Outlook for Investment Markets
The global economic outlook has become more difficult. Inflation has proved to be a bigger problem than expected, and financial markets are now more concerned that central banks, in their efforts to bring inflation down, may raise interest rates to the point where they choke off the post-coronavirus cyclical recovery of the global economy (excluding China, where lockdowns have been slowing its economy).
Geopolitical risk also remains elevated: Ukraine’s doughty defence was good news, but more recently Russia has upped its offensive in eastern Ukraine, and the ultimate political, economic, and financial outcomes are still very unclear. In the meantime, the war-related disruptions to commodity and energy markets have furthered boosted short-term inflationary pressures and added to the residual supply chain issues caused by the pandemic. Both local and global bonds (wary of higher interest rates) and international equities (wary of a weakening economic cycle) are down for the year, although Australian shares have been a welcome exception, helped by the miners and the banks. The near-term outlook is unlikely to support any quick turnaround. In an environment of higher than usual uncertainty, prudent portfolio diversification remains key, including exposure to more-defensive sectors and inflation hedges.
Australian Cash and Fixed Interest
Short-term interest rates have increased modestly, and the 90-day bank bill yield is now just over 0.3%, up 0.25% this year. Long-term interest rates have risen more significantly, and the 10-year Commonwealth bond yield is now just over 3%, a 1.4% increase for the year. The Aussie dollar has appreciated year to date and is up 4.6% in overall value. On its headline cross rate against the U.S. dollar it is up 2.8% to 74.6 U.S. cents.
Up to April, the Reserve Bank of Australia had been stressing that it was prepared to be patient about eventual rate increases, but the minutes of its April meeting said that assorted developments, notably the recent pickup in inflation, “have brought forward the likely timing of the first increase in interest rates”. Some forecasters are still of the view that this means a modest, gradual process.
National Australia Bank, for example, sees the RBA’s target cash rate at 1% at the end of this year, compared with its current 0.1%. The futures market has a significantly more activist track in mind, and expects short-term rates to be more like 2% higher by the end of this year, which would not be surprising given the unexpected strength of recent inflationary pressures.
Forecasters currently expect some appreciation of the Aussie dollar to anywhere between 75 cents (ANZ) and 80 cents (NAB) by the end of this year. If they prove to be right, the likely drivers will be a reasonably rapid schedule of cash rate hikes from the RBA, and an ongoing boom in Australian commodity prices, which in March were 42.7% up on a year ago in Aussie dollar terms (on the RBA’s index). But not all the moving parts are aligned: The Fed is on its own significant tightening path, the ongoing war in Ukraine is not helpful for currencies like the Aussie that tend to do better in less unsettled times, and countries like Australia will be affected by the current slowdown in the Chinese
economy. Stability, or an appreciation at the lower end of the forecast’s range, could well be on the cards.
Australian shares have bucked the global bear market and are modestly ahead for the year. The S&P/ASX 200 Index has made a small capital gain of 1.1% and delivered a total return including dividends of 2.6%. The booming resources sector has been an important contributor: The S&P/ASX 300 Index of metals and mining is up 17.4%, and the heavy weighting in the benchmark index of the banks has also helped, as the financials ex the A-REITs are up by 4.0%. At the weaker end, the IT sector is down 17.5% and consumer discretionary stocks are down 14.5%.
At its April policy meeting the RBA was upbeat about the economic outlook: “The Australian economy had been resilient in the face of global and domestic supply shocks, including the war in Ukraine, the Omicron outbreak and the floods along Australia’s east coast. Policy settings remained supportive of the recovery and national income had been substantially boosted by the large increases in commodity prices; it was likely that the terms of trade would exceed previous highs. Overall, the growth outlook remained positive for this year and next”.
Business surveys tend to support this view. The Ai Group’s activity March indexes for manufacturing, services, and construction showed all three sectors growing (growth accelerated in construction and manufacturing, while services grew a bit more slowly). And the March National Australia Bank business survey found that “Business conditions surged higher in March and confidence also strengthened. Trading conditions and profitability rose markedly, suggesting demand remains strong, and employment also rose”. The Westpac/Melbourne Institute leading indicator, which aims to get an early read on the activity outlook over the next three to six months, also strengthened in March, with Westpac commenting that the data “are consistent with Westpac’s upbeat view of the growth momentum in the economy for most of 2022”.
If there is an issue on the horizon, it is around consumer spending. The recent weakness of consumer discretionary shares mirrors households’ wariness: Consumer confidence on both the Westpac/Melbourne Institute and ANZ/Roy Morgan indexes remains low, with families evidently feeling pressured by the prospect of higher interest rates and by the impact of inflation on their purchasing power. In the ANZ/Roy Morgan poll, for example, only 13% of respondents expected “good times” for the Australian economy over the next year compared with 28% expecting “bad times”. Sectors most exposed to consumer spending may consequently continue to underperform, but otherwise the stability of the banks and the ongoing commodity boom suggest that Australian equities may well be able to continue to outperform overseas counterparts.
World shares started to recover in March after the initial shock of the invasion of Ukraine, but have relapsed since the end of March. This year to date the MSCI World Index of developed economy share markets is now down by 8.6% in U.S. dollars. Only the U.K. is ahead, with the FTSE100 Index up 3.1% thanks to the London listings of some big beneficiaries of global inflation (notably oil and gas producers, up 30.4% for the year to date, and miners, up 30.2%). Elsewhere, in the U.S. the S&P 500 is down 7.9% and the Nasdaq down 14.8%, in Europe Germany’s DAX is down 10.8% and France’s CAC down 7.9%, while in Japan the Nikkei is down 6.9% in yen terms, with the loss compounded by a depreciating yen (down 9.4% against the U.S. dollar year to date).
Emerging markets are down 10.2% in U.S. dollars. The only bright spot has been commodity beneficiary Brazil, where the Bovespa Index is up 32.1% and the MSCI Brazil up 30.2%. In U.S. dollars, Indian shares are down a little (MSCI India down 2.8%), and Chinese shares have been weak (MSCI China down 16.2%). Unsurprisingly, Russian shares have tumbled: The FTSE Russia is down 27.7% and the RTS Index is down 42.0%.
The global economy is still growing. The J.P. Morgan Global Composite Index in March came in at 52.7, where numbers greater than 50 indicate ongoing expansion. J.P. Morgan commented that the waning of Omicron has allowed activity to recover in much of the developed world, though its outbreak in China and the associated lockdowns has resulted in a sizeable setback to Chinese growth, while activity has also weakened very significantly in Russia.
But the outlook from here is becoming more challenging. The IMF in its World Economic Outlook forecasts now expects 2022 to be tougher going than it previously anticipated. The world economy should still grow by 3.6% this year, but that will be 0.8% slower than the IMF had expected back in January, and a full 1.3% slower than it had expected a year ago. And the 3.6% is by no means guaranteed: The IMF said that “The risks to the outlook are to the downside. Although a fast resolution of the war in Ukraine would lift confidence, ease pressure on commodity markets, and reduce supply bottlenecks, it is more likely that growth could slow further and inflation turn out higher than expected.
Overall, risks are elevated and broadly comparable to the situation at the start of the [COVID-19] pandemic—an unprecedented combination of factors shapes the outlook, with individual elements interacting in ways that are inherently difficult to predict”. The IMF’s long list of things that could go wrong includes a worsening of the Ukraine war, increased social tensions (for example in response to more expensive food), a resurgence of COVID-19, a sharper slowdown in China, higher inflation expectations requiring a stronger monetary response, debt fragilities in the wake of higher interest rates, geopolitical tensions spreading, and climate change events.
Fund managers have also turned markedly downbeat. In the latest (April) Bank of America fund manager survey, the percentage of managers pessimistic about the global growth outlook has fallen to the lowest level ever recorded in the survey (which dates back to 1994), and is even lower than the depths of pessimistic sentiment recorded through the global financial crisis in 2006-08. Their top fear is now a
global recession (mentioned by 26%), followed by the twin issues of hawkish central banks (25%) and inflation (21%). These macroeconomic issues have displaced the war itself (16%) and asset bubbles popping (7%), while COVID-19 is now seen as a distinctly secondary risk compared with everything else going on (1%).
Reproduced from Morningstar Research, Economic Update: Australia, April 2022. written April 21, 2022