, there are reasons to maintain the course.

1. Long-term investors are seeing the corrections in bond and equity markets as an opportunity, as lower prices mean improved valuations and higher future long-term returns.
2. In general, key economies remain strong and unemployment is very low. While the market has concerns about economic growth in 2023, the growth outlook is less concerning over the remainder of 2022.
3. Balance sheets remain strong and debt is not a major concern for many corporates.
4. Inflation is expected to reduce as supply side disruption eases as China will not remain locked down forever.