The Interest Rate Tightrope

June 2022 Monthly CiN-sights

Major global equity markets ended flat after a turbulent May trading, bouncing off their intra-month lows as hopes inflation may have peaked boosted confidence. Whilst no surprise that central banks will continue to lift interest rates, this has seen valuations retreat, prompting some investors back into risk assets. During the month the S&P500 and the Nasdaq Composite both snapped a seven week losing streak, the longest since 2001. The S&P500 briefly flirted with bear market territory before closing the month unchanged, off 13.9% from its peak. The ASX200 was down 3% for the month.  

The Federal Election saw the Labor (ALP) party return to power for the first time in nearly a decade. At the time of writing they are set to govern with a majority, likely winning 77 seats. A majority will potentially provide the new Government with more fiscal flexibility in the face of monetary policy tightening. With inflation spiking, one focus of the election campaign was wages to address the cost-of-living squeeze, with the ALP supporting upward adjustments to combat these pressures on households. Their agenda has also signalled greater urgency in the change of Australia’s climate policy, which is supportive for our Carnbrea ESG model portfolio. 

Whether or not we have seen the peak in inflation, expect to see global Central banks continue to tighten monetary policy to combat the current multi-decade CPI highs. Unfortunately, these policy makers have been woefully behind the curve on the heightened global inflationary pressures and only now are being forced to react. The US Federal Reserve has conceded it will have to continue to take aggressive interest rate action to cool inflation, but their challenge with this policy is not causing a growth collapse. Economists expect consecutive hikes over the remaining five FOMC meetings this year, with some forecasting +0.5% at each meeting.

Even the dovish European ECB is expected to lift rates in coming months for the first time in a decade, as inflation prints at over three times their target rate and the region’s largest economy Germany, recorded an astounding 33.5% YoY increase in the April producer price index. Even excluding the volatile energy prices courtesy of Russian sanctions, the index still rose 16.3%. In the UK, the BOE seems to have been the most pragmatic with four consecutive hikes and the Governor stating that inflation could spike to 10%. The latest CPI data in the UK hit a 40 year peak of 9.0% YoY.

In Australia, the RBA’s May 0.25% increase in the official cash rate was the first hike since November 2010. Similar to their global peers, the board now expects more will follow as they lift their 2022 domestic inflation estimate to 6% and 4.75% for headline and core respectively. Most forecasters see interest rates at 1.5% by year end and circa 2.25% in 2023, which has led to GDP growth expectations for CY23 being pared back to around 2.25% from previous 2.5-2.75%. As global economic growth expectations have dimmed, not surprisingly the volatility has spilled over to the AUD. Having rallied to a 2022 high of 0.76 in early April as commodity prices spiked, the currency came under pressure through May as forecasters cut their global GDP estimates, particularly for China, our largest trading partner. Estimates for China’s CY22 growth have been slashed to approx. 4.0% from 5.0% as strict Covid lockdown restrictions have curbed activity, with one economist cutting their expectation to only 3% growth versus the official government estimate of 5.5%. This slowdown was evidenced by a surprise fall of 2.9% YoY in April industrial production, the first decline since March 2020. Combined with an understandable slump in retail sales and the ongoing concerns on the domestic property market, the PBOC unlike other central banks, cut its 5 year prime rate by 15bps to 4.45% to stimulate activity. The read through to global supply chains remains challenging.

AUD/USD Rate Over the Past 6 Months

As the US Q1 reporting season comes to a close, we have seen solid earnings growth for S&P500 companies of +9.2%. However, the commentary from several management briefings was weaker guidance into Q2, noticeably from some of the mega-tech names plus a highly challenging cost environment as seen with behemoth retailer Walmart (and Target). Retailers are experiencing a wave of pressures with fuel, staff and inventory costs all ratcheting higher in an environment where there is an inherent risk to consumer discretionary spending, courtesy of the income shock consequence of inflation. Strategists in the US have continued to reduce their year-end target for the S&P500, with estimates now in a range of 4,000 to 4,200. One analyst flagging that a recession in 2023 could see the index fall to 3,400.

As global equity markets reprice to now hawkish central banks, the continuing priority for investors is appropriate valuations in this period of rampant inflation and rising interest rates, coupled with the threat of a global growth crunch. Forward PE valuations have retraced, with the ASX200 now trading on circa 15.0x for FY23, albeit with a muted earnings growth outlook. In the US the S&P500 PE ratio has fallen to 17.0x, which is now below its 5 and 10 year average. We retain our current neutral weighting to US and EU equities and slight overweight to AU, which will be reviewed in our upcoming September quarter asset allocation due for release on July 1st.

Global Equities are More Attractively Valued After the Recent Sell-off

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