Financial markets in the June quarter oscillated between concerns about inflation and growth. This resulted in elevated levels of volatility across all asset classes. Bond yields moved in a wide range, from a low of 2.8% to a high of 4.2%. The Australian dollar moved from a high of 75.8 US cents in April to a low of 68.1 US cents in June. Similarly, oil prices moved from a low of $US94.30 in April to a high of $US122.11 in June. Both concerns, high inflation and weak growth, weighed on bonds and equities making it a challenging quarter for balanced fund investors.
1. Inflation fears
The May CPI report out of the US was a turning point for the US Federal Reserve. The expected deceleration in goods prices was fairly minor driven in part by an easing in used car and truck prices. More concerning, however, was the acceleration and broadening in service sector prices, due mainly to an acceleration in housing costs and medical care services. The report confirmed signs that inflation is too high for comfort and requires central banks to prioritise its abasement even if it means sacrificing growth outcomes. The longer inflation remains elevated, the higher the risk that it becomes embedded in expectations which are then fed into wage negotiations. Evidence of rising inflation expectations among consumers became very clear in the first quarter.
Chart 1: Rising consumer expectations of inflation
2. Growth fears
The surge in inflation to multi-decade highs has forced central banks to swiftly raise interest rates, dealing a hefty blow to economic growth. As the quarter came to an end, the primary concern of financial markets became recession risk. Central banks from Australia to Zimbabwe (where inflation is currently 192%) became more determined to fight inflation with aggressive rate hikes. Zimbabwe took the title as the worlds most aggressive central bank taking its interest rate to 200%. The US Federal Reserve raised interest rates by the most since 1994. With persistent price pressures straining household budgets consumer spending, the single largest component of any economy, is slowing. Americans spent more on gas, housing and utilities in May and cut spending on new cars and trucks. For the first time in four months they spent less dining out. Forecasts for US growth for this year and next were sitting at 3.9% and 2.5% in December last year. By June this year those forecasts were trimmed to 2.6% and 2.0%.
Chart 2: Household savings rates (% household income) – the shrinking savings buffer
3. Earnings fears
Despite higher inflation, rising interest rates and slowing growth, corporate America’s earnings estimates are inching higher. That’s a concerning sign given it suggests equity prices are not fully reflecting the risks facing the US economy. The gap between what analysts expect from earnings and what actually eventuates typically widens around recessions. Equity anaysts tend to be eternally optimistic until the evidence to the contrary is clear. Downward earnings revisions are likely coming, however, as more businesses struggle to pass on higher (labour, commodity, logistics) costs to consumers. This risk of a downgrade in earnings should be reflected in market valuations but it is not and so leaves the risk for the market still to the downside.
Chart 3: US Earnings – Analyst optimism is the most excessive around recessions
- Following six successive quarters of positive performance, the Australian equity market experienced a sharp correction in the June quarter, losing 8.8% for the three months.
- The primary catalyst for equity declines were the rapidly changing expectations for a much sharper cycle of monetary policy tightening as the RBA shifted towards a more hawkish stance to rein in inflation.
- This placed further pressure on the more growth-orientated sectors of the market and stocks trading on higher PEs, particularly inflromation technology. While the energy sector continued to advance on a stronger oil price, mining stocks suffered late in the quarter as commodity prices weakened in response to the growing risk of slowing global growth into the second half of the year.
- Among our large cap funds, those with a more diversified approach across the various sectors of the market experienced a smaller drawdown compared to those that focus on companies with higher earnings growth. This was reflected in the marginal outperformance of Pendal, while WaveStone’s return was broadly in line with the benchmark.
- While the resources sector was less of a headwind compared with the March quarter, the market’s valuation adjustment was still most evident in higher growth sectors that are significantly overweight in the portfolios of Bennelong and Selector, leading to the underperformance of both. These funds also hold limited exposure to defensive sectors (such as consumer staples) which performed well relative to the benchmark.
- As is typical during periods of heightened market volatility, small caps underperformed large caps materially in the June quarter, returning -20.4%. The combination of rising inflation and higher interest rates has proven to be a much more significant headwind for the small cap sector of the Australian market.
- Spheria was the standout performer for the quarter among small cap funds, with the manager’s focus on high cash flow generative, defensive businesses holding it in good stead. Our other small cap managers struggled for performance in the quarter, with most lagging the benchmark Small Ordinaries Index to varying degrees. QVG was a key laggard, as some of the concentrated fund’s larger holdings posted weak performance over the three month period.
- Global equities remain challenged in the second quarter as fears of persistently high inflation drove central banks to become far more aggressive in their tightening cycle. No fewer than 20 of the major central banks around the world, including Australia and the US, raised interest rates further in the June quarter. The speed of the tightening cycle is unprecedented and is leading to concerns by equity investors that central banks will tightening too much and send economies into a recession.
- As a result, equity markets in general were weaker in the past three months by between 11-16%. The US was among the worst performers with the S&P500 down 16.4%. The tech-heavy Nasdaq fell even more, by 22%. Overall, developed markets fell by 15.7%, underperforming emerging markets which fell by 11.3%. Chinese equities were the one standout, rising by 1.9%.
- Among the sectors, the worst performers were consumer discretionary, information technology (which was particularly challenged in the quarter by the rise in bond yields), financials and materials.
- The Australian dollar fell by 7.7% leaving our unhedged international equitiy funds generally outperforming hedged. Such was the case with MFS where the unhedged fund outperformed the hedged version by almost six percentage points. A similar situation was evident for the ClearBridge RARE Infrastructure Funds where the unhedged income fund outperformed the hedged version by almost five percentage points.
- We are firmly of the view that Australian investors should be 100% unhedged international equities unless there is a very clear dislocation in currencies such as what occurred in March 2020 when the Australian dollar fell through 60 US cents while the Federal Reserve was aggressively printing money (quatitative easing). We believe it is incredibly difficult to accurately forecast currency movements and so instead prefer to view the currency as a risk management tool. For Australian investors, in a risk-off environment where international equities decline, typically the Australian dollar will also fall. By being unhedged, Australian investors will benefit from a cushion of support as international returns are translated back into Australian dollars.
- The worst performing funds over the quarter were the small companies funds. Smaller companies tend to be more sensitive to the economic cycle and so expectations of recessionary conditions tends to weigh more heavily on them. From a valuation perspective, the selloff we have seen in small cap names has made them the most attractive relative to large cap in over 20 years.
- The best performing fund in the quarter was the Fidelity Asian Fund, which rose by 3.9%, well ahead of its benchmark. The fund was well positioned to take advantage of the rise in Chinese equities over the quarter.
- During most of the second quarter there was largely a parallel reaction of widening credit spreads and rising interest rates. In the final weeks of the quarter the dynamic changed: spreads continued to widen, but yields dropped dramatically as fears of inflation were supplanted by fears of recession.
- Government bond yields finished the quarter some 60-80 basis points higher than where they started leading to a loss of capital for bond funds. Such a dramatic increase in bond yields over such a short period of time is unprecedented and was the principal drive of poor returns for fixed income investors over the three months.
- This was particularly the case for the PIMCO Global Bond Fund and the Western Asset Management Australian Bond Fund.
- The widening in credit spreads over the quarter also left its mark particularly for credit funds such as the PIMCO Global Credit Fund and the Bentham Global Income Fund. Credit spreads widened as a result of persistently high inflation leading central banks to become more aggressive in raising interest rates. This aggressive tightening cycle from the central banks has in turn raised concerns about economic growth. The widening in credit spreads will have a market-to-market impact on credit funds which will be erased when credit spreads return to more normal levels. In credit, there is only a permanent loss of capital in the event of default. Default risk is expected to remain low but is managed in our funds through heavy diversification.
- While our liquidity funds, the Realm High Income Fund and the Alexander Credit Income are at the less risky end of our fixed income range of funds, they still take some risk – as any fund does as soon as it moves away from cash. Of these liquidity funds, the Realm High Income Fund has the highest exposure to credit (though still substantially lower than our pure credit funds) and so was negatively affected over the quarter, in particular the month of June, by the response of credit markets to recession fears.
- Realm believe the widening in credit spreads offer an attractive entry point to take advantage of the eventual correction back to normal levels. While this position has been too early, given credit spreads have moved wider since the position was placed, the fund is benefiting from a higher yield, now 4.9% versus 2.5% in December 2021.
- The second quarter remained difficult for global financial markets. Inflation concerns, interest rate uncertainty and fears of a potential recession have been the key catalysts for the decline in equity markets. This combination of these factors impacted hedge fund performance over the quarter.
- Equity long short manager Munro Global Growth finished the quarter -7.8% against the backdrop of highly volatile equity markets. The bulk of the losses occurred in April in the long book following the sell-off in equity markets. From a stock perspective across the quarter, some of the largest cap tech companies, Nvidia, Amazon and Microsoft were the key detractors. Positive contributions came from each of hedging, shorts and foreign exchange. Given the current environment, the fund remains cautiously with elevated cash levels.
- Second quarter activity remains subdued for private equity (PE) markets as managers continue to deal with a complex macroeconomic and geopolitical environment. Deal activity in PE markets fell by 27% compared to the record high set in the fourth quarter of 2021 however still remained above longer term average levels. PE backed exits however have fallen below its four quarter average as PE fund managers remain cautious about selling existing portfolio companies with valuations weakening.
- Our PE managers finished the three month period ending May-22 slightly higher with Partners Group Global Value Fund up 0.7% while Hamilton Lane Global Private Assets Hedged was up 2.7% compared to global listed equity markets falling 4.8% over the same period. Despite public market multiples continuing to contract, both funds saw strong fundamental performance over the quarter as the main driver of performance as companies in the logistics and industrials sectors posted strong earnings driving valuations higher.
- In the private debt space, Merricks Partners Fund added 2.9% over the three months ending June 2022. Underlying loan portfolio income was up for the quarter due in part to three new loans settling during June and the extension of an existing loan improving investor returns. The portfolio currently comprises senior secured loans diversified across fourteen sub-sectors and is additionally diversified by geographic spread and borrowers. The investment opportunity in private credit is increasing with the reduction of liquidity in the markets from the banking sector creating a strong outlook for the investment sector across Australia and New Zealand.
- In direct property markets Barwon Healthcare Property Fund added 2.1% over the quarter. For FY22 the fund had a total return of 19.8% with a capital return of 14.1% and an income return of 5.7%. Healthcare property valuations continued to increase throughout FY22 as investors pivot toward defensive assets within the real estate sector. The portfolio has a 99% occupancy rate and a weighted average lease expiry of six years and benefits from a strong tenant profile including government entities and large ASX listed healthcare companies.