Global Equities rebounded sharply in July as investor focus shifted from inflation to growth. In the U.S., data indicating a slowing economy has meant expectations of a larger-scale rate hike cycle have cooled, spurring a rally in both stocks and bonds. In developed markets, the MSCI World Index increased 8.0% over the month. US equities led global gains, with the S&P500 rising 9.2%, and the tech-heavy Nasdaq rallying 12.4%. In Australia, strength in financials and IT were offset somewhat by weakness in resources as the Iron Ore price declined, resulting in the ASX200 climbing a relatively smaller 5.8%.
Bonds also rallied over July as long-term growth expectations were reigned in, which saw bond yields decline significantly. In the U.S., the 10-Year Treasury Bond yield fell 33bps to 2.64%, down almost 1% from its peak of 3.5% in mid-June. The 10-Year Government Bond yield in Australia declined an even further 60bps to 3.06%.
Commodity markets softened in July as investors expressed concerns about an impending recession. The price of Iron Ore declined 17.5% to $US107, while the price of Brent Crude also fell 8.2% to $US110/bbl. In currency markets, expectations that the Fed will be able to slow the pace of interest rate hikes saw the US Dollar weaken. As a result, the Australian Dollar appreciated 1.5% to $US0.70.
The Fed – are we past peak hawikishness?
The Fed raised interest rates by 75bps in July, bringing the Fed Funds Rate to a range of 2.25-2.50%. This has broadly been estimated to be the neutral rate which is neither restrictive nor supportive for the economy. The economic assessment provided in Chair Powell’s speech was brief but acknowledged that recent growth indicators have softened while the labour market remains strong.
Given the above, the Fed has arguably reached a point where hikes in the coming months are likely to be smaller and much more reactive to incoming economic data. With two months until the next Fed meeting, there will be multiple data points for the committee to respond to, with growth rather than inflation readings becoming relatively more important. In fact, Chair Powell stated that the future policy path would depend on incoming inflation and labour data as well as the “evolving outlook for the economy”.
While guidance was vague, the reaction from the market was to interpret this dovishly, given it could be construed as a more forward-looking approach. All in all, signs suggest that the Fed is moving on from peak hawkishness as U.S. inflation rates start to fall. This might suggest that yields have peaked and that bonds offer some insurance against a potentially worse economic outlook.
What’s in the earnings?
Year to date, we have seen U.S. equities sell off, the yield curve invert, and the U.S. dollar strengthen on the back of rapidly rising rates and deteriorating investor risk appetite. The above, coupled with declining economic data, pose risks to corporate earnings.
Currently, the consensus expectations are for U.S. equities to deliver ~11%/9% earnings growth in 2022/2023, respectively, with cumulative year-to-date earnings revisions still in positive territory. However, the risk of an economic recession over the next 12 to 24 months has risen significantly. Does that mean there could also be a significant earnings recession that would further lower equity returns? Recent research from JP Morgan has reviewed the evolution of the year-on-year earnings growth throughout business cycles, covering eight recessions since December 1968.
Source: Bloomberg, NBER, J.P. Morgan Asset Management. Analysis starts from 12/31/1968 – 06/30/2022. The tables above indicate median trailing 12-month return experience 3m/6m/12m before recessions and 3m/6m/12m after recessions. Data are as of June 30, 2022.
The report concluded the following three things:
- Earnings growth is at best a coincident/lagging indicator—it reflects the weakness that has already occurred. Across the past eight recessions, the negative year-on-year earnings growth are typically coincident with recessions.
- Historically, leading up to a recession, the median year-on-year earnings growth experience has positively contributed to U.S. equity returns while valuations detract. It is not until during and after the recession has occurred that we start to see year-on-year earnings growth detract from returns.
- A closer look at the composition of U.S. equity returns in the ’70s and ’80s (when inflation was much higher) showed a much stronger detraction from the valuation component of returns. Earnings growth, however, was surprisingly resilient, with companies displaying an ability to pass on higher costs to the end consumers.
Applying the long-term findings to the current environment, we believe that earnings expectations may come down closer to mid-single digits. However, an outright earnings recession this year is unlikely.
We continue to believe that a cautious portfolio positioning with a neutral weight to global equities remains warranted. Nonetheless, the recent sell-off has markedly improved valuations across equities, with multiples now approaching long-term averages. However, some further weakness on the back of lower earnings and ongoing recessionary fears is plausible.
Fixed interest asset classes have seen both government bonds and credit yields increase in response to tightening monetary policy, as well as increasing chances of recession. Further declines in bond prices from rising rates (duration risk) have likely reduced, and corporate credit spreads have returned close to their long-term averages, even though default rates remain low. At these levels, introducing some duration back into portfolios seems reasonable, while corporate credit should remain a resilient source of income.
Core real assets such as real estate, infrastructure, timberland and transportation should continue to provide investors with both inflation protection and income. We also remain positive on various alternative investments and private market opportunities for downside protection and diversification of return streams in portfolios.
We continue to recommend that clients remain invested yet maintain some cash outside the portfolio, giving them dry powder when a better entry-point into risk assets presents itself. In times of market volatility, it is important to have a robust investment framework and focus on long-term investment objectives. If you would like to discuss the positioning of your portfolios, we encourage you to reach out to your Lipman Burgon Adviser.
We encourage you to contact us should you wish to discuss this further or if you have any questions about how these trends are impacting your portfolio.