Sovereign Wealth Partners and InvestSense Pty Ltd
Most equity markets ended March higher, despite, or perhaps even because of, the war in Ukraine, with Australia, the best performing market up by almost 6%. This was mostly thanks to Energy stocks and in Australia’s case Iron Ore prices as well as the other commodities that we produce. The local banks also made a meaningfully positive contribution as the economic outlook for Australia seemed to brighten – a combination of gathering economic momentum due to reopening as well as the prospect of being one of only a few commodity-rich democracies. The quarter was nevertheless the worst in 2 years with overseas markets down around 5%, Australia flat and the UK’s FTSE 100 the best performing major market behind gold, with returns of 2% and 4% respectively.
The one constant was the bond market, with yields rising consistently throughout the period except for a brief dip at the onset of the war. Mounting inflation pressures that, have only been exacerbated by the Ukraine War, have made it increasingly obvious that the Federal Reserve and other central banks are likely to have little choice but to ramp up rates quicker than they would have otherwise liked amidst a fragile recovery and even the growing prospect of an imminent recession.
Popular gauges that use metrics like energy prices and the slope of the yield curve put the probability of a recession sometime this year at around 50% which makes the stock market’s resilience all the more surprising. A so-called inverted yield curve (which the bond market has been flirting with in recent weeks) means longer-term yields are lower than short term yields, implying that rates are expected to fall in the future in response to very weak economic activity.
The initial falls in January and early February are most likely related to rising interest rates and inflation expectations in the context of moderating growth (higher rates mean the value in today’s money of future cash flows becomes less).
The strength of markets in March on the other hand is perplexing many market watchers. Prominent explanations include the flow effects of rotation out of particularly inflation-sensitive fixed income bonds into equities and maybe a sense of geopolitical relief that Xi Jinping might have become less likely to launch his own assault on Taiwan. The first explanation is supported by the performance of global sectors which saw typically defensive stocks like utilities, consumer staples and healthcare perform especially well. The latter explanation is also supported by the bounce in large and influential Chinese tech stocks in recent weeks although other emerging markets have done even better (Brazil is up some 15% this year).
Relative to their risk profile therefore, bond investors have had the worst of it this year as government bonds have fallen by similar amounts to global equity markets and high-grade fixed income credit has actually performed worse (down by 8-9%) as it has been subject to both interest rate rises and (so far) modest increases in credit spreads. In March 2020 similar falls were experienced but it was mainly due to corporate credit concerns. For government bond investors you would have to go back to the early 1980’s to have experienced anything similar in terms of short-term losses. That makes the lacklustre returns of minus 2-3% from many of the more actively managed diversified and floating rate bond funds since the beginning of the year a little more palatable.
It now seems clear that central banks are stuck between a rock and a hard place, and they are desperately hoping that inflation pressures subside before they are forced to take the kind of action that would precipitate a recession, or at least be seen to have done (it is possible a recession is already underway).
With a great deal of hindsight, it seems that the policy mistake was made last year but that is now spilt milk. That might seem to be an obvious cue to position defensively but as the last few weeks have shown second-guessing the market is fraught with difficulty and the flow/rotational effects described above can lead to unexpected outcomes.
For our part, we tend to position for the long term and try not to be surprised when markets quickly discount long-term risk premiums in a short space of time. We are keeping any eye on some of the long-term scenarios that could suddenly arrive on our doorsteps in the coming months. As well as inflation and rates we are also keeping a particularly keen eye on liquidity trends and credit markets (where all is reasonably quiet for now).