As you are all aware financial markets have been through a period of elevated volatility in the past couple of weeks, which has served to punctuate the regime change we have been experiencing in markets so far in 2022, in particular, this June quarter. This regime change is coming from the world ‘re-opening’ post the Covid 19 lockdowns, which has led to both rising demand and ongoing disruption to the supply of manufactured products. This has in turn led to rising inflationary pressure and some outsized responses by central banks in the near term, with the expectation of more interest rate rises to come.
In relation to events of the past 2 weeks, share markets began softening from about Wednesday 8 June ahead of the US Inflation data release on Friday morning, 10 June. From a global perspective, the US inflation data for May was critical because its level would provide strong guidance to the US Federal Reserve’s (Fed) interest rate policy setting. The US Consumer Price Inflation (CPI) came in at 1.0% for the month of May (8.6% p.a. for the year), while ‘core’ inflation (which excludes food and energy) came in at 6.0% p.a. The CPI data in particular, was much higher than anticipated by share and bond markets and this led to a heavy selloff both in the US and globally. Further, it was clear evidence that peak inflation and bond yields may still be yet to occur. This contrasted with the views of many market participants who believed this event had recently passed. In Australia, our markets were spooked by RBA Governor Philip Lowe raising our cash rate by 0.50% on 7 June 2022, a larger rise than anticipated by the markets and local shares and bonds responded by selling off.
With the higher inflation data for May, the US Fed determined to increase US cash rates by a very large 0.75% at its meeting on 15 June, to set rates in the range of 1.50% to 1.75%. Fed Chair, Jerome Powell, in his commentary indicated that another increase of 0.75% or 0.50% was anticipated from its meeting in early August. If this occurs, the US cash rate will rise to at least 2.0% and possibly as high as 2.5%. Similarly, in Australia, RBA Governor Lowe commented that inflation could rise to 7.0% by December, from which markets inferred a further 0.50% rate increase was likely here in early July.
While current economic data paints a reasonably positive backdrop (i.e. employment is strong, corporate earnings are holding up and the Chinese economy is turning on again after a 60-day Covid lockdown of major industrial and commercial centres), forward looking indicators are pointing to a slowdown of growth in the developed world. Of these indicators, softening US retail sales, very weak consumer sentiment and continued elevation of oil and energy prices are indicating the increased probability of a recession. This added fuel to the fire of market volatility last week when markets also had to factor in further increases to interest rates in the near term. This confluence of events is largely responsible for the elevated market volatility of the past two weeks.
Despite this, financial markets are forward looking and adjust quickly to new information, a good example being last week. While the risk of recession has risen, the prospect of this occurring in the near-term is not likely. We believe that the global economy can continue grow as the world re-opens from Covid, given demand remains resilient. Also, we are yet to see any broad slowdown in corporate earnings with many companies having beaten analysts’ expectations recently, giving us some confidence in share market valuations.
We also consider inflation is likely to moderate over the remainder of the year. Assuming this occurs, it will reduce the need for the US Fed, the RBA and others to hike interest rates by as much as is now priced into markets. This is the economic ‘soft landing’ outcome we currently think is most probable but is contingent on consumption, corporate earnings and economic growth remaining positive.
Author: Jeff Mitchell, Chief Commercial Officer, Infocus