Themes For March

Equity markets recorded an impressive rebound during March clawing back some of the ground lost so far in calendar 2022. The Australian market returned a healthy 6.9% due to strong commodity prices which boosted our resource sector and led to substantial earnings upgrades for our major mining companies.

Overseas markets posted solid gains with the US market up 3.7%, the UK 2.5% and Germany 3.7% however the Chinese market fell 7.7% on news of a major COVID outbreak in Shanghai which threatens to curtail manufacturing activity.

A feature of financial markets since the Russian invasion of Ukraine has been the strength of commodity-based markets and currencies such as Australia, at the expense of commodity importing countries such as many European nations, and countries which pose geopolitical risks such as China. With no sign that inflation is abating, bond markets sold off with US 10-year treasury yields increasing by 51 basis points to close at 2.39% while Australian 10-year bonds increased by 77 basis points to finish at 2.86%.

Commodity prices were once again strong, particularly natural gas that was up 18.7%, iron ore up 8.1% while nickel was once again the standout base metal performer, up 29%. The oil price took a breather from its recent strong advance falling by 7% to close at just over US $105 dollars. Not surprisingly, the strength in commodity prices saw the AUD appreciate by 3.5% to finish at US75 cents.

 

Ukraine conflict likely to drag on

With no end in sight for the conflict in Ukraine, markets have become somewhat complacent about the potential economic consequences of the war. While the tough economic sanctions imposed by the West are certainly being felt within Russia, they seem to be no impediment to President Putin’s goal of annexing Ukraine to Russia. As mentioned last month, inflation is the major economic challenge confronting the global economy (particularly in the US) with higher petrol prices adding to already uncomfortably high inflation pressures. In addition to the recent 25bp rate rise, US Federal Reserve is likely to tighten in similar increments seven more times this calendar year. They are also likely to increase the rate of balance sheet run off to $95 billion/month to further tighten liquidity conditions. In their recent monetary policy statement, Australia’s RBA also signalled that higher cash rates are not far away with the first increase possibly as early as June, just after the Federal Election. The predicate for higher cash rates in Australia is confirmation of higher wage growth which seems likely given the tight labour market. Bond markets have reacted to the inflation outlook with long term yields rising again this month pushing returns into negative territory. The uncertain economic outlook in the US has resulted in less companies issuing positive earnings guidance the first quarter in 2022, which, in combination with higher bond yields, makes the recent market gains somewhat surprising.

The Federal budget handed down during the month provided some pre-election incentives but offered little in the way of the long-term structural reform that would influence asset markets. With neither major party focussed on reducing government expenditure, a return to a balanced budget is reliant on revenue from future growth and seems a long way off. A challenge for future governments will be how to manage the servicing burden of government debt approaching $1 trillion as lower coupon bonds are refinanced at higher rates.

 Investment Outlook

Events over the month have not changed our cautious approach to risk markets. While rising inflation and higher bond yields present valuation challenges for equities, we would expect improving economic conditions in the second half of the year to be supportive of corporate earnings. The uncertainty over events in Ukraine and their impact on energy prices and economic growth are unlikely to be resolved in the near term. The Australian market is fortunate to be a beneficiary of the current investment outlook given the strong representation of commodity producers which will attract attention from global investors. A further positive is that we are observing a high level of corporate activity in our market such as the recently completed takeover of Sydney Airports by a consortium of industry superannuation funds, together with active takeover proposals for companies such as Crown Resorts, Western Areas (nickel miner) and the asset manager Pendal Holdings. Corporate activity is a positive sign for the market as it highlights the long-term value these businesses offer at current valuations.

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