Investment & Economic Review July 2022

Economic trends and geopolitical events converged pessimistically in the June quarter, causing the unusual scenario where all major investment asset classes – shares, property, and bonds – fell concurrently.

Bonds prices were particularly weak, due to the sudden and rapid increase in duration-based interest rates. It was the combination of starkly increasing inflation and an about-turn by Central Banks’ monetary policies that caused the bond rout.

Share prices can be reactive to interest rate movements, especially those types of shares that are priced with reference to yet-to-be-achieved profits, (think some technology sectors). The quick movement up in bond yields has the effect of increasing the rate upon which future cashflows are discounted, thereby lowering their present value (present share price).

Inflation has so far proved difficult to tame. Part of the problem is the supply side dynamic – the blockages at port and distribution networks caused by COVID in 2021 were intensified by more specific energy and food supply shocks from the Ukraine war, then exacerbated by recent supply lockdowns in China. Consumers have suffered the effects worldwide, notably in higher food, fuel, and construction costs. Thankfully the core supply-side inflationary pressures are now easing. The price of oil for example has fallen back to the pre-Ukraine war price, as has the price of wheat. Statistical inflation in 2022/23 will be much lower, yet many costs are now embedded, and are unlikely to decline.

An unavoidable consequence of inflation and higher interest rates is a less rapid rate of economic expansion. Some commentators are forecasting a recession, though I disagree as I find it hard to justify when one of the preconditions, employment, is so strong. Corporate profits will be affected, so be prepared for a raft of downgraded outlook statements with inflationary and labour costs copping the blame. The largesse of government and central bank stimulus programs during the pandemic caused a severe burden to public sector finances. The federal budget, slated for 25th October, will seek to address burgeoning indebtedness, so some tough financial medicine is coming, perhaps a COVID or debt reduction levy.

The Australian stock market, as measured by the S&P ASX200 Index, had a shocking June quarter, falling by 12.4%. For the full 2021/22 financial year the market declined by 10.2%, all the drop coming in the final quarter. Dividends averaged 3.7% for large companies, somewhat improved over the COVID affected previous year. There were some notable large dividend increases due to robust commodity prices and volumes, and lots of buybacks, both on and off market. Dividends from industrial, consumer and financial stocks are expected to be modestly higher this coming financial year, but perhaps a bit lower from certain energy and mining stocks, reversing some of the windfalls of last year.

There was an unusually wide dispersion of performance between stocks in different economic subsectors last financial year. Woodside, for example, was up a full 50%, benefitting from rampant energy prices and demand, whilst Ansell shares fell 40% as the pandemic-induced mass demand for its health and safety products started to dissipate, and higher raw material prices increased production costs. There was also a flurry of takeover activity, with cheap money and cashed up superannuation and private equity vehicles looking to spend. In our model portfolio, Sydney Airport, CIMIC and Spark Infrastructure were all acquired at inflated prices, whilst offers have been made for AGL, Link and Ramsay Healthcare. The mega-deal sale of BHP’s petroleum division to Woodside, in which BHP shareholders were distributed Woodside shares as a fully franked dividend, proved beneficial for both companies’ shareholders.

The recent retreat in the ASX200 index makes large company shares in Australia good value. Share investors require appropriate compensation for the risk taken, known in the industry as the equity risk premium. At current share prices, long-term investors are being offered more than adequate compensation for risk, such that shares can be held or acquired prospectively. Markets will undoubtedly suffer further periods of volatility this year, but when buying opportunities present investors should be prepared to buy.

The release of company financial reports and outlook statements in August will be closely watched and represent a useful gauge for the year ahead. We expect plenty of commentary about inflationary pressures and the tight labour market, but moderate optimism based on the extraordinary build up of household wealth and the generational low in unemployment.

A modest market recovery is likely this coming financial year but will need to compete with higher interest rates and inflation, a moderating of economic growth and hopefully a peaceful resolution of the Ukraine crisis.

In the June quarter the MSCI world stock market index fell dramatically by 16.5%, representing one of the worst periods in recent times, caused by the confluence of geopolitical concerns, rising interest rates, rampant inflation, and a hasty policy retreat by global central banks.

The market pain was most notable in the technology and future growth type stocks and industries, which fell precipitously. The United States NASDAQ index fell a staggering 22% in just three months, as a risk-off approach spooked speculative investors. Prices crashed in riskier peripheral investments such as cryptocurrencies, proving yet again the aptness of Sir Isaac Newton’s ‘madness of the crowd’ proclamation. Investors are urged to carefully assess the tangible nature of any prospective investments, and not be tempted by faddish trends.

Some US shares and sectors bucked the negative trend, mostly in the consumer staple, health and pharmaceutical, and energy sectors. US shares are now underpriced, however the very strong US dollar of late has lessened the prospective relative value for Australian dollar domiciled investors. Nevertheless, some global leading US technology shares should represent cornerstone investments in any diversified growth portfolio.

Some European economies are suffering materially from the high energy prices and disrupted supply. Germany has been increasingly reliant on transitional and renewable energy and have been decommissioning nuclear plants, so the spike in energy prices and supply blockages hit them particularly hard. Unsurprisingly, German shares have suffered, disproportionately in our opinion. Consequently, many German and other European based shares are excellent value for the patient investor, and the relative weakness of the Euro provides a good investment opportunity.

In Asia, the big technology stocks followed the worldwide rout in that sector, but otherwise markets were generally less volatile. The Japanese Yen has been particularly weak, reflecting their energy import status, and the stubborn persistence by the Bank of Japan to maintain ultra-low bond yields and accommodating monetary settings. The low Yen makes Japanese shares appealing, particularly those in the industrial and factory automation sectors, in which Japanese manufacturers excel. Singapore remains a preferred investment destination due to its economic stability and strong governance. The Singapore stock exchange was one of the few that didn’t decline in the 2021/22 financial year.

The prices of listed Real Estate Investment Trusts (REITs) fell by 15% in the 2021/22 financial year, most of the decline coming in May and June. The cause of the decline was a combination of the generally weaker investment markets globally, an expectation of weakening tenancy demand and more specifically higher interest rates, which negatively affect valuations.

Commercial property values have mostly been stable, as physical occupancy continues to recover from lockdown periods. Head lease vacancy rates for offices are rising, now about 10% in the major CBD’s. Higher quality properties are attracting tenants, albeit with generous incentives, but lesser quality buildings will likely suffer a valuation decline next year.

Industrial property occupancy continues to be very high, approaching 100% in the major cities. Capitalisation rates have hence fallen to an unsustainable low, so its probable that the investment entities that focus on this sector will struggle to achieve much positive growth in the years ahead.

The retail sector has been remarkably resilient, given the negative expectations during the COVID lockdown periods. Footfall at the major shopping centres has recovered completely, in some cases exceeding pre-COVID. Scentre Group, which operates the Westfield malls, reported strong occupancy of 98.7% and major and specialty store sales more than pre-pandemic levels.

Residential property prices are starting to soften, as the reality of rising interest rates curtails demand. Banks have been quick to pass through Reserve Bank interest rate increases, and there are more to come, so a general weakness in house prices is expected to persist for a while, though strong employment and high household savings are likely to make the percentage decline modest.

Real Estate Investment Trust unit prices are determined by reference to a combination of their underlying property prospective values, cash distribution potential, degree of indebtedness, the value of their management and development businesses and their funds from operations. It is this last point, the funds from operations, that is capturing the concern of the market. Cash flow receipts (mostly from rent) are under some pressure, particularly in the commercial sector, as new tenants are contracted with generous incentives – often in the form of rent reduction. Hence profits and distributable income growth will be more difficult to attain. Nevertheless, the decline in REIT prices has been significant, and overdone, so it is our expectation that further downside risk is minimal, and this sector offers a decent investment prospect.

The central banks of most major economies are now engineering brisk increases in short term interest rates. Investors should expect further regular and rapid increases in rates around the world in the months ahead, as the collective programs to stifle inflation continue.

The Australian Reserve Bank raised the cash rate from to 0.35% in May, 0.85% in June and 1.35% in July, with further rises to come. We expect the cash rate to rise to between 2% and 3% in the coming months, following which the RBA will probably pause to assess the economic impacts, and consider inflationary data and trends.

A regrettable consequence of the RBA’s actions is an increased strain on household budgets, mostly those with high mortgage, personal loan, or credit card indebtedness. The RBA’s actions however are premised on their assessment of inflationary and employment trends and risks, so they will not hesitate to raise rates if their concerns about either persist.

The 90-day bank bill rate has risen to about 2.2%, in lock step with expectations of the cash rate. Bank bills are often the reference rate upon which many investment securities have their income distributions based. Bank hybrid and subordinated notes for example, typically pay a quarterly variable interest rate at a margin above bank bills. Consequently, the future quarterly distributions from these types of securities will rapidly increase, materially improving the income generation for investors.

Credit based investments have weakened recently as there has been a general widening of spreads, a lesser appetite for risk and some consternation about deteriorating economic activity. Also, there is little point in taking risk for a relatively low-income return, when a government bond will now pay 3% or more, with very little risk. Term deposit rates have also risen, as banks seek to diversify their sources of funding now that the RBA is withdrawing its subsidy programs.

An interesting market trend of late is long-term bond yields, which have actually fallen a bit from their June peak of 4.2% to about 3.4%. This represents a flattening of the yield curve – short term interest rates rising and long-term rates steady or falling. This evolving pattern is often seen as a prewarning of weaker economic times ahead, logical due to the demand crimping effect of rising rates.

In the United States this pattern is more pronounced, such that the 2-year treasury note is now slightly higher than the 10-year note. This is interpreted as a pre-recessionary indicator, mostly because of historical precedent. However, it’s hard to see a recession occurring when the employment market is so robust – indeed almost full employment has been achieved in the United States and Australia.

Looking ahead, the Reserve Bank will likely raise short-term rates again in August and several more times after that. This will have the effect of further flattening the yield curve, as we don’t expect material further rate rises in long dated interest rates. Bond prices will remain volatile, particularly around statistical inflation release dates.