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Growth in focus as inflation fears recede
May 2022
At the start of the year our Chief Investment Office forecast a volatile year for markets as stimulus measures were withdrawn.
Markets have subsequently whipsawed from one issue to the next. With peak inflation seemingly reached in the US, investor attention has turned towards growth and whether the Fed can ultimately engineer a ‘soft landing’. Our Chief Investment Office discusses the outlook further.
Our View
Tenzing-Hillary Airport in Nepal is home to arguably the world’s most dangerous runway. Situated on a cliffside between mountains, it’s a mere 527m long, and drops straight into an abyss, leaving no option to abort take-off or landing. Further complicating the matter is the speed at which planes must land. The gateway to Everest, as it’s otherwise known, sits almost 3,000m above sea level. The greater the altitude, the lesser the air density — meaning planes need to touchdown at faster speeds. With little room for error, engineering a soft landing is no mean feat.
The US Federal Reserve (Fed) currently faces a similar predicament. A looming monetary and fiscal cliff is compounded by a need to slow inflation without bringing growth crashing down. This is made more difficult by the way markets are digesting headlines. Seemingly good news is perceived as bad news and bad news as good news. Just last week, equity markets fell on better-than-expected PMI numbers and subsequently rallied a day later following weaker employment growth.
The reality is the market is swinging wildly on changing economic data as analysts assess how high and how quickly the Fed will ascent — each day presenting new headwinds. Where inflation was the main concern only a few weeks ago, now growth is the primary focal point.
Following a desynchronized global recovery, a synchronized slowdown is now underway. Globally, PMI numbers have continued to trend downward. And although the US surprised to the upside last week and most countries remain in expansionary mode (a figure greater than 50), data prints are well below the highs of 2021. Recession risks have increased according to market commentators, with a 40 per cent probability of recession before the end of 2023 now accepted by most.
The possibility of peak inflation has also brought with it a greater chance of dovish surprises. Bond market volatility has tempered recently, an environment that equities could benefit from. Sentiment is incredibly bearish and positioning the most defensive since the onset of the pandemic. With so much negative news priced into markets it may take only a small amount of good news for equities to gather momentum once more. And China’s zero-COVID policy, the Ukraine conflict, and a slew of economic data provide plenty of opportunity for this.
Clearly risks remain skewed to the downside. Even so, consumption remains strong, employment robust and household balance sheets in the US now hold more cash than debt for the first time in three decades. While these provide a strong starting point to stave off recession, they also mean the Fed may need to attempt a soft landing at even greater speed. Part of the predicament lies in what is driving inflation — supply or demand. Monetary policy is a blunt instrument and if inflationary pressures prove to be predominantly supply-side driven then rates are unlikely to have the desired impact, increasing the potential for the Fed to push too hard and crash into recession. While the runway and margin for error available to the Fed has shortened, no recession remains our base case. Engineering this outcome will be no mean feat.
Purchasing Managers Indices (PMI)
Source: Bloomberg, ANZ PB&A CIO as at 31 May 2022
What this means for our diversified portfolios
At the start of the year, we forecast significant volatility and a more difficult environment for returns. While the pullback in markets has surprised us somewhat, the level volatility has not, and we have positioned portfolios for this environment. Buying the dip or selling the rally may seem appealing, however, we continue to advocate for a long-term and diversified investment strategy when navigating volatile markets. Significant drawdowns are often followed by sharp sustained recoveries and timing this is extremely difficult.
Bond markets are more appealing following the sell-off in recent months, yet inflationary pressures persist, meaning real returns from this segment are likely to remain negative for now. Equities should still provide a better possibility of real returns in this environment. As such, we remain in ‘wait and see’ mode for another month and retain a very mild overweight to risk assets, expressed via a modest overweight to developed market equities and mild underweight to duration and global bonds.
To upgrade risk, we would need to see further evidence of a peak in inflation, stability in China or some solidification of corporate earnings. Conversely, to downgrade risk we would need to see growth hit more sharply, either through weakening PMIs or corporate earnings. If inflation proves more stubborn than currently expected this could also increase the case for a risk-off stance.
Following substantial outperformance over the start of 2022, the domestic market underperformed global indices in May. Having benefitted from strong commodity prices, the Australian market was once again held up by materials and energy stocks during the month as most other sectors fell more than one per cent — the ASX 20 outperforming the ASX 300 ex-20 by more than 2.5% in the process.
With the price of iron ore expected to fall sharply in 2023, and the value/growth differential at month-end standing at more than 18% year-to-date, it widens the possibility of future underperformance from the domestic market should the value trade fade and commodities weaken.
Portfolios are positioned at benchmark to Australian shares with a preference for more defensive assets within the equity bucket — specifically global developed market shares.
ASX 20 vs. ASX 300 ex-20 – May Performance
Source: Bloomberg, ANZ PB&A CIO as at 31 May 2022
Global equity markets finished May broadly flat, masking the continuation of extreme volatility that’s pervaded financial markets since the start of 2022. After a solid start to May, the S&P 500 briefly flirted with a bear market mid-month. A sharp rally into month-end followed, as mostly upbeat earnings guidance and solid economic prints provided hope that the Fed would succeed in bringing inflation under control without taking the economy into contractionary territory. At month-end almost 80 per cent of companies in the S&P 500 had beat consensus expectations and May’s US PMI showed an economy that was gathering momentum.
Sentiment remains incredibly weak and positioning bearish. Given this, and that much of the recessionary risk is seemingly priced into markets we look for any positive surprise as a potential boost for equities. A quicker resolution to the Ukraine conflict, inflation retreating faster than expected, dovish tones from the Fed or earnings gathering momentum could all result in a surprise to the upside. Conversely, weaker PMIs or further downgrades to earnings might push equities lower but we would likely need to see another exogenous shock to push them down materially. It’s worthwhile remembering that the US labour market is incredibly tight and while rising rates may impinge on consumer spending, household balance sheets remain in rude health at this time.
As such we maintain our mild overweight to developed market equities relative to emerging markets and domestic shares. Quality and defensive stocks with high dividend yields, pricing power and stable margins should perform better in this environment.
Developed Markets – May Regional Performance
Source: Bloomberg, ANZ PB&A CIO as at 31 May 2022
Emerging markets could have turned a corner in May, as restrictions from China’s zero-Covid policy were eased and economic activity, despite remaining in contractionary territory, began to tick-upwards once again. The near-term growth outlook remains weak in China and any meaningful change is probably still some months away. With limited ability to stimulate activity via monetary policy, fiscal support looks to be the tool of choice to reignite a spluttering Chinese economy — significant tax cuts and infrastructure spends are likely.
Despite the promising signs, it is still too early to upgrade our stance to emerging markets. China remains susceptible to further lockdowns, the global outlook for rates appears bleak and although having potentially reached peak strength, the USD remains strong (EM historically has a strong inverse relationship to the dollar). Furthermore, geopolitical risks remain elevated throughout emerging markets, both in Ukraine and closer to home.
Tactically we remain at benchmark this month. Valuations are attractive and on a medium-to-longer term basis we are constructive towards the asset class. Should the recovery in China stabilise further we may look to increase positioning.
Emerging Markets – May Regional Performance
Source: Bloomberg, ANZ PB&A CIO as at 31 May 2022
Listed infrastructure continued to provide strong returns in May, outperforming both global real estate investment trusts (GREITs) and equity markets. This further widened the gap in year-to-date performance (+ 13% relative to both) and resulted in a drift upwards towards benchmark.
GREITs have performed broadly in line with global shares on a year-to-date basis and having fallen more than 12% since the start of the year are beginning to look attractive on a valuation basis once more. If rates volatility reduces in the coming months then GREITs (which have long-duration characteristics), may become more enticing.
Much like global bonds we are not quite at the point of adjusting our duration call yet and therefore remain at benchmark to both GREITs and infrastructure. Listed real assets continue to provide a hedge against inflation, valuable income and diversification to portfolios.
GLOBAL INFRASTRUCTURE VS. GLOBAL EQUITIES
Source: Bloomberg, ANZ PB&A CIO as at 31 May 2022
We remain at benchmark to high yield this month, continuing to favour global developed market equities within risk assets and retain our very mild dislike for duration.
High yield typically performs well in an environment of both moderate growth and inflation. Strong economic growth and low inflation followed the depths of the pandemic and we are now entering a period of weakening growth and higher sustained inflation. Despite very attractive valuations, high yield spreads appear tactically vulnerable to weaker fundamentals including slowing growth, fading central bank liquidity and a recession tail risk which would provide a possible backdrop for higher default rates. Moreover, recent moves in bond markets have seen the yield on government bonds (which are accompanied by a lower risk profile) increase to the point that the risk premia is not enticing enough to increase our position at this time.
Bloomberg Global High Yield – Option Adjusted Spread to Treasury
Source: Bloomberg, ANZ PB&A CIO as at 31 May 2022
Bond yields trended sideways in May, briefly popping early in the month before retracing into month-end. Domestically, the economy remains in a strong position. Unemployment is at a 50-year low and PMIs remain expansionary, albeit slowing. Data released earlier this month saw solid GDP growth, which accompanied by significant wage pressures, forced the Reserve Bank of Australia (RBA) to increase the cash rate by 50bps — the largest hike since February 2000. The market is currently pricing another 230bps of tightening before year-end. We expect significant tightening but view this as too aggressive.
We retain our benchmark to Aussie rates this month. The Australian bond market has a lower duration profile than the global market — where we remain mildly underweight. When considering our portfolio construction this provides a mild underweight to duration as a whole and with the local market having suffered more than global peers in recent months it could provide better upside potential if yields revert in the near-term.
10Y AUSTRALIA BOND YIELD (%)
Source: Bloomberg, ANZ PB&A CIO as at 31 May 2022
Global yields have begun to stabilise after a period of significant volatility. Like the Australian market, the 10yr US Treasury yield tracked in a mostly sideways manner over May and may be entering a period of range-trading after rising sharply through March and April.
While yields are attractive at present, inflation remains strong and therefore any real gain is likely to be limited based on yields only. The Fed continues to signal a hawkish intent, and while market pricing has come back in recent weeks, we believe this is still overdone and some repricing is likely to eventuate before year-end. This combined with attractive yields could provide sound real returns in time.
For now, we maintain our mild dislike for duration and global bonds. We await further evidence of inflation peaking and an easing of pressure on the Fed before we consider a shift towards neutral.
10Y AUSTRALIA VS US TREASURY 10Y (%)
Source: Bloomberg, ANZ PB&A CIO as at 31 May 2022
The AUD is currently being influenced by two key factors — USD strength and the global growth outlook. On the one hand, USD outperformance appears to be topping out with Fed hawkishness having likely peaked for now. This has kept a floor under the AUD recently. Opposing this is the deteriorating outlook for global growth as PMIs and Fed surveys demonstrate the supply side pressures constraining manufacturing. COVID lockdowns in China continue to weigh on consumer and producer activity — albeit lifting in May — and this is impacting key industrial commodities. The global growth outlook is clearly impacting risk appetite. Conversely, in Australia, the economic recovery remains strong with unemployment sitting at fifty-year lows, GDP growth robust and wage pressures lifting — ultimately forcing the RBA to hike by 50bps in June.
Yields across the overnight indexed swap (OIS) curve fell through May as the global path for rate hikes was recalibrated. However, post the June RBA meeting, market pricing once again shifted higher — a further 230bps of hikes priced in by the end of 2022. In our view, this remains aggressive and provides a decent window for disappointment. As such, we have marginally downgraded our year-end forecast for the AUD.
Within portfolios we remain mildly underweight the AUD, continuing to prefer developed market foreign currency exposure. The position should provide some capital protection in the event of weakness across equity markets.
Market pricing – RBA Policy Rate
Source: Bloomberg, RBA, ANZ Research as of June 2022
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