End of Quarter Review – March 2022

The March 2022 quarter was a challenging one for global share markets, with investor confidence exasperated by both volatility and uncertainty. After most markets reached all time highs in January, share markets around the world were then hit hard by increasing evidence from economic data that inflation was soaring globally.

Major central banks around the world soon flagged that interest rates would need to rise in order to get inflation under control. Faced with the prospect that central banks could dampen economic growth and possibly cause a recession, global share markets went into retreat. Investor concerns were then intensified even further when Russia invaded Ukraine, adding even more volatility to the existing slew of worries.

On a brighter note however, the global economy shook off the latest COVID-19 Omicron wave with a decline in case numbers and restrictions on mobility being eased or completely removed, thereby increasing services sector activity, building economic momentum and returning towards a more ‘normal’ post-pandemic life. As the quarter drew to a close, investor confidence returned, exhibited by renewed optimism and resilience in the face of rising bond yields, increased inflationary expectations and heightened geopolitical tensions.

The MSCI All Country World Index declined 5.7% to 712 points for the quarter and China’s Shanghai Composite Index underperformed, down 10.6% to 3,252 points. The S&P 500 index reversed its early negative tone (down 13% at one stage from its January high), exhibiting a swift recovery in the later part of the quarter, to finish down only 4.9% at 4,530 points. The Australian S&P/ASX 200 Index outperformed all others, rising 0.7% to 7,500 points for the quarter after falling to a low of 6,838 points on 27 January. Domestically, the Energy and Utilities sectors were the standouts— rallying 25.1% and 12.7% respectively. The most significant fall of the quarter came in Information Technology, which was down 14.0% mainly as a result of a sharp sell-off in tech companies globally.

The Australian share market was focused on the profit reporting season in February with domestic companies rebounding strongly coming out of lockdowns on the back of improved business conditions. On balance, earnings across the market over the reporting season were above analyst expectations. As anticipated, a number of companies beat dividend forecasts including Worley, Santos, Woodside Petroleum, Insurance Australia Group, Perpetual and Suncorp Group. We also saw buybacks announced by South32, JB Hi-fi, Sonic Healthcare, and Commonwealth Bank.

In commodities, the quoted iron ore price strengthened 31% to US$158 per tonne and gold climbed 6% over the quarter to US$1,937/oz. The Brent oil price finished the quarter markedly higher, soaring 38% to US$107 per barrel partly on supply constraints due to sanctions on Russia. In addition, supply shortage fears remained elevated due to OPEC+’s decision not to increase supply, opting instead to stick to its previously mandated output increases. Also, US crude stockpile drawdowns thus far have had a minimal impact to ease supply concerns.

Very recently, the Federal Treasurer delivered his fourth budget, which maintained a focus on fiscal repair with the government opting to use around 70% of the improved revenue outlook from stronger activity on rebuilding the fiscal buffers and reducing government debt. However, a cut to fuel excise tax, a one-off cash payment, and an increase in the low and middle income tax offset (LMITO) has also raised the prospects that the pro-cyclical budget could lead to higher inflation.

Following a 1.9% contraction in the September 2021 quarter, the Australian economy rebounded strongly in the December 2021 quarter, expanding 3.4% as NSW, Victoria and the ACT came out of extended lockdowns in October. On an annualised basis, GDP was up a solid 4.2%, supported by growth in domestic demand and strong household spending on both goods and services.

Domestically, the Reserve Bank of Australia (RBA) continues to hold the cash rate at an historic low of 0.10%, albeit the RBA now considers it ‘plausible’ to move rates higher later this year. The latest unemployment rate of 4.0%  ̶  a 14 year low is now at what is considered ‘full employment’ around four months ahead of the RBA’s forecast. Overall, the outlook for the labour market remains positive with unemployment expected to fall below 4.0% by end of this year and wage growth to accelerate.

Underlying inflation is now expected to overshoot the RBA’s 2%-3% target range throughout 2022. In this regard, the most recent underlying inflation rate increased to 2.6% in the December quarter from 2.1% in the September quarter. We therefore forecast three cash rate hikes in 2022 with the first one anticipated as early as August to take the cash rate to 0.75% by end of this calendar year.

Against the global backdrop of moderating economic growth and rising inflation, we now expect the world economy to expand by a modest 3.3% in CY22 and then at a slightly lower 3.1% in CY23. As regards the Australian economy, we forecast an expansion of 4.3% in CY22 and then 2.3% in CY23.

The Australian share market is currently valued on a forward consensus price earnings ratio of 15.0x, which is only ~3% above the long term average of 14.6x. The forward consensus dividend yield for the Australian share market is an attractive 4.4% (80% franked).

Overall, we expect a cautious investment environment for the global share markets given the rising stagflation risks associated with higher short term interest rates as central banks tighten monetary policy to combat rising inflation. Nevertheless, the sharp upwards lift in 10-year bond yields since August 2021— from 1.2% to 2.3% in the US and from 1.1% to 2.8% in Australia — appears to be already largely priced into the market.

Furthermore, while the evolution of the Russia – Ukraine conflict remains uncertain, it is worth noting that Australia has insignificant trade links with Russia or Ukraine. However, Australia is a net energy exporter, and a metals and agriculture goods exporter so the higher commodity prices as a result of the conflict are likely to see an expansion in Australia’s terms of trade and have a positive impact on growth.

All up, there is elevated uncertainty in the current investment environment as economic growth moderates while inflation rises. Therefore, earnings forecasts are likely to face facing downward pressure in the coming months and we expect a rotation out of ‘value’ stocks towards ‘growth’ stocks as EPS growth becomes harder to find. We also view defensive stocks as likely to outperform cyclicals in a stagflationary environment with these companies likely to benefit from inflation-linked revenues and interest rate hedging strategies.