The Market rebounded strongly during the month of July with most global share markets in positive territory. Together with the US S&P 500 up 9%, Nasdaq up 12%, the UK FTSE 100 up 3.6%, the Euro STOXX 50 up 7.0%, and the Australian All Ordinaries up 6.9%.
The Oracle model portfolios followed suit and were up similar amounts, see our latest quarterly newsletter for further explanation.
Similar macroeconomic themes continued throughout the month of July, including inflation and interest rates. Australia posted an annual inflation figure of 6.1% for the June quarter. This inflation rate is still well below the inflation rate in the US but remains above the Reserve Bank’s target level of 2-3%. It is expected that interest rates will continue to rise to lower this inflation rate. The futures market is currently pricing the official cash rate in Australia to reach 2.95% by Christmas, which is a further four rises of the standard 0.25%. It should be noted that this expectation has declined in recent weeks from approximately 3.4%, which suggests that the market doesn’t believe the RBA needs to be as aggressive as previously thought.
Inflation in Australia
It’s worth understanding what contributed to Australia’s 6.1% inflation number. Transport (including fuel and vehicles) was the largest at a 13.1% annual increase, followed by housing (including rent) at 9%, and household furnishings and equipment at 6.3%. The largest one is food and beverage, which experienced a smaller increase but represents a large component of most family budgets and so is a high weight in the consumer price index (CPI) basket. The chart below depicts the annual Consumer Price Index Constituent change:
Looking forward 12 months, we question what could these numbers be? It is very important to understand that inflation is a rate of change measure. So, for inflation to be 6.1% next June quarter these prices need to keep increasing at the same rate that they are today. To state another way, and at the risk of being redundant, if prices remain exactly at these elevated levels, inflation next year will be 0%, which would be a pleasing outcome to the Reserve Bank.
Purchasing a car
Anyone who has attempted to purchase a car recently, will tell you that used car prices are very high. It is very difficult to purchase a new car due to supply shortages. The former has been caused by the latter. We believe there is a good chance that this will resolve itself by next June and will therefore be a much smaller contributor to inflation, perhaps even showing deflation. Our theory is based on simple mean reversion caused by reduced spending on large items and an eventual resolution of supply shortages. Used car prices are currently approximately 19% higher this year than last (source). Similarly, fuel prices are up substantially due to strong demand for oil products from the rebound in travel activity worldwide and made worse by the Russia-Ukraine war. We will not try and forecast the resolution of war and removal of sanctions (unlikely regardless) but see it unlikely that oil prices will surge a similar magnitude over the next twelve months as it has in the last twelve.
Housing Market
The housing market is currently driven higher by shortages in building supplies and labour, as well as higher freight costs for materials. All this in an environment that is still seeing strong construction activity. Tighter monetary policy should reduce demand for capital projects and investment such as housing and should relieve some of the upward pressure on housing prices. Indeed, the ABS has reported that new dwelling commencements declined 6.5% in the March quarter after falling 13.5% in the December quarter.
See below chart that shows the rising number of dwellings under construction:
The chart below shows the rise of Dwellings approved in the private sector houses since 2007 to 2022:
Raising cost of food
Food and beverage prices have been impacted by rising agricultural prices, because of adverse weather events such as flooding and reduced grain exports out of Ukraine and Russia. This has also led to other travesties such as KFC using cabbage on burgers. This is difficult to forecast, but there is every chance there is some mean reversion downwards or some stability at the current level over the next 12 months.
Strong demand pushes up prices
The other categories we speak to as a group, because these are likely seeing price increases because of strong aggregate demand in the economy, which is both leading to and is caused by a tight labour market as defined by historically low unemployment, which is pushing up wages. This is precisely what the RBA is targeting with their rate increases. The RBA aims to reduce aggregate demand in the economy, or at least slow growth to keep prices at a stable level. Their target is for annual inflation of 2-3%. Prior to 2021 inflation was well below this level and in 2022 it has overcorrected. This has resulted in borrowing being more expensive for individuals and businesses, it is expected that investment will reduce, and the flow of money around the economy will also reduce, which will relieve pressure on prices.
This works for demand-side inflationary pressures; however, it will do little to dent inflationary pressures if those pressures come from restricted supply (as is the case with commodities exported by Ukraine such as grain or commodities under sanction from Russia such as oil and gas). Some components of Australia’s 6.1% inflation are being driven by supply restrictions and have every chance of reversing over the next 12 months, and some components are driven by strong demand, and will likely require interest rate rises to assist in reducing.
And now we come full circle. As mentioned, the market is pricing in a cash rate of 2.95% by Christmas, which suggests this is the level the market believes will bring inflation under control. The RBA is forecasting that the inflation rate will begin declining towards their target of 2-3% in the second half of 2022.
The Current Market Environment
The rally in equity markets over the past month has been strongest in the sectors whose profits are more heavily weighted to the future such as growth and technology companies. This suggests to us that the market in general may finally be on the same page as the central banks in terms of where rates are going.
At the start of the year, particularly in Australia, central banks were not forecasting large rate rises in the immediate future. Conversely, the market was expecting significant rises in interest rates which sent the markets in a downward direction. Then when rates did rise, they were larger than expected and the market reacted negatively. This month, when the US Federal Reserve (Fed) raised rates by 75 basis points, the market rallied, suggesting that this was smaller than expected, or perhaps even suggesting that the faster we get to the “terminal interest rate” the better. Indeed, Fed chair Jerome Powell stated that he believes they have now raised rates to a level that they believe is “in line with neutral interest rates,” meaning he believes interest rates are neither stimulatory nor contractive. The market liked this commentary as it now expects less rate rises into the future in the name of unwinding the accommodative covid policy, but they will return to being “much more data dependent going forward”.
In our view, share prices now appear to be trading less on macroeconomic forecasts (such as interest rates) and are now reacting more to company-specific factors such as earnings releases.
We have mentioned previously that it is likely that a recession (at least in the US and Australia) is likely to happen, which will either be brought on by high inflation or engineered by the respective central banks through interest rate rises in fighting inflation. One economic indicator that has historically foreshadowed a recession is the government bond yield curve. When shorter dated government bonds such as the 2-year US Treasury (which typically have a lower yield) are priced by the market at a higher yield than longer dated bonds such as the US 10-year Treasury (which typically have a higher yield), the market is signaling that it demands higher compensation for investments shorter in length due to the economic risks it collectively perceives in the short term. The following chart shows the difference (called the spread) in the 10-year US Treasury and the 2-year US Treasury yields. Where the line dips below zero is where the yield curve is said to have “inverted,” whereby the 2-year yield was priced higher than the 10-year yield.
All that prelude was to comment that just last week the US reported its second consecutive quarter of negative GDP growth – widely understood to be the definition of a recession. However, this is not technically the correct definition. In the US, at least, the National Bureau of Economic Research (NBER) has the job of declaring when and if the economy enters a recession. It is typically not declared until months down the road and the numbers have all been crunched, as there are other inputs it considers declaring a recession. For one, the US still has very low unemployment of 3.6%, which is causing some hesitation in calling the recession right now.
Is Australia in a recession?
We don’t believe so, as Australia still posted annual GDP growth of 3.7% for the March 2022 quarter and unemployment still at record lows around 3.5% (source: ABS). However, interest rate rises have only just started taking their toll and it remains to be seen what impact they will have on economy through the rest of the year. Remember, the Fed began raising rates a few months earlier than the RBA.
Markets look forward, and the risk of recession may already be priced into current market levels. We will continue to monitor for further signs of weakness in the portfolios, reducing positions where appropriate, while equally looking for companies that are undervalued where a fall in earnings and valuation may present a good long-term opportunity.
Written by Luke Durbin
Portfolio Manager
Oracle Investment Management
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