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Monthly Wrap: May 2022

Market thematics remained largely unchanged in May with concerns about high inflation and tighter monetary policies, particular in the US, continuing to drive markets. The Reserve Bank of Australia increased the cash rate and signalled more to come. Bond yields, after rising sharply since the start of 2022, showed early signs of stabilising. Equity markets continued to fall in the first half of May but rallied toward the end of the month. Most developed equity indices finished with modest losses in May.

       Written by George Lin
Senior Investment Manager | Colonial First State
   

Central banks tightened monetary policies and signalled more rate rises to come

May saw another round of central banks increasing cash rates. The Reserve Bank 0f New Zealand (25 May, +0.50%), the Bank of Korea (26 May, +0.25%) and the Bank of England (5 May, +0.25%) were among the central banks which increased cash rates. As usual, Australian investors focused their attention on the Reserve Bank of Australia (RBA) and the Federal Reserve (the Fed) in the US. Both raised cash rates as expected.

US inflation and its implication on US monetary policy continued to capture investors’ attention. The April US Consumer Price Index (CPI) data, released in early May, pointed to some signs that US inflation is at least peaking. Headline US CPI rose a strong 1.2% monthly rise in March and resulted in an 8.6% annual rate, slightly lower than April’s 8.2% matching consensus expectations. As expected, energy prices rose a substantial 11% on a monthly basis, due to significantly higher retail gas prices and higher electricity prices. Food prices also rose a strong 1.0% month on month, reflecting the disruption in agricultural markets since the start of the Ukraine invasion. Although the rise in Core CPI (which excludes food and energy) was softer than market consensus at 0.32%, it was largely driven by an unexpected large fall in used car prices which most analysts did not believe was sustainable. While the increase in goods prices seem to be moderating, investors were alarmed by the strong price rises in the service sector, with core service prices rising 0.60% monthly in April. Service price inflation, driven partly by labour market shortage, is now driving US inflation.

global policy rates
Source: Factset
US YOY CPI inflation
Source: Factset

The US CPI release was quickly followed by the Federal Open Market Committee (FOMC) meeting. As expected, the Fed increased the target Federal Fund rate by 50 basis points. It also announced a balance sheet reduction which will start on 1 June. The runoff in the Fed’s balance sheet will commence with a $30 billion per month cap on Treasury maturities and $17.5 billion per month cap on Mortgage Backed Securities (MBS) maturities, which will rise after three months to $60 billion and $35 billlion respectively. The post meeting statement left no doubt that the trajectory for cash rates is upwards, as the committee “anticipates that ongoing increases in the target range will be appropriate.”

The aggressive ‘front loading’ of interest rate increases by the Fed escalated concerns about US economic growth. Markets are increasingly concerned that at some point, the Fed will “break the economy”. Most economic indicators in the US are still pointing to healthy economic growth, albeit at a slower pace than in 2021. However, some small cracks have started to appear. Sales in newly built homes fell 16.6% in April from March to an annual rate of 591,000, the lowest level since April 2020. The fall is likely driven by the significant increase in mortgage interest rates. The average rate on a 30-year fixed rate in the US rose to 5.25% in late May, compared to 3.10% at the start of 2022. Indicators are also pointing to a tightening in financial conditions. Financial markets are divided on the prospect of a US economic recession over the next 12 months.

The RBA increased the cash rate target by 25 basis points to 35 basis points on 5 May. While the first rate rise since the COVID-19 crisis was widely anticipated by markets, the move signalled a significant pivoting to more hawkish monetary policy for several reasons. The RBA raised its 2022 central forecast for headline inflation to 6% and underlying inflation of around 4.75%, with the expectation for both to moderate to around 3.0% in 2024. Critically, the RBA emphasised “these forecasts are based on an assumption of further increases in interest rates”, signalling its willingness to raise interest rates further to lower inflation.

China in recession

While the rest of the world is struggling with rising inflation, China is facing the equally daunting but opposing problem of managing a drastic slow down in its economy. A slate of Chinese economic data, released in May, pointed to an economic slow down which is eclipsed only in magnitude by the early 2020 COVID-19 driven recession. Purchasing Manager Indices (PMI) fell below the critical level of 50, suggesting that both manufacturing and services sectors in China contracted in April. The services sector was particularly hard hit by the lockdown in various capital cities. Other economic indicators also confirmed the severity of the economic down turn. Industrial production fell 2.91% year on year in April, while retail sales plummeted by 11.1%, the second consecutive month of negative growth. An alarming anecdotal evidence is that not a single passenger vehicle was sold in Shanghai in April according to the local dealer association.

Chinese PMI
Source: Factset
China - major economic indicators
Source: Factset

The poor economic data alarmed Beijing, with authorities promising policy actions to revive the economy. After its reduction of Reserve Requirement Ratio (RRR) in April, the People Bank of China (PBOC) reduced its 5 year Loan Prime Rate (LPR) by 15 bps to 4.45% on 20 May. The official media also reported that PBOC and CBIRC, China’s banking regulator, jointly pledged to increase credit issuance and enhance financial support for key businesses and fields. In China’s highly regulated banking sector, this signals a central government’s push to revive bank lending, especially to industries worst affected by the lockdown.

Generally poor equity markets but bond yields have started to stabilise

After the sharp rise in developed market bond yields since the start of 2022, developed bond markets showed some early signs of stabilising in the last two weeks of April. The US 10 year bond yield reached a high of 3.13% in early May and drifted down to finish the month at USD $2.85. The Australian 10 year bond yield followed a similar pattern, reaching a peak of 3.53%, then declined to close at 3.34%. Shorter maturity bond yields also fell, but by a less pronounced margin, with the Australian 2 year bond yield closing at 2.52% while US 2 year yield closing at 2.54%.

What are the reasons for this pulse in rising bond yields? The aggressive anti-inflation rhetoric, backed up by equally aggressive rate rises, has produced a subtle change in investor sentiment. There are increasing concerns that higher interest rates will result in an economic recession, especially in the US. Technical factors also contributed to the relief rally in bond markets. At a yield of close to or more than 3.0%, Australian and US sovereign offer a comfortable coupon buffet even if interest rates rise further and a relatively attractive insurance policy against falling equity markets in the event of a recession.

10 year government bond yield
Source: Factset
Main equity indices
Source: Factset

Equity markets generally had a volatile but modestly negative May, despite a strong rally in the last week of the month as bond yields stabilised. Investors remained alarmed by the prospect of higher inflation and rising bond yields. Concerns about economic recession also harmed equities, as investors focused on the prospect of slower earnings growth. US equity markets, with its large share of highly valued technology stocks, underperformed. The S&P 500 fell 0.01%, while the technology dominated NASDAQ fell by 2.05%. Since their respective peaks, the S&P 500 has fallen by 13.9% and NASDAQ by 24.8%. Hong Kong’s Hang Seng outperformed with a 1.54% rise, although it is still a noticeable laggard over the longer term. In a case of “bad news is good news”, investors were encouraged by tentative signs of more accommodating Chinese economic policies. Australia’s All Ordinaries Index fell by 3.49% in May. AREIT led the market down with a 11.6% fall in May.

 

Table: Drawdowns since peak in major equity indices
  Peak to current (%)
S&P 500 -13.9
NASDAQ -24.8
EuroSTOXX -13.3
Hang Seng -31.1
All Ordinaries -5.95

Source: Factset

Forward looking views

Given the sharp rally in global equity prices in the past two weeks, a top of the mind question for investors is whether equity markets are at the end of a technical correction? Supporters of this thesis point to the attractive opportunities in some US technology names after the recent sell off, as well as the stabilisation of bond yields. While we agreed that valuation in equities has improved, we have reservations about calling the bottom in global equity markets - at least at this point in time.

The key is the direction of US inflation and global bond yields. Valuation in bonds has improved due to the sharp rise in global bond yields. Future markets have priced in a target Federal Fund rate of 3.0% to 3.25% by March 2023 – an aggressive level which suggests limited upside surprise.. Our concern is that US inflation will not decelerate sufficiently to allow the Fed to declare victory and pause in early 2023. US core inflation will fall but may remain above the Fed’s target of 2.0 to 3.0% by the end of 2022. The driver of this stubbornness in inflation will likely be higher commodity prices (in both energy and agricultural), supply chain issues which are taking longer than expected to ease, and an overheated US labour market.

Overall, equity market valuations have unquestionably improved. But is this sufficient? The charts below plot the current valuations of various equity indices versus their 20 year history. On a trailing 12-month price earning basis, most of the major indices are around their long term median, with the noticeable exception of the Hang Seng. On a forward-looking price earning basis, valuations for S&P 500, NASDAQ and to a lesser extent the ASX are still above their long term median. Furthermore, if one expects a marked economic slowdown, it seems reasonable to expect actual earnings to miss forecast earning. While the equilibrium value of price earning ratio is always open to debate, using a simple 20 years average valuation suggests that it is unclear if the equity market valuation has fallen sufficiently.

Trailing 12 month
Source: Factset
Forward 12 month
Source: Factset

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