Themes For May

Following the sharp correction last month, equity markets were relatively stable during May. The US market was flat while the UK and China both improved by 1.3%. The Australian market declined by 2.6%, however, it has been a standout performer so far this year due to the strength in the commodity related materials and energy sectors improving by 1% compared to a 13% decline in the US market.

Australian 10-year bonds yields increased 22 basis points following the Reserve Bank’s decision to increase the cash rate for the first time since 2010 by 25 basis points. Early in June they followed this up with a surprisingly large 50 basis point increase as the RBA attempts to suppressed inflation before it gets embedded in the wage setting process. US treasuries were stable as the 50-basis point increase in the Fed funds rate was largely anticipated by the bond market as are two more 50bp moves in June and July.

The Australian Federal election produced a change of government as expected but had very little market impact with the incoming administration yet to announce any major economic reforms.

In commodity markets, supply shortages saw energy prices spike higher with the oil price up 12%, natural gas 10% higher, and thermal coal up 30% for the month.

Australian dollar improved marginally against the US dollar increasing by about 1 cent to finish it 72 US cents.

Paying a high price for policy errors

Tightening monetary conditions are providing a strong headwind for equity markets. Of the 37 major global central banks, 29 have increased interest rates in the past three months, a trend which is likely to continue for the rest of 2022. The failure to recognise nascent inflationary pressures in mid-2021 has put central banks well behind the inflation curve. Consequently, most will now have to play catch up by tightening policy aggressively between now and the end of the year. For the past 20 years central banks around the world had been very successful at maintaining inflation within a 2 to 3% band by acting pre-emptively to raise interest rates before inflationary pressures started to develop.

In 2021 the “emergency measures” designed to support the global economy during the pandemic flooded the financial system with liquidity through very low interest rates and money creation. Against the backdrop of severely constrained supply due to shutdowns, emerging inflationary pressures were shrugged off as being “transitory” as opposed to structural. This policy error was compounded by profligate spending by federal governments injecting massive stimulus to the economy with printed money which over stimulated demand creating a fertile environment for inflation.

The consequence of this is that we are facing sharp increases in interest rates to contain inflationary pressures that are now well above acceptable levels and embedded in pricing behaviour. Higher inflation expectations have been most notably reflected in bond yields which are now more than 3% in the USA and 3.5% in Australia. This has placed pressure on equity valuations with P/E ratios falling from around 21 times earnings at the start of this year to roughly 16 times earnings now. This contraction in earnings multiples has been the primary catalyst for the share price falls we have seen so far this year.

 The challenge going forward is the degree to which earnings expectations will be negatively revised as the market begins to anticipate the possibility of an economic recession. Monetary policy tends to influence economic activity with a lag of about 12 months meaning that the impact of the current tightening program will not be felt until the middle of 2023. Therefore, the risk to the market now is that earnings expectations are too high.

Investment Outlook

It is likely that equity market conditions for the balance of 2022 are going to remain difficult, so investors need to be realistic about returns for the balance of the year. In challenging times such as this it is important to focus on the medium to long term and maintain a well-diversified portfolio of high-quality assets. The cycle will inevitably turn and conditions will become more favourable as we reach the end of the monetary tightening cycle and earnings expectations shift to focus on an upswing in economic conditions.