Virtually all global equity markets were sold down in the first half of 2022 as markets worried about Central banks lifting interest rates to fight runaway inflation. The first six months saw the US Nasdaq drop over 30%, while the S&P 500 was down over 20%, its biggest first-half percentage drop since 1970. There was no safe haven in bonds, with both the US and Australian fixed interest benchmarks at one stage down around 13% since January. This was almost double the ‘famous’ bond bear market of 1994.
The US has now raised the Fed funds rate four times (including by 0.75% the last two times), with the Federal Funds rate sitting at 2.25% to 2.50%. The RBA has lifted the cash rate four times so far to 1.85% (including by 0.50% the last 3 times).
The concern for markets earlier in the year was that higher rates would tip many economies into recession, and we would end up with very low or negative growth with persistently high inflation, or stagflation like that in the 1970s and 80s.
However, the current feeling in markets is that a slowing US economy will result in the Fed either not raising as much as first thought or needing to quickly reverse policy sooner than previously expected. So at least for the moment, markets, and more particularly bond markets are more concerned with slowing growth rather than high inflation. The US 10-year government bond yield peaked at around 3.5% in mid-June while the Australian 10 year peaked just under 4.2% at the same time. This was also when equity markets bottomed, with the S&P 500 subsequently increasing around 17%.
The worries about growth have resulted in Australian equities also finally joining the global pullback after holding up early in the year. The Australian market benefited early on with our high weighting to resources seen as an inflation hedge. However, resources exposure is now seen as a negative as markets are worried about slowing growth or a recession in the US and Europe. The war in Ukraine caused a big spike in commodities prices but many of these (e.g., oil and copper) have pulled back on these growth concerns. In fact, industrial metals have suffered their worst quarter since the 2008 financial crisis.
The Australian dollar, at 75 US cents on 31 March is now trading below 69 cents, again reflecting global growth concerns as well as a US Fed that is seen as more aggressive in hiking rates. Australian equities have also bounced around 9% on the global rally but are still in negative territory for 2022.
The current RBA forecast is for Australian CPI inflation to reach 7.75% by the end of 2022 from the current 6.1% and to fall to 3% by the end of 2024.
The Australian economy grew by 4.8% in the calendar year 2021 which was the fastest growth in 23 years. However, this is forecast to be closer to 2% in 2023.
Global growth forecasts have been steadily revised down in 2022. The IMF for example downgraded its forecast for global growth in July to 3.2% in 2022 (from 6.1% in 2021). This is 0.4% below its April forecast. Growth in 2023 is projected to be even lower at 2.9%. Growth in China is likely to be closer to 3% this year than the official target of 5.5%, as it persists with a zero Covid policy.
When is a recession not a recession?
The US economy shrank at an annualized rate of 0.9% in Q2 of 2022, following a 1.6% drop in Q1, and technically entered a recession. However, there were 528,000 jobs created in July and the unemployment rate came in at 3.5%. As these figures are not consistent with a recession, the NBER (National Bureau of Economic Research) has not called a recession which requires a broader economic downturn than the current data suggest.
The good news is that US CPI inflation for July came in at 8.5%, unchanged from June and down from the recent peak of 9.1%. This was mainly due to a fall in energy prices. The producer price index (PPI) fell 0.5% in July to be up 9.8% from a year ago. This was the first fall in the PPI since April 2020 and again was due to lower energy costs.
‘Peak’ inflation in the US and lower bond yields have resulted in a strong rebound in equity markets. However, the jury is out on whether this is just a bear market rally with more falls to come down the track. In the early 1980s (the era of stagflation), it took 3 years and 2 recessions before the Fed was able to control inflation. In previous periods, the Fed has had to raise the cash rate to the level of inflation, to get inflation under control. Currently, expectations are for the US cash rate to peak around 3.6% in April of 2023, before gradually coming down. We would suggest that a peak cash rate at this level would be a good result, given how high rates have been hiked in previous cycles.
The thing that may hold the Fed back is the bond yield inversion that currently exists. The 2-year bond yield is trading above that of the 10 year by 0.3% to 0.4%. This normally signals an economic slowdown and is around 80% accurate in predicting a recession. This inversion first occurred in March 2022. Historically, the timing between yield inversion to recession has averaged around 13 months for the last 8 recessions.
In terms of the probability of a recession, the situation is probably worse in Europe than the US, while the probability seems lower in Australia. Germany, the largest European economy, is a special case in that they are dependent on Russian gas which has been weaponised by Putin. Germany’s producer prices (PPI) rose by 37% in the 12 months to July, driven by higher energy prices, posting the biggest increase ever recorded. The producer prices index rose 5.3% in July alone, the biggest month-on-month increase ever recorded.
Stock market and price-to-earnings (PE) ratios
We have had a lot of PE compression (which was expected) this year as cash rates and bond yields have been rising. The US S&P 500 PE fell from 21.5x earnings at the start of 2022 to a low of 15.5x in mid-June. However, the recent rally has seen the US forward PE move up to over 18x (which is above the 25-year average PE of 16.8x).
In addition, earnings expectations for this year and 2023 have been coming down slowly. We would expect this downgrade cycle to continue for a while but it is hard to estimate the extent of it. The other complicating factor is that markets tend to rise part way through one of these downgrade cycles, i.e., they anticipate improvements in earnings before analysts start raising forecasts. The Australian PE multiple was 12.9x the June 2023 estimates at 30 June 22, but is now closer to 14x after the rally. The major reason for the low multiple is that resource stocks are trading on very low PEs as there is an expectation that commodity prices will fall further.
Equity markets have bounced from the oversold levels in June but as a result are now less compelling, as they are trading close to long term average valuation levels (with added risk). We suspect we are probably in a trading range for a while until we get a better idea of how high cash rates need to go to get inflation under control. Markets seem to be expecting the US Fed to start lowering rates in 2023 but that is far from certain. They have not given any indication that they are going to pivot to a less hawkish stance. In fact, they have come out and jaw boned markets when they have got too exuberant. So, unless valuations improve again, or we get some resolution on inflation we are going to be pretty cautious going forward.
We continue to believe you should hold a mixture of equity styles such as Value/Cyclicals and Growth. While Value has been a huge winner so far in 2022, we expect this will turn unpredictably.