The September quarter has been all about inflation and the central bank response to it. The one exception to this was in the UK where the newly installed Prime Minister announced a sizeable, debt-funded, fiscal stimulus package that sent a shockwave through UK financial markets and wreaked havoc inside UK pension plans. The impact was so great the Bank of England had to intervene to restore stability. Meanwhile, central banks around the world continued to lift interest rates leaving both shares and bonds lower over the quarter after a rally in July.
1. Yes Minister
The September quarter finished with a bang thanks to the new UK Prime Minister and her Treasurer. The UK government announced a large debt-funded stimulus package that sent the pound down to a 37-year low and yields up to a 15-year high as investors worried about inflation and borrowing. The Bank of England was forced to intervene and buy back its government bonds to ease the pressure on UK pension plans who were being forced to liquidate portfolios to raise cash to meet margin calls. That intervention is due to end on October 14th. All eyes will be on whether the market can cope without that support.
The UK first sold Gilts to pay for war with France in 1694, so it is hard to say this is the worst selloff ever, but on the last day of the month yields rose by an astonishing 10 standard deviations.
Chart 1: UK 10-year yields rise to highest since the global financial crisis
2. Housing Taking a Hit
The most interest-sensitive sector of the economy is housing so it is no surprise to see most of the pain from high interest rates concentrated there. The US housing market is showing increasing signs of stress as mortgage rates soar past 7 percent, up from 3 percent at the start of the year. Mortgage applications are down by a third over that time and are now at the lowest level since 1997.
So far there has been little evidence of forced selling, but this could change if the labour market deteriorates. The flow through to prices could be painful given the lack of buyers – home purchase sentiment is at its lowest level since 2011.
Record low levels of unemployment mean the fall in house prices so far, recorded in the US, Canada, New Zealand and Australia, have been relatively gradual. US house prices fell by 0.4% in the month of July, the first decline since 2012. Over the year, prices still remain up 15.8%.
Chart 2: US 30-year mortgage rate highest level since 2007
3. The Mighty Dollar
On a trade-weighted basis the US dollar has risen to its highest level since 2002. The recent leg higher has been closely associated with rising credit stress as markets question the viability of government budget plans in a high interest rate environment. Historically, the greenback has been the go-to currency during times of credit stress. With central bankers focused on bringing inflation down, this stress is likely to grow. A stronger US dollar will help ease imported inflation into the US but will act as a headwind for the 30 percent or so of US S&P500 corporate earnings that are generated from overseas. An easing of US dollar strength will likely require the US central bank to slow its rate hike cycle, something that doesn’t seem likely before the end of the year at least.
Chart 3: The US dollar at its highest since 2002
While equity prices have come under pressure this from the sharp rise in interest rates, the underlying earnings environment for Australian equities continues to defy the growing recessionary risks. Forward earnings for the market have expanded by more than 25% over the course of 2022, which has been underpinned by the resources sector and despite a recent correction in commodity prices. Other key sectors have also had a positive trend through the year and the recent weakness in the Australian dollar has also been a positive contributing factor.
Chart 4: Earnings Expand in 2022 Despite Softening Outlook
Growing dividends and falling equity prices has led to a rise in the forward dividend yield on the market, which is again approaching 5%. Yields have expanded through this year on industrials and financials, though have only returned to similar levels prior to the onset of the COVID crisis. The overall market’s yield, however, is largely propped up by the resources sector (on a yield of almost 7%), with these companies continuing to return most of their elevated profits to shareholders. Further weakness in commodity prices may see these dividends under some pressure.
Chart 5: Market Dividend Nears 5% Again, Supported by Resources
- The Australian equity market generated a flat quarter of performance to September 30, though intra-quarter experienced high levels of volatility, with September’s losses cancelling out the gains through July.
- August’s reporting season was better than many investors had anticipated, with a solid set of results across the board demonstrating that Australian companies had been handling the various headwinds through the year relatively well. This helped the domestic market again outperform overseas markets, which has been a theme of 2022.
- Overall, the impact of rising interest rates was less of a factor through the quarter, as long bond yields declined through July before reversing course in the second half of the quarter as central banks continued on their course of aggressively hiking rates in order to rein in inflation. Individual fund performance was hence more driven by stock selection for the quarter as opposed to the macro environment.
- Despite weakening commodity prices on concerns of slowing global economic growth, resources managed to keep pace with industrials, in part due to corporate activity following BHP’s bid for Oz Minerals. The five best performing stocks in the ASX 100 for the quarter were all mid-cap mining companies.
- Large cap equities outperformed small caps. Small caps again traded with a higher level of volatility, initially rebounding stronger in July before declining sharply in September and consistent with their higher leverage to the economic cycle.
- Most of our large cap equity funds generated returns broadly in line with the benchmark ASX 200 Accumulation Index through the quarter. Our best performing large cap fund was WaveStone. The fund generated steady performance over the quarter, with returns enhanced by strong gains among some of the manager’s small cap positions.
- While all of our small cap managers managed to beat the benchmark Small Ords Accumulation Index, the returns of QVG Opportunities stood out. Several of the manager’s high conviction positions did well in the quarter and returns were enhanced by another takeover of one of their holdings.
- Pendal Microcaps, a fund we have recently added, also performed well in the quarter. While small and microcaps were subject to high levels of volatility, the manager’s current focus on strong balance sheets and profit-generating businesses held the fund in good stead through September’s drawdown.
Strains on businesses from higher interest rates, inflation, labour and supply-chain woes take time to result in bankruptcies and restructurings. But still, for now bankruptcies are very low and even if they do rise, the increase will be coming off a record low base. For high yield bonds, much will depend on whether a distressed cycle manifests. The depth of a given distressed cycle is less problematic for junk bond performance than its duration. In the early 1990s and early 2000s, bankruptcies lingered for longer. That resulted in spreads holding at elevated levels even as bankruptcies began to recede. Yet high yield bonds’ risk-off cycles in 2011 (Greek debt crisis), 2015 (energy) and 2020 (COVID-19) that lifted index yields above 8% resulted in nearly universal positive returns, starting no more than three months after the 8% yield level was breached.
Chart 6: US Corporate Bankruptcies Still Low
Utilities, consumer staples and health care have fared better than most S&P 500 sectors besides energy YTD. As recession concerns grow, investors look to add exposure to these industries that are expected to show resiliency during a downturn. Earnings remain a threat but it hasn’t deterred investors so far. Despite losing ground, cyclicals are expected to maintain their earnings growth edge over defensives into late 2024, according to Bloomberg forecasts. Apart from energy, cyclicals such as industrials and consumer discretionary are seen as posting the largest earnings growth in 3Q and 4Q, for example, while health care and consumer staples are staring at negative estimates. However, as recession odds rise, numbers may quickly change.
Chart 7: S&P500 Cyclicals / Defensives
- Global equities remain challenged in the third quarter as fears of persistently high inflation drove central banks to become far more aggressive in their tightening cycle. About 90 central banks have raised interest rates this year, and half of them have hiked by at least 75 basis points in one go. Many did so more than once. This was the case in the US where rates have been lifted by ¾ of a percent in the last three consecutive meetings.
- Consequently, equity markets fell in the past three months. The US was among the worst performers with the S&P500 down 5.3%. The tech-heavy Nasdaq fell by 4.1%. Overall, developed markets fell by 6.6%, outperforming emerging markets which fell by 12.5% weighed down by a 22.9% drop in Chinese equities.
- Among the sectors, the worst performers were consumer staples, materials and information technology (which was particularly challenged in the quarter by the rise in bond yields).
- The Australian dollar fell by 7.3% after a 7.7% decline in the June quarter. This left our unhedged international equity funds generally outperforming hedged. Such was the case with MFS where the unhedged fund outperformed the hedged version by almost five percentage points. The difference was even greater with our Royal London Concentrated Global Share Fund – -8.1% for the hedged version versus +0.4% for the unhedged version.
- The worst performing funds over the quarter were our emerging markets funds, the Fidelity Asia Fund, which was heavily impacted by the decline in Chinese equities, and the Redwheel Global EM Fund. Our ClearBridge RARE Infrastructure Funds also suffered heavy losses in the last few days of September driven by the valuation hit that came from the surge in UK bond yields. Our interactions with the fund manager confirm that nothing fundamental had changed with the fund. Rather, the higher discount rate driven by the rise in UK yields lowered the present value of the fund.
- The best performing fund in the quarter was the WCM Quality Global Growth Fund followed closely by the Franklin Global Growth Fund. These funds benefited from the swing to growth away from value investing.
The Reserve Bank of Australia’s decision to opt for a smaller increase came as a surprise even though Governor Philip Lowe had flagged his intent well in advance. Nevertheless, its decision means that there is yet another reason for investors to take a grim view of the Aussie dollar. Market participants are pricing in a terminal rate circa 3.60%, which reflects the scale of work still left for the RBA. The Australian dollar has taken a hit so far this year against the greenback, exposed by inflation-adjusted yield differentials that have swung in favour of the US dollar. The RBA’s decision to shift gears means that the gap is unlikely to be closed anytime soon, and in a regime of broad US dollar strength, the Aussie is likely to drift lower. The currency is undervalued in relation to commodity prices but that trend is set to continue for now.
Chart 8: RBA Lifts Rates by 25bpts to 2.6%
What is good for lenders (income investors) is not so good for borrowers (corporates). The ramp up in yields means that corporate borrowing costs for investment-grade companies are now the highest since the financial crisis. Higher inflation will mitigate that effect to some extent, but even discounting inflation expectations, real borrowing costs are rising sharply. Cost pressures are building for corporates (labour, transport, logistics, currency, and borrowing) which will weigh on earnings.
Chart 9: Yield on Global Investment Grade Bonds (%)
- Government bond yields finished the quarter some 20-120 basis points higher than where they started leading to a loss of capital for bond funds. Australian bonds outperformed global peers. Italy saw the greatest sell-off in bonds where the risk of fiscal profligacy is seen as heightened following the election of the far-right Brothers of Italy party.
- Credit spreads widened again, driven mainly by investment grade bonds where duration risk is highest. At this point, duration rather than credit is seen as the greatest risk by the market but as recession risks intensify we would expect credit risks to dominate.
- The rise in bond yields and widening in credit spreads was particularly detrimental for the PIMCO Global Bond Fund and the PIMCO Global Credit Fund.
- The best performance funds were our liquidity funds, the Realm Short Term Income Fund, the Realm High Income Fund and the Alexander Credit Income. These funds are at the less risky end of our fixed income range of funds, though they still take some risk – as any fund does as soon as it moves away from cash.
- 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 4.7% versus 2.5% in December 2021.
Following a record-setting 2021, private debt fundraising decelerated slightly in the first half of 2022. Managers raised $82.0 billion globally in the first six months of the year. Looking at the trailing 12-month period, however, fundraising is on par with its 2021 peak, totalling $211.3 billion in commitments in the year ended Q2 2022. The macroeconomic backdrop – characterized by rising rates, has seen the floating-rate nature of many of these instruments makes existing loans more lucrative, as coupon rates will rise in step with central bank rate hikes.
Chart 10: Private Debt Fundraising
After seven quarters in a row during which commodities outperformed other asset classes, the broader complex is now retreating and outcomes are becoming more divergent from one another with heightened volatility across the space. The Bloomberg Energy Index was up over 100% by early June, driven primarily by supply disruption, only to give back roughly half of those gains by the middle of September, as softer demand outlook. Industrial metals including copper and iron ore have been the hardest hit throughout the year as prospects of weaker demand from heavy industrial regions like Asia and Europe see economic activity slowing significantly. Agriculture markets initially surged on supply disruption in Ukraine however slowing demand in China and excess supplies in the US of key grains has brought prices back down recently.
Chart 11: Choppy Trading Across Commodity Complex
- The third quarter remained difficult for global financial markets. The ongoing combination of inflation concerns, interest rate uncertainty and recessionary fears led to a volatile market environment and difficult trading environment.
- Equity long short manager Munro Global Growth finished the quarter +2.7% against the backdrop of a difficult market environment. The bulk of the gains came in July where long positions were the key contributor. From a stock perspective Amazon, Constellation Energy and Nutrien all saw their shares rally on the back of solid results. Overall, the fund remains cautiously positioned however has started to deploy some of the portfolio’s elevated cash levels during the quarter.
- Private equity (PE) activity continued at a more modest pace throughout the second quarter and into Q3 2022 whilst exit activity slowed at a more notable pace over the same period. PE fund managers remain positive on potential opportunities however given the elevated levels of dry powder in private markets waiting to be deployed at more attractive valuations.
- Our PE managers experienced mixed results over the three-month period ending August 2022 with the Partners Group Global Value Fund down 1.3% and the Hamilton Lane Global Private Assets Fund up 5.7%. Partners Group was more impacted by the fund’s larger allocation to Europe as the region continues to suffer from the war in Ukraine and surging energy prices. Hamilton Lane gained on the back of strong fundamental performance for direct equity and secondary portfolio positions in sectors such as technology and utilities.
- In the private debt space, Merrick’s partners added 2.1% over the three months ending September 2022. Underlying loan portfolio income benefited from floating loans passing through rising rates in Australia and New Zealand. The portfolio currently comprises senior secured loans diversified across fourteen sub-sectors and is additionally diversified by geographic spread and borrowers. In agriculture, the pressure on supply chains, in particular infrastructure and logistics, has highlighted a funding gap in these sectors providing a broad range of opportunities.
- In direct property markets Barwon Healthcare Property Fund added 1.5% over the three-month perioding ending August 2022 whilst Charter Hall Wholesale Property Series (WPS2) added 6.5% over the same period. Charter Hall WPS2 benefitted from strong returns to the industrial and logistic sectors where the fund has a 25% allocation. Property valuations in the industrial space rose strongly over the previous 12 months as leasing activity outstripped its long-term average levels whilst supply of new buildings has not kept up with the increased demand.