Themes For April

Markets corrected sharply during April spooked by the prospect of higher interest rates spurred by rising inflation. The prospect of aggressive policy action to tighten liquidity conditions saw the US Federal Reserve increase interest rates by 50 basis points following the 25bp rise in March and signalled a series of similar moves before the end of 2022. In addition to this, they announced their intention to allow their $9 trillion balance sheet to run-off at a rate of $95 billion per month from June onwards.

Faced with an emerging liquidity head wind, the US share market fell by 8.7% with the tech laden NASDAQ fairing even worse declining by 13.4%. First quarter earnings results in the US were reasonable but not sufficient to overcome the negative valuation impact of higher bond rates.

The Australian market fared much better than the US falling by just 0.9% buoyed by firm commodity prices and a lower exposure to long duration technology stocks. Bond markets were sharply weaker as yield curves began to factor in tighter liquidity conditions.

US 10-year treasuries were 53 basis points higher to finish at 2.89% while Australian 10-year bonds increased by 29 basis points to finish at 3.12%. In the corporate bond market, credit spreads also widened reflecting equity risk conditions.

The US dollar once again proved its safe-haven qualities by strengthening against major cross rates with the Australian dollar falling from $US 0.75 to $US 0.71 at month’s end. In commodity markets, oil and iron ore were relatively flat, however, natural gas continued its advance increasing by 30.4% due to supply shortages associated with the ongoing Russia-Ukraine conflict.

 

Central banks are well behind the inflation curve

The hallmark of monetary policy for the past two decades has been that central banks have contained inflation by moving pre-emptively to tighten interest rates well before higher inflation printed in official data. During the pandemic, conventional economic policy was set aside as emergency measures were adopted in an attempt to suppress the spread of COVID-19. The economic effects of this are now being felt as sharp imbalances have arisen as supply chains were disrupted by lockdowns and demand was over stimulated though generous deficit funded government compensation schemes and very easy liquidity conditions. History will show that the US Federal Reserve made a serious miscalculation by declaring the nascent rise in US inflation in mid-2021 to be “transitory” and delayed raising interest rates until March 2022. With US inflation now at 40-year highs, the Fed must play catch up and increase rates aggressively for the rest of 2022.

In Australia, the Reserve Bank tightened interest rates by 25 basis points early in May for the first time in over a decade. With underlying inflation reading 3.7% (well above the 2-3% target band) it’s clear that the RBA has also been slow to react to emerging inflationary conditions and will have to tighten rates on several more occasions in the coming months. The task ahead is a difficult one for central banks as they tread a very fine line between suppressing inflation through monetary tightening and avoiding a recession.

The earnings outlook for many companies reflects an expectation of more difficult trading conditions ahead in anticipation of slower economic activity. While US Q1 profit results still showed positive earnings growth of just under 5%, this was the lowest level recorded since Q4 in 2020. With tighter monetary settings, supply disruptions from China’s zero COVID policy, negative profit revisions plus geopolitical uncertainty from Russia’s invasion of Ukraine, it’s understandable that markets have been unusually volatile in recent times.

Investment  Outlook

While financial markets are climbing a wall of worry, it’s easy to get overly pessimistic about prospective investment returns. While conditions are likely to remain turbulent in the short term, it’s worth remembering that it is normal for markets to experience this kind of downturn every five years or so. It is equally true that economic variables will inevitably re-balance following a period of re-adjustment and markets will eventually resume their upward trajectory. The balance of this year is likely to be problematic, however, as we look out towards calendar 2023 financial conditions should be much more supportive for both company profits and share prices. The key for investors is to stay the course through difficult times and maintain focus on the long-term.

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