A poor May Consumer Price Inflation (CPI) release in the US triggered significant falls in global equity markets. In a bid to control inflation, the Federal Reserve raised the target Federal Funds rate by 75 basis points on 15 June and indicated more rate rises to follow. So what have been the implications so far?
|Written by George Lin
Senior Investment Manager | Colonial First State
A rally in financial markets, with bond yields stabilising and equity markets rising, started in mid-May but faltered in early June. The retreat has since escalated with the publication of a poor US Consumer Price Index (CPI) result on 9 June. US consumer price inflation rose by 8.6% annually, with underlying core inflation rising by 6.0%. The details in the data are even more alarming than the depressing headline figures – inflation is increasingly broadly based, more entrenched and cannot be blamed on specific, one-off rises such as costs of air travel or used car prices. The poor inflation data dashed any hope of “Peak Inflation, Peak Rate” in the US – the idea that the Federal Reserve may “pause” after the June Federal Open Markets Committee (FOMC) meeting and adopt a wait and see approach before raising the Federal Funds rate further. Separately, the Reserve Bank of Australia (RBA) delivered its second rate rise in the cycle on 7 June, increasing the target cash rate by 50 basis points to 0.85%. Australian investors were surprised by the magnitude of the rate rise.
After the publication of the US CPI data, financial markets quickly priced in a 75 basis points tightening by the Federal Reserve. This quick repricing was assisted by the Wall Street Journal publishing an article suggesting that a 75 basis points increase was under consideration. Yields rose sharply – the US 10 year bond yield closed at 3.48%, while Australian 10 year bond yield broke through the 4.0% barrier and closed at 4.19% before the FOMC meeting. At the same time, equity indices fell significantly. As at end of trading on 15 June, the major equity indices have fallen by between 14% and 31% from their peak in early 2022.
Table 1: Drawdowns since peak in major equity indices as at 15th June 2022
|Peak to current (%)|
Paradoxically, the prompt repricing in financial markets over the past few days helped to blunt any short term, negative surprise from the rate hike. As expected, the Federal Reserve raised the target Federal Funds rate by 75 basis points to the range of 1.50% to 1.75% on 15 June. US equity indices rose immediately after the rate decision. The S&P 500 rose 1.46%, while the NASDAQ rose 2.50% overnight. In particular, yield-sensitive growth stocks staged a strong rally as US bond yields fell. US 10 year yield fell close to 10 basis points and closed at 3.29%. The All Ordinaries also rose modestly in the following morning’s trading session.
However the rally in equity markers was short-lived with markets falling the following day, the S&P 500 falling 3.3% and the All Ordinaries down 1.8%. Despite these falls, we are sceptical that equity markets have reached their lows in this cycle. The main reason is our view is that the Federal Reserve and the RBA will likely raise policy rates further over the next 12 months.
First, let’s look at the Federal Reserve’s position. While some investors took comfort from Powell’s post meeting comment that “today’s 75 basis point increase is an unusually large one, and I do not expect moves of this size to be common”; we highlight that Powell also stated unambiguously that the choice at the next FOMC meeting in July is between a 50 basis point rise or a 75 basis points rise. In any case, neither is a likely positive outcome for equities. Furthermore, the so-called dot points (the FOMC members’ forecasts of major economic variables) suggest further and rapid rise sin policy rates. The median forecast for the end of 2022 Federal Funds rate was revised upward from 1.9% in March to 3.4%. The forecast for the end of 2023 rate was increased by another 100 bps to 3.8%. The Federal Reserve is trying to play catch-up with markets and retain its inflation fighting credibility. Finally, the FOMC’s core inflation forecast for the end of 2022 was only increased by 0.2% to a comparatively modest 4.1%. This suggests to us that inflation risks remain biased to the upside and the Federal Reserve may have to raise rates even further than its published forecasts. Investors are rightly concerned that as the Federal Reserve continues raising rates, something in the US economy will break. We are already seeing early signs of cracks in the US economy and US economic growth will likely slow, as interest rates move higher. A US recession is an increasingly likely outcome in 2023.
The RBA is facing broadly similar dynamics as the Federal Reserve, but with a lag. Inflationary pressures in Australia are slightly less intense than in the US. The Australian labour market has not suffered the same level of dislocation as in the US. Nonetheless, the upward inflationary pressure in Australia is real. Inflation is driven by the similar combination of higher commodity prices, supply-side logistic bottle necks and a strong recovery in demand. The RBA will continue to raise rates in the hope of avoiding further economic pain in 2023.
The silver lining in the recent equity market corrections is that equities are becoming more attractively valued. However, on a longer term basis most developed equity indices remain reasonably valued rather than attractively valued. At some point in time, inexpensive valuations will lead to a recovery in equity prices. However, we believe it’s too early to call the bottom given the outlook on inflation and interest rates, and the increasing likelihood of a US recession in 2023.
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Colonial First State Investments Limited ABN 98 002 348 352, AFSL 232468 (CFSIL) is the issuer of super, pension and investment products. This document is based on the understanding of current regulatory requirements and laws as at June 2022. While all care has been taken in the preparation of this document (using sources believed to be reliable and accurate), to the maximum extent permitted by law, no person including accepts responsibility for any loss suffered by any person arising from reliance on this information. This document provides information for the adviser only and is not to be handed on to any investor. It does not take into account any person’s individual objectives, financial situation or needs. You should read the relevant Product Disclosure Statement (PDS) and Financial Services Guide (FSG) before making any recommendations to a client. Clients should read the PDS and FSG before making an investment decision and consider talking to a financial adviser. The PDS and FSG can be obtained from www.cfs.com.au or by calling us on 13 18 36. Past performance is no indication of future performance.