Themes For June

Equity markets were sharply weaker in June to rule off what has been a forgettable first half of calendar 2022 as markets have struggled in the face of higher inflation and rising bond yields. The Australian market was down 8.8% for the month and 6.5% for the financial year. Most other global markets followed a similar pattern with the US down 8.3%, Europe 8.5% and the UK 5.2%. China bucked the trend improving by 6.7% as COVID restrictions in Shanghai were eased following a strict lock down.

Bond markets were marginally weaker with Australian 10-year bond yields increasing 32 basis points to 3.66% and its US counterpart closing 13 basis points higher at 2.98%.

As expected during the month the US Federal Reserve increased the Fed funds rate by 75 basis points and the Reserve Bank followed suit increasing cash rates by 50 basis points. It is likely global central banks will continue to increase rates until they are satisfied that inflation pressures have started to moderate. The US dollar strengthened against most major currencies reinforcing its safe-haven status, with the Australian dollar falling 4.1% against the greenback to finish at US68.8 cents.

In commodity markets, oil fell by 7.8% on the expectation of lower demand due to weaker economic conditions, the iron ore price was 2.3% weaker as were most base metals with copper down 11% and aluminium 15%.

The party may be over for crypto currencies

While the recent fall in traditional investment markets has been significant, crypto currency markets have been severely hit, falling some 70% from the highs of late last year. While early investors in crypto are still well in the money, more recent converts are sitting on substantial unrealised losses.

Promoters of crypto currencies like Bitcoin are quick to emphasise benefits such as a low correlation to equities, a safe haven in uncertain times (digital gold) or as an effective inflation hedge. Unfortunately, in recent times they have failed to demonstrate any of these qualities which raises the question as to what exactly is the intrinsic value of crypto – if any? It’s often said that crypto currency is part currency, part commodity and part cult given the zealous band of devotees it has attracted.  What is clear is that crypto prices have been inflated by plentiful liquidity, courtesy of profligate central bank money creation fuelling rampant speculation amongst the enthusiastic crypto investing community. With central banks now turning off the money spigots and unwinding balance sheets, crypto prices can no longer rely on this tail wind to boost demand. While Bitcoin was the trail blazer in this space, there have been a plethora of other crypto currencies available that are all substantially unregulated by government securities agencies.

The founding principle behind Bitcoin is quite sound, a digital currency with a maximum of 21 million coins that can be “mined” that cannot be diluted in value by increased supply. This is in stark contrast to the enormous amount of monetary creation by central banks since the GFC in 2008 which accelerated in response to the pandemic in early 2020. This has substantially contributed to the inflationary problems we are now experiencing and debased the value of government issued “fiat” currency. Rather than being intermediated by the traditional banking system, crypto currencies are a form of person-to-person financial exchange with transactions recorded in an encrypted digital ledger driven by the innovative “blockchain technology”. Whereas fiat currency is explicitly backed by the “full faith and credit” of the issuing government, crypto relies on the mutual acceptance of its value between the counterparties to the transaction. To date most of the demand for crypto has been driven by blind speculation which tends to become self-fulfilling but can unwind very quickly with a change in sentiment. The real long-term driver of demand will be if it gains traction as a legitimate form of exchange for goods and services and for cross border trade. While there has been some evidence of this such as Tesla accepting Bitcoin for electric vehicle purchases, crypto currency cannot efficiently process high volumes of transactions and the process of mining new coins is incredibly power intensive.

A significant hurdle ahead is the inevitability of regulatory risk. It is simply inconceivable that governments will allow an unregulated form of digital currency to supplant fiat currency as it would severely impair their ability to manage the financial system. Possible regulatory measures include taxes on fiat to crypto conversion, capital controls or outright bans as is the case in China. Crypto exchanges and advisers will also be subject to prudential supervision. A further threat is that central banks are developing their own forms of digital currency which will have the advantage of both being regulated and carry an explicit government guarantee. While crypto will retain popular appeal for speculators, its intrinsic value derived from its use as an alternative form of currency is likely to be limited.

Investment Outlook

The decline in equity markets that we’ve seen so far in 2022 has been almost entirely driven by the increase in bond rates due to higher inflation. As the chart below shows, earnings expectations have been remarkably stable over this period and were only modestly revised lower in the June half year. This seems to be factoring in more buoyant economic conditions than are likely to occur.

With the focus of policy now directed towards suppressing demand, the challenge for markets going forward will be how to cope with the likelihood that earnings will be negatively revised consistent with slowing economic activity and a possible recession. Signs that growth is slowing will be positive for the bond market but negative for earnings revisions. The challenge for policy makers is to reduce the level of demand without inducing a severe recession. This is made even more difficult by the fact that monetary policy is a blunt tool not a fine-tuning instrument. It is likely that equities will be subdued for at least the next couple of months until it’s clear that tighter policy is having an impact on inflation. While a firmer bond market will provide some valuation relief, we would need to see a positive earnings revision trend before committing more equity risk to multi-asset portfolios.