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Article | 12-minute read
To hike or not to hike? That is no longer the question.
May 2022
It’s not a matter of when; rather how high and how quickly rates will rise. Our Chief Investment Office discusses the implications for markets in the near-term and why there is still a case for equities over bonds in a rising rate environment.
Our View
If a week is a long time in politics, then a month can be an eternity in financial markets. After ducking behind terms including ‘patience’ and ‘transitory’ the Reserve Bank of Australia (RBA) and US Federal Reserve (Fed) have been forced out of hiding, humbled by rampant inflation.
Only a month ago debate raged about whether a 50bps hike from the Fed was warranted. A few weeks later that figure had shifted to 75bps with similar increases not discounted at future meetings. As it transpired the Fed shifted the policy rate by 50bps at its May meeting and cleared the path towards reaching a neutral policy rate (the level deemed to be neither contractionary nor expansionary) by year-end. While many market estimates have this figure sitting around 3%, others have it much higher - which may not be bad for equities over the short-to-medium term given it decreases the risk of the Fed taking rates too quickly into contractionary territory. That said, if neutral is reached by year-end it would mark one of the most abrupt shifts in Fed policy history and carry with it the risks that accompany such a sharp change - namely overtightening and plunging the economy into recession. It has been an incredible about-turn from the world’s most influential central bank.
Perhaps the only central bank looking more embarrassed is that of our own, the RBA, forced to eat humble pie after as recently as November 2021 it noted “…the first increase in the cash rate being in 2024”. Where little more than a month ago the RBA was preaching ‘patience’, last week it hiked the cash rate for the first time in more than a decade. Like the Fed, it too has set course for rapid fire tightening with many estimates of an official cash rate of between 1% and 2% expected by year-end.
There is a general assumption that rate rises aren’t good for equities as they drag on valuations - many equity valuation methods incorporate the discounted cash flow model whereby an increase in interest rates will also increase the discount rate. Therefore, if rates go up, stock prices must go down - or so the theory goes. Not always, particularly when the hiking cycle has started from a relatively low base as is the case now. In fact, four of the past five US tightening cycles have seen equities rise across the period. Rather, increasing rates tend to lead to aggressive sector rotations and increased volatility in the short-term. This is because rates aren’t the only factor impacting equity prices.
Cumulative returns over different time periods
Source: Dow Jones Market Data
Inflation is currently running hot. Much is made of the supply-side constraints; however, the reality is consumer demand remains incredibly strong owing to fiscal stimulus, record employment levels, increased household savings and near-zero borrowing costs. This has allowed corporations to pass increased costs through to consumers with earnings remaining relatively strong - for now.
Currently, the war in Ukraine is expected to increase inflation rather than damage growth prospects. We see inflation nearing its peak (but remaining elevated) in the US thanks to base effects, the continued reversion from goods to services spending and an easing of supply chain issues over the medium-term.
In short, it is the macroeconomic backdrop under which rates rise which is important. Rising rates alone doesn’t necessarily sound a negative signal for equities. If inflation can be brought under control without stifling the economy, then the macro environment should remain positive and equities are likely to remain supported by strong corporate profits.
Given much, if not all the hawkishness is already priced into markets, should inflation recede it could provide the Fed with some breathing room and allow the opportunity for another about-turn (dovish this time). If this occurs, equities could pop from their current lows.
As noted at the start of 2022, the unwind of the extraordinary fiscal and monetary policy unleashed at the onset of the pandemic will test central banks. As long as the impacts from the war in Ukraine, lockdowns in China, and eventual tightening cycle remain opaque; markets will remain volatile.
What this means for our diversified portfolios
We remain in a ‘wait and see’ mode. Many equity markets have hit or tested year-to-date lows in the past month. Given this, we believe the downside risk is somewhat capped in the near-term. We would likely need another exogenous shock or for the Fed to send the US into a dramatic recession by tightening too swiftly (something we see as unlikely anytime soon) for markets to capitulate.
Conversely, to upgrade risk we would need to see central banks roll over to a dovish narrative. Again, we are probably too early for that scenario.
As such, in a rising rate environment that is accompanied by strong inflationary pressures we see equities outperforming bonds. For that reason, we retain our very mild preference for equities and mild dislike for duration. We continue to monitor markets closely and remain in regular dialogue with our asset consultants and fund managers.
The Australian share market has been somewhat insulated from the global equity meltdown, primarily owing to its significant exposure to commodity heavyweights which have benefitted from the sustained strength in resource prices. This is perhaps best exhibited by a closer look at the index, where the ASX 20 has risen almost 4% over the year compared to a fall of more than 2% from the ASX 300 ex-20. On a year-to date basis, Australian shares have now outperformed global markets by more than 12%.
Despite this outperformance we are reticent to upgrade our current position from benchmark. We recognise Australian cyclicals should continue to outperform global cyclicals due to the high-quality assets, however, the value/resource trade may be nearing its peak and we prefer more defensive exposure at this time. Given the outperformance, we await any relative pullback from the domestic market and a better entry point before further considering an increase.
ASX 20 VS. ASX 300 EX-20 – 3 month performance
Bloomberg, ANZ PB&A CIO as at 30 April 2022
Global share markets bounced around again in April, testing yearly lows late in the month, as brief rallies were followed by slides and vice versa. Volatility has been a constant in 2022 and we don’t see it abating anytime soon as central banks embark on a path of quantitative and monetary tightening.
Equities have retreated largely due to the increasing inflationary pressures, which is reflected through rising bond yields. It is not all negative though. Even amongst this backdrop we remain somewhat constructive towards equities, particularly on a relative basis where we continue to prefer shares to bonds in an environment of strong inflationary and rising interest rate expectations. Amidst the turmoil in equity and bond markets, economic activity remains somewhat robust in the US (even despite a fall in Q1 GDP - where underlying detail showed private demand growth remains strong). Corporate and household balance sheets are well positioned to weather the forthcoming hiking cycle, unemployment levels are at decade lows and earnings results have largely been positive. Furthermore, inflation has likely peaked in the US, albeit from a 40-year high. While a prolonged conflict in Ukraine increases the likelihood of recession in Europe, the US appears sheltered to some extent, remaining susceptible to second-order effects should global growth slow materially and inflation broaden further.
With many equity markets near year-to-date lows we believe it would probably require another significant shock to push share prices materially lower in the near-term. The market is pricing for the Fed to undertake one of the sharpest tightening cycles in history. It will need to be aggressive to curb inflation, however, in our view this pricing is likely overdone. Rather, if inflation does recede in the coming months and the Fed strikes a more dovish tone this could provide a welcome boon for equities. We maintain our very mild overweight to developed market shares as a result.
DM Equities - April Regional Performance
Source: Bloomberg, ANZ PB&A CIO as at 30 April 2022
The zero-Covid policy in China continues to create headwinds for emerging market shares and although activity levels in some regions, including Shenzen and Guangzhou has bounced back quickly we remain cautious about the ongoing impact of lockdowns across Beijing and Shanghai. We would expect any normalisation of activity levels to be some months away and likewise any meaningful stimulus from the People's Bank of China to be delayed until such time.
Elsewhere geopolitical risks remain high due to the ongoing conflict in Ukraine and cyclical stocks could come under pressure, in particular across Latin America, where taxation laws threaten to place downward pressure on some miners.
Tactically we remain at benchmark this month despite the headwinds. Valuations continue to be attractive and on a medium-to-longer term basis we are constructive towards the asset class. We wait for an easing of these headwinds before considering an increase to our tactical positioning.
EM Equities – April Regional Performance
Source: Bloomberg, ANZ PB&A CIO as at 30 April 2022
Listed infrastructure and global real estate investment trusts (GREITs) outperformed global equities in April, the former now more than 12% higher than global equities on a year-to-date basis. GREITs are closer to 3% ahead over the same period. This outperformance from listed infrastructure has seen our position drift towards neutral while GREITs remain at benchmark.
Despite the recent outperformance, given the long-duration characteristics of this segment of the portfolio and our current mild dislike for duration we remain at benchmark overall with no compelling case to upgrade our position. Should the bond market normalise and our duration stance become more positive we may look to add to our holdings.
For now, the positions continue to provide a hedge against inflation, income for portfolios and important portfolio diversification.
Global Infrastructure vs. Global Equities
Source: Bloomberg Finance L.P., DWS Investment GmbH; as at April 2022
Following its introduction to portfolios at benchmark in March we retain this position again this month. Over the medium-term we believe US and European high yield should be better supported by sound fundamentals including low default rates and an attractive carry.
Although spreads remain attractive within the high yield market, the recent sell-off in bond markets has 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. We retain a mild dislike for duration and within risk assets continue to see better near-term potential in global developed market and Australian equities.
Bloomberg Global High Yield Corporate Stats Index
Source: Bloomberg, ANZ PB&A CIO as at 30 April 2022
Australian bonds yields continued to advance in April, the 10-year government bond yield breaching 3% for the first time since 2015, as short-term inflation expectations placed pressure on the local bond market.
The RBA has been humbled by the most recent inflation print which saw annual inflation reach 5.1%, its highest level in more than two decades. While still lagging global peers, the RBA was forced to hike the cash rate for the first time since 2010 at its most recent meeting. Markets continue to price a swift move higher in the overnight cash rate before year-end.
The additional pressure in April saw our mild overweight position drift to benchmark during the month. Despite the recent turmoil, we believe yields are close to topping out. 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. Due to this we hold onto our benchmark position to Aussie rates this month. Combined with a mild underweight to global fixed income this position is reflective of our current mild dislike for duration in portfolios.
10Y Australia Bond Yield
Source: Bloomberg, ANZ PB&A CIO as at 30 April 2022
The 10yr US Treasury yield continued to rise in April, narrowly falling shy of the 3% mid-month as talk of a 50bps rise in the policy rate increased to a potential 75bps of tightening. Fed officials have been forthright in their commentary, aggressively signalling an intent to tame the inflation genie. Even an unexpected contraction in Q1 US GDP late in the month wasn’t enough to drag yields materially lower.
The market is expecting a ‘neutral’ rate of close to 3% to be reached by year-end. We acknowledge the Fed will need to hike strongly, however, see it as unlikely to be as aggressive as current pricing indicates. Given the current hawkish speed and terminal rate priced in, some repricing or at least respite for the bond market may be in order.
We continue to prefer credit to sovereign bonds where valuations remain unattractive considering the inflationary environment. While yields are likely to see their peak in the near-term, we currently lack enough conviction to increase our position in global fixed income. Instead we maintain our mild underweight this month.
10y Australia vs US Treasury 10y
Source: Bloomberg Finance L.P., DWS Investment GmbH; as at April 2022
The Australian dollar weakened over the past month as the market’s focus shifted from a commodity super cycle to the relative pace of hiking cycles. With aggressive rhetoric from Fed members signalling an intent to finally reign in inflationary pressures, US yields shot higher, bringing the USD with it. However, having struck a more dovish tone than central bank peers, the RBA has now been forced to pivot quickly. With annual inflation jumping to 5.1%, following a 2.1% Q1 print, the RBA’s hand was forced and a more than decade long wait for a cash rate increase is now over. Strong commodity prices should continue lending support to the AUD in the near-term, particularly against commodity importers like EUR and JPY. Similarly, the boost to Australia’s terms of trade looks sustainable, and in turn should lift AUD fair value above current levels.
We remain mildly underweight the AUD within portfolios, continuing to express a preference for developed market foreign currency exposure (in particular the USD). This position is partly held to mitigate risk. In the event of any further equity market weakness an underweight to the AUD should provide some capital protection given its tendency to underperform in ‘risk-off’ scenarios.
Strong Commodity Prices are Supporting Australia's Terms of Trade
Source: ABS, Bloomberg, Macrobond, ANZ Research as at April 2022
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