• Equity Markets have started the year softly impacted by increasing inflation signals, hawkish central banks, rising rates, the Russia-Ukraine conflict and ‘stagflation’ concerns. However, an enduring feature this year of the Australian equity market has been one of resilience relative to the rest of the world.
• Australia outperformed global equity markets - In local currency, the ASX200 (+2.4%) outperformed the US S&P500 (-4.9%), the MSCI World ex Australia Index (-5.8%) and the MSCI Asia Pacific ex Japan Index (-6.1%). Australia has outperformed due to its geographic isolation, recovery post Covid lockdowns, commodity leverage, strong governance, earnings upgrades, fiscal strength, high dividend yield and strong consumer fundamentals.
• Stagflation concerns rising - Globally, the predominant focus has been climbing inflation while economic growth forecasts are stumbling. Global growth has been downgraded on a combination of lower Chinese growth (Covid lockdowns), the Russia-Ukraine conflict and impact on Europe, and higher inflation and interest rate forecasts which have thwarted consumption expectations.
• Solid Australian economic growth – The unemployment rate fell to 4% - the equal lowest level since 1974. Consumer spending was strong driven by easing lockdown restrictions, increasing employment and a drawdown in savings. The FY23 Budget position improved with significant revenue tailwinds boosting the bottom line and driving new fiscal support measures.
• The Fed became decidedly more hawkish – The US Federal Reserve raised rates in March 25bp. Economists ratcheted up their near-term US rate hike expectations sharply as the Fed communicated that they would move more aggressively to combat inflation. The Reserve Bank of Australia (RBA) maintained rates at 0.1% over the quarter awaiting sustainable inflation indicators. The market bet they would move much earlier than their guidance.
• Bonds sold off aggressively – Despite the ‘relatively’ more dovish RBA, Australian 3-year Bond yields rose 143 basis points (bps) to 2.34% and 10-year bond yields rose 117bps to 2.84%. US 2-year bond yields rose 163bps to 2.36% and 10-year yields rose 81bps to 2.32% leading to a flattening (and partially inversion) of the yield curve. The futures market is pricing steep rate hikes by both the RBA and US Federal Reserve.
• Commodity strength was broad-based – The Commodity Bureau Research (CRB) Index rose 27%, the London Metals Exchange (LME) Index rose 15.5% (Aluminium +24% and Nickel +54%) and the Precious Metals index increased 6.9%. The Russia-Ukraine conflict saw oil (WTI) soar 30.3% to over US$100/bbl, Natural gas prices rocket up 51.3% and wheat prices climb 30.5% as supply concerns increased. Iron ore rallied 29.4% and Hard Coking coal rose 49.1%. Tightness in European gas markets led to thermal coal prices rising more than 50%.
• Commodities fuelled $A strength - The Australian dollar appreciated 3% to close at 74.82 US cents.
• ASX200 earnings revisions continued with the positive trend for the broader market up 6.5% over the quarter driven by Energy (+25%), Utilities (+16.4%) and Material (+13%). The Australian equity market has also led dividend upgrades thus far in 2022, with Dividend-per-share revisions for the ASX200 up 4.9%.
Outlook and Strategy
Over the last 18 months we have had some consistent, high conviction views concerning key macro drivers and market conditions. At a simplistic level, we have believed that sustained stimulus from accommodative monetary and fiscal policy (domestic and global), combined with effective vaccine rollouts would lead to sustained above trend GDP growth. We were early and consistent on the view that inflation would not be transitory and would persist, requiring Central banks to bring forward the pace and rate of interest rate rises. Despite elevated valuations we felt these conditions would support equity markets and adversely affect Fixed Income returns.
The current picture is far less certain, and conviction is lower.
The debate on inflation is largely over and with unemployment at near record lows, Central Banks, led by the US Federal Reserve have begun to act. Fixed Income markets have reacted aggressively, and the yield curve has lifted quickly with 10-year bond yields above 3% in Australia and 2.8% in the US. The pace of change in the US, including the scale of intended bond purchases has caused the short end of the curve to sell off even more aggressively and invert. This rare event could be seen as the bond market contemplating heightened risk of a recessionary environment.
Of course, we also have heightened geopolitical risk with the deeply concerning conflict in the Ukraine, which apart from the terrible humanitarian cost, has increased the downside risk to economic growth and added further fuel to the inflationary fire through its impact on energy and broader commodity markets.
In this environment, it is less clear why equity markets should remain near all-time highs. While our base case is still for GDP growth to remain above trend, we believe that there are likely to be current market forecasts are liable to be downgraded. Corporate profits are likely to come under greater pressure as cost pressures amount, particularly those with a high proportion of labour costs, as wage pressure mounts.
Central to the above trend GDP expectation is the attitude of consumers. In recent years, household balance sheets have been strengthened as savings rates have elevated, borrowing costs been reduced and governments have provided copious support. Consumers are thus well placed to pick up the baton as government and central banks pull back support although this is very much contingent on them remaining confident in the future. There are worrying signs of consumer sentiment weakening as many adults/households are exposed to an interest rate rise for the first time as well as rising inflation and cost of living pressures.
Increased uncertainty in the external environment is likely to lead to periods of volatility and more muted portfolio returns this year relative to 2021. At an asset allocation level, we have removed our underweight to fixed income and have a relatively neutral tactical asset allocation positioning. We are considering increasing allocation to cash (although noting this is generally an under-performing decision over time).
Within Australian equities, we continue to apply our Quality at a Reasonable Price lens and focus largely on bottom up factors. In the current environment, quality factors such as favourable industry structure, pricing power and balance sheet will become increasingly important. Importantly, dividend income continues to recover and remains an important, and less volatile, contributor to total return. We would consider the portfolio to be somewhat defensively positioned which has seen it hold up well in recent periods of market downturn but lag in March as markets accelerated higher.