July Review

14 August 2024

The Australian share market was the standout performer in July, returning an impressive 4.2% for the month, driven by strong gains in the retail and gold sectors. The market was relieved when the RBA held rates steady despite some fears that stubbornly high inflation would compel them to hike rates. Other markets were more subdued with the US improving 1.3% after a strong run so far this year, the UK rallied 2.5% following their decisive general election outcome while China continued to struggle by declining 1.3%.

Commodity markets were mixed with the gold price improving 5.7% supported by lower bond yields, iron ore was flat while the oil price fell 4.9% despite ongoing tensions in the Middle East.

Growing confidence about a September rate cut saw US bond yields rally by 32bp while Australian 10-year bonds were more subdued falling 19bp reflecting less favourable inflation conditions. A stronger greenback saw the Australian dollar decline by 2.2% to finish at US 65 cents.

Markets overreact to recession fears

In early August, markets experienced a sharp correction following the release of weaker than expected US employment numbers, sparking fears that the US economy would move into recession. The market reaction was exacerbated by the unwinding of leveraged positions financed in Yen following a surprise 0.25% rate hike by the BoJ which led to an appreciation of the Yen and a 12% fall in the Japanese share market. The chart below shows movements in the VIX often defined as the “fear index” and used as a proxy for negative investor sentiment. While there was certainly a spike in the VIX, it was nowhere near levels seen during the COVID outbreak or the GFC.

Global bond yields rallied as expectations for a cut in the Fed funds rate were brought forward to as early as September this year. While there is certainly evidence that the US economy is beginning to feel the bite of a sustained period of tighter monetary policy which has seen inflation fall from 9% to around 3%, there isn’t broad based economic evidence yet that a meaningful recession is imminent. While the term “recession” is an emotive word that tends to alarm investors, it is merely an economic definition which describes two consecutive quarters of GDP contraction. While a mild recession is nothing to be concerned about, a more severe downturn would simply bring forward the timing of interest rate cuts by central banks. This will have the dual impact of improving market valuations through lower bond yields, but also provide relief for corporate profits towards the end of next year and beyond.

Of some concern to global financial markets is the simmering tension in the Middle East with Iran and their proxy army in Lebanon (Hezbollah) threatening retaliatory action against Israel following the assassination of two Iranian backed military leaders. This would represent an escalation in the conflict between Israel and Hamas, as Iran and its proxy in Yemen (the Houthis) could potentially disrupt global oil supply leading to an inflationary spike in the crude oil price. While geopolitical events are incredibly difficult to predict with certainty, it is a risk that cannot be ignored.

Strategy and Outlook

The market jitters experienced in early August should not be of any great concern to long term investors. It is perfectly normal for markets to experience a correction following a long period of strong performance, which is often a necessary predicate for a more sustained market rally. While it is certainly possible there will be further short-term market turbulence if additional bad economic news emerges, the inevitable response from central banks will cushion the extent of any downturn. Market corrections emphasise the importance of diversification in multi-asset portfolios particularly the value of holding assets that have a negative correlation to equity markets such as cash, government bonds and the US dollar all of which rallied during the recent correction.

Gary Burke
Chief Investment Officer