Themes For July

Equity markets recovered much of their lost ground from last month with most major markets posting healthy gains during July. A firmer bond market was the catalyst for a stronger US equity market which advanced by 9.1%, the strongest monthly return since July 2020. The technology heavy NASDAQ performed even better rising by an impressive 12% as long duration tech company earnings are particularly sensitive to bond yields. The Australian market also fared well improving by 5.7%, Europe advanced 7%, the UK 3.5% with the only laggard being China which fell by 9.3% on concerns about a slowing economy particularly in the property sector.

Bond markets rallied on expectations that slower economic growth would moderate inflation concerns with US 10-year yields firming by 33 basis points and Australian 10-year bonds 60 basis points lower. Even though inflation data around the world continues to print at unacceptably high levels, the bond market rally in July seemed to reflect a belief that inflation would begin to moderate. Global central banks continue to raise cash rates as expected with the US Fed and the Australian Reserve Bank increasing cash rates by 75 points and 50 basis points respectively.

Commodity markets were generally weaker with crude oil falling 8.2% and iron ore down 17.5% on slower Chinese demand. The exception was natural gas which advanced an incredible 52.6% on expectations of supply shortages in Europe associated with the Russian Ukrainian war.

The Australian dollar firmed marginally against the USD due to healthy trade surplus to finish close to 70 US cents.

Earnings risk still the major challenge for markets

While the recovery in equity markets during June was pleasing, it was almost entirely driven by the rally in the bond market which improved equity valuations. The US second quarter reporting season showed that for the year ending June, earnings in the US improved by around 5% which was heavily inflated by strong energy company profits. Forward looking earnings expectations for Q3 and Q4 and into CY2023 are implying an acceleration in earnings growth which to us looks inconsistent with increasing macroeconomic headwinds.

The Australian reporting season is about to get underway and will be keenly watched especially for mining companies exposed to the lower bulk commodities prices. Similar to the US, earnings expectations for our market look too high especially for companies exposed to the global economy.

While valuation measures such as PE ratios look reasonably attractive at around 17.5 times earnings, our strong suspicion is that this is based on earnings that are likely to be negatively revised in coming weeks once analysts thoroughly review earnings results, outlook statements and meet with company management.

Investment Outlook

With the market undergoing a substantial correction in the first half of the year, many investors are wondering when the appropriate time is to buy into the market. While the “contrarian” approach of buying into a falling market (buy the dip) has often rewarded investors, this is a very simplistic approach which relies more on good luck than judgement as market troughs are very difficult to predict. While interest rates and bond yields do have an influence on equity valuations, over the full economic cycle company earnings are the primary driver of equity prices. As interest rates begin to normalise and money printing programs are unwound, it’s logical that improving earnings growth is a prerequisite for a stronger market going forward. With earnings likely to be negatively revised consistent with a weakening global economy, in our judgement it would be folly to buy into a market when earnings fundamentals are deteriorating. Once we see a stabilisation in earnings revisions, it will give us confidence that a sustainable upward trend in equity markets is likely to resume which would be the catalyst for high equity weightings in multi-asset portfolios.