Article by Russell Investments

Global share markets fall

Global share markets fell further in the June quarter, driven by concerns that more aggressive central bank action in the face of persistently high inflation could derail the global recovery. In the US, consumer prices climbed a further 1.0% in May to be 8.6% higher for the year as a sharp rise in the prices paid for energy, gas and food continued to impact the cost of living. The outcome followed the 8.3% gain we saw in the 12 months to 30 April and marked the measure’s largest reading since December 1981. In response, the US Federal Reserve (Fed) raised interest rates by a further 0.75% (to an effective range of 1.50% to 1.75%) midway through June. The move, which was the Bank’s biggest rate hike in almost 30 years, came on the heels of a 0.50% increase in early May and sparked fears that higher and faster rate hikes could tip the world’s largest economy (and potentially the global economy) into recession. Compounding these fears were subsequent comments from Fed chairman Jerome Powell, who said that another 0.75% increase was on the table when officials next meet in July. He even went as far as to say that interest rates could rise by as much as 1.00% at any of the Bank’s forthcoming meetings should efforts to get inflation under control prove unsuccessful. Powell also acknowledged that higher interest rates could lead to a recession, though for now he believes the US economy is strong enough to withstand tighter monetary conditions. Elsewhere, record high inflation in the euro-zone saw the European Central Bank (ECB) confirm that it would raise interest rates in July. Annual inflation in the 19 countries that make up the euro-zone jumped 8.1% in May; well up on the 7.4% recorded in April and worse than the 7.7% outcome the market had anticipated. The ECB also said that it will cease its asset-purchasing program at the end of June. Meanwhile, in the UK, inflation surged 9.1% in the 12 months to 31 May, forcing the Bank of England to raise interest rates a further 0.25% (to 1.25%) – its fifth rate hike since December last year – and warn that the economy is likely to shrink 0.3% in the second quarter. Other central banks to raise interest rates over the period were the Swiss National Bank, Norges Bank (Norway), the Bank of Canada and the Reserve Bank of New Zealand. Stocks were also impacted by ongoing geopolitical uncertainty, with the European Union imposing additional sanctions on Russia in response to its invasion of Ukraine, and Finland and Sweden announcing their intention to join the North Atlantic Treaty Organisation (NATO) military alliance. The European Union’s latest round of sanctions included an agreement to cut around 90% of Russian oil imports by the end of the year, while the prospect of Finland and Sweden joining NATO, which currently comprises 28 European nations, the US and Canada, marks a significant departure from their policy of military non-alignment. NATO also formally classified China, which continues to back Russia’s invasion of Ukraine, as a threat to its interests, security and values, while the Biden Administration said it would ramp up the US’s military presence in the region. Sentiment was further impacted by Chinese growth concerns, with widespread lockdowns as a result of Beijing’s aggressive COVID-zero policy likely to make it difficult for the government to achieve its 5.5% growth target this year. Indeed, many analysts have already downgraded their 2022 China growth forecasts to around 3.0%. Encouragingly, though, we did see officials in Beijing and Shanghai begin to ease some restrictions toward the end of the period as the number of reported COVID-19 cases in the two cities fell. More broadly, stocks were also impacted by news that both the World Bank and the Organisation for Economic Co-operation and Development (OECD) had downgraded their respective 2022 global growth forecasts. The World Bank now expects the global economy to grow 2.9% this year, down on its previous forecast of 3.2%, while the OECD expects growth to slow to 3.0%; down sharply on the 4.5% it predicted just a few months ago. The global economy expanded 5.7% in 2021. Meanwhile, economic data was mostly disappointing over the period. The latest US growth figures showed the world’s biggest economy contracted 1.5% on an annualised basis in the March quarter. The outcome, which followed the 6.9% growth we saw in the final quarter of last year, was well below the 1.1% expansion the market had anticipated. We also saw softer-than-expected US consumer confidence and spending figures as well as declines in the latest euro-zone manufacturing and investor confidence data.

Limiting the decline was a series of robust US and European earnings updates. In the US, electric car maker Tesla, JPMorgan Chase and Johnson & Johnson all posted better-than-expected results, as did ConocoPhillips, Oracle and Proctor & Gamble. In saying that, there were some notable misses, including General Electric and major retailers Walmart and Target; both of which reported sharply weaker earnings on the back of rising labour, fuel and freight costs. We also saw some positive updates from French spirits group Remy Cointreau, Switzerland’s Nestlé and British oil giants BP and Shell. Stocks also benefited from further corporate activity; notably Tesla founder Elon Musk’s proposed USD44 billion acquisition of social networking platform Twitter. We also saw a Blackstone-led consortium offer EUR58 billion to take Italian roads and airports group Atlantia SpA private and Philip Morris International agree to buy fellow tobacco company Swedish Match AB for USD16 billion.

At the country level, all three major US indices – the benchmark S&P 500 Index, the Dow Jones Industrial Average and the tech-heavy NASDAQ – fell sharply over the period, with both the S&P 500 Index and the NASDAQ entering bear market[1] territory. Stocks were also lower in Europe, Japan and the UK, while China recorded good gains as the country finally began to emerge from government-imposed lockdowns. Australian shares tracked their global counterparts lower over the period, driven largely by the Reserve Bank of Australia (RBA)’s decision to raise interest rates in response to a further spike in inflation; the Bank lifting the official cash rate twice over the period. The local market was also impacted by steep declines across the major banks and miners, which together make up a large part of the index. The miners fell on the back of weakness across the broader commodities complex, while the ‘Big Four’ banks all posted double-digit declines amid concerns that rising interest rates will force lenders to set aside more money for bad loans. Stocks were further impacted by news of a security pact between China and the Solomon Islands and the ongoing uncertainty surrounding the war in Ukraine. Limiting the decline was news the local economy expanded further in the first quarter, with gross domestic product (GDP) for the three months to 31 March coming in at 0.8%. Stocks also benefited from some encouraging corporate updates from the likes of Woolworths, oil and gas producer Santos and industrial property giant Goodman Group.

RBA raises rates for the first time in over a decade

The Reserve Bank of Australia (RBA) raised interest rates twice over the period, taking the official cash rate from a historically low 0.10% to 0.85% as officials moved to combat rising prices. Headline inflation jumped 2.1% in the March quarter, while underlying inflation – the RBA’s preferred measure – rose 1.4%. For the year, underlying inflation hit 3.7%, which not only marked the largest annual gain since March 2009, but also put it well beyond the Bank’s 2-3% target range. The first move came in early May, with the RBA lifting interest rates by 0.25%; the first increase in the official cash rate since November 2010. The second rate hike came in early June, when the Bank raised interest rates by a further 0.50%; the steepest increase in 22 years. The latter move caught the market by surprise, with a majority of analysts having anticipated a 0.40% increase.

In its June post-meeting statement, the Bank recognised that inflation in Australia had increased significantly amid a combination of global and domestic factors; the latter including capacity constraints in some sectors and a tighter labour market. Officials said they expect inflation to increase further before falling back toward the target range next year. The Bank also acknowledged that the local economy has proven resilient, though officials noted the ongoing uncertainties surrounding the global economy; namely rising inflation, the war in Ukraine and the disruptions caused by COVID-19, particularly in China. Locally, one source of uncertainty regarding the economic outlook is how household spending evolves given the increasing pressure on Australian households’ budgets from higher inflation. Meanwhile, the Bank noted that the labour market remains strong, with the unemployment rate at its lowest rate in almost 50 years. The RBA concluded its June meeting by saying its second rate hike in as many months was a further step in the withdrawal of the extraordinary monetary support that was put in place to help the Australian economy during the COVID-19 pandemic. The resilience of the economy and higher inflation mean that this extraordinary support is no longer needed. The Bank said it expects to take further steps in the process of normalising monetary conditions in Australia over the months ahead. The size and timing of future interest rate increases will be guided by incoming data and the Bank’s assessment of the outlook for inflation and the labour market. Moreover, the Bank remains committed to doing whatever is necessary to ensure that inflation in Australia returns to target over time. [Note: the RBA raised the official cash rate a further 0.50% (to 1.35%) at its early July meeting, noting that inflation is forecast to peak later this year before falling back toward its 2-3% target range next year.]

The RBA has kept the door open for further rate increases of more than 0.25% in the future, though it appears likely that the Bank will raise interest rates by another 0.50% in August should June quarter inflation print above expectations. The labour market and consumer spending will remain the RBA’s key focal points. We maintain our view that market pricing of future RBA rate hikes looks too aggressive.

Australian economy expands further

The Australian economy expanded further in the first quarter of 2022, with GDP for the three months to 31 March coming in at 0.8% despite headwinds that included supply chain disruptions, the ongoing effects of COVID-19 and widespread flooding in the country’s east. The outcome, which follows the upwardly revised 3.6% expansion we saw in the December quarter, beat analysts’ expectations of 0.5% growth. Together, household and government spending accounted for much of the result. Household consumption was driven by increased spending on transport services, recreation and hotels, cafes and restaurants, while government spending was largely underpinned by healthcare-related costs associated with COVID-19 and the response to floods across New South Wales and Queensland. Partly offsetting this was a sharp rise in imports as businesses moved to restock amid an easing in some of the supply chain bottlenecks caused by COVID-19. On an annual basis, the economy grew 3.3%; well above market expectations of 2.9% growth.

Australian dollar falls

The Australian dollar (AUD) fell over the period, driven in part by the prospect of more aggressive rate hikes globally, expectations of softer Chinese growth and a sharp decline in iron ore prices. The AUD was also impacted by general US dollar (USD) strength; the USD making strong gains after the Fed moved to raise interest rates higher and faster than initially expected. Limiting the currency’s decline were multiple domestic rate hikes (and expectations of more to come) and encouraging jobs and retail sales data.

The AUD fell 7.9% against the USD, 1.7% against the euro and 0.6% against the British pound. It rose 2.7% against the Japanese yen, while the broader Australian Trade-Weighted Index[1] closed the quarter 2.8% lower.

Looking ahead

Recession fears and central bank tightening continue to drive market volatility. We believe equity markets are oversold and that US core inflation has likely peaked. In our view, this should help markets stabilise and possibly recover through the second half of 2022.

Markets have faced a laundry list of concerns so far this year, including Russia’s invasion of Ukraine, surging inflation, central bank tightening and the impact of COVID-19 on China’s economy. Our composite sentiment index, which measures investor sentiment for the US S&P 500 Index via a range of technical, positioning and survey indicators, reads as deeply oversold. This provides some reassurance that markets have accounted for the bad news so far and could recover if inflation and growth turn out better than currently feared. Of course, it is possible that investors will panic and reach a ‘sell everything’ capitulation point. The lesson from previous market corrections, however, is that periods of panic can provide the best opportunities for longer-term investors.

The main uncertainty is the outlook for the US economy. We believe the pace and magnitude of Fed tightening creates the risk of a recession by the second half of 2023. While a deep recession could trigger a larger equity bear market, we feel a slowdown or mild recession are the two most likely outcomes. The upside risk for the US economy and markets comes from the possibility that US core inflation has peaked. This, combined with some softening in the labour market, could allow the Fed to become less hawkish in the second half of the year.

We still prefer non-US developed equities over US equities. We believe non-US developed equities are relatively cheaper and likely to benefit from weakness in the USD should the Fed become less hawkish.

For fixed income assets, we think government bond valuations have improved after the rise in yields, with US bonds now offering good value. However, we still view Japanese, German and UK bonds as moderately expensive. A positive for government bonds is that markets have fully priced in hawkish outlooks for most central banks. In our view, this should limit the extent of any further selloff.

In the currency space, the USD has made gains this year on the back of Fed hawkishness and its traditionally defensive characteristics during the war in Ukraine. We believe the USD should weaken if hostilities subside and if lower inflation outcomes later in the year lead to less Fed tightening than markets currently expect. The main beneficiaries of a weaker USD are likely to be the euro, which has become more undervalued, and the Japanese yen, which has weakened on commodity price inflation and Chinese growth concerns.

The bottom line is that investors are worried about rising inflation, slowing growth and the potential for an aggressive Fed to cause a severe recession. We believe US core inflation can trend lower over the remainder of the year, but the key question is by how much. A sustained move lower would ease fears around excessive Fed tightening and a deep recession. However, until this becomes apparent, markets are likely to remain volatile.