Quarterly Market Outlook

JUNE 2022
David_Chen-bw.jpg
By David Chen,
Quantitative Analyst Capital & Investment
“Global growth continues to slow due to high inflation resulting in central banks raising policy rates. The significant pace of monetary tightening has sparked recession fears.”



“High inflation, particularly in oil and food remains the key risk for global economies”




China’s strict Covid-zero policy led to a slowdown in growth amidst frequent virus outbreaks, further exacerbating fragile supply chains and resulted in high unemployment.



“The ongoing war caused oil prices to peak around $120 per barrel in early June and resulted in severe supply shocks to food and other commodities.”


The main risk from labour shortage is that the higher wages to attract workers are then passed onto consumers resulting in higher prices of goods and services


We remain cautious over the near-term and we have tilted towards a more defensive risk position.


Headwinds from record inflation, the Russia-Ukraine war and China’s lockdowns continue to place pressure on global equities. We expect a significant interest rate rise as a response by the US Fed during their July meeting which will add further pressure to equity markets.






 
 

      Key Insights

  • Lingering high inflation continues to hurt households

  • Central banks globally have increased the pace and magnitude of rate hikes to quell inflation

  • The war in Ukraine has dealt a major shock to the global energy and agricultural sectors, disrupting both production and trade

  • China’s hardline Covid zero policy has exacerbated disruptions to fragile supply chains and adversely impacted the labour market

  • We remain cautious in the near-term and have positioned the portfolio to a more defensive position.

 

Overview

“Global growth continues to slow due to high inflation resulting in central banks raising policy rates. The significant pace of monetary tightening has sparked recession fears.”

Global growth continues to slow due to high inflation resulting in central banks raising policy rates. The significant pace of monetary tightening has sparked recession fears, leading to a heavy selloff in equity markets during the June quarter. Australian financial markets have experienced significant volatility similar to other developed economies despite a lower inflation rate. Recession fears caused commodity prices to drop sharply at the end of the June quarter, hurting the high index weighted materials and energy sectors. The Australian construction industry continues to face significant pressure due to high-cost pressures, leading to thousands of builders going bust. 

Consumer sentiment is at historical lows, which is at odds with the strong labour market. Consumers are spending cautiously and this has dampened expectations for future demand. The war in Ukraine continues to disrupt supply chains in Europe, particularly for commodities and food.  Geopolitical risks are further exacerbated by a Covid-zero policy in China. The US Federal Reserve’s (Fed) hope for a ‘soft landing’ is rapidly fading and the risk of a recession for global economies has increased. The higher risk of recession was reflected in observed further inversion of the two-year and ten-year US bond yields. This observation has been an accurate signal of an imminent recession since 1955. 

Overall, risks have risen, and financial markets are expected to remain volatile. We have maintained defensive settings in our portfolios.

 

Economic Views and Key Risks

“High inflation, particularly in oil and food remains the key risk for global economies”

Chart 1: US Core vs Headline Inflation

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Source: Bloomberg
 
 
Chart 2: Crude Oil Price (USD)
Screen_Shot_2022-07-28_at_4.59.22_pm.png
Source: Bloomberg
 

High inflation, particularly in oil and food remains the key risk for global economies. From a portfolio perspective, high inflation is negative for both equities and fixed income as it leads to more aggressive rate hikes to dampen demand. This reduces earnings for companies and simultaneously increases bond yields, which reduces valuations. The key drivers of inflation are higher commodity prices, ongoing supply chain disruptions and tight labour market conditions. The most recent June US CPI of 9.1% was above expectations and will likely lead to another significant rate hike by the Fed in their July meeting. The silver lining is that core inflation (which strips out volatile food and fuel components) slowed for the third consecutive month as shown in Chart 1. Chart 2 shows the oil prices peaked in early June but has since fallen below $100. If this trend continues, it could mean a peak in headline inflation that investors have been hoping for, driving central banks to soften their hawkish stance.  

Australia’s March CPI data hit historical highs and the RBA was forced to hike rates earlier than expected. In Chart 3, we see the hiking cycle beginning slowly in both the US and Australia with a 25bps hike but quickly stepped up in momentum as higher than expected CPI data was released. The latest rate hikes of 75bps in the US and 50 bps in Australia were the highest since 1994. 

China’s strict Covid-zero policy led to a slowdown in growth amidst frequent virus outbreaks, further exacerbating fragile supply chains and resulted in high unemployment.

 

 

Chart 3: AU and US Cash Rate

Screen_Shot_2022-07-28_at_5.16.02_pm.png

Source: Bloomberg 

 

Chart 4: China Unemployment Rate

Screen_Shot_2022-07-28_at_5.19.58_pm.png

 Source: China’s National Bureau of Statistics


China’s strict Covid-zero policy led to a slowdown in growth amidst frequent virus outbreaks, further exacerbating fragile supply chains. A large Covid outbreak in Shanghai culminated in a 2-month long strict lockdown which ended on the 1st of June. Whilst strict lockdowns have been effective in containing the spread of the virus, the damage to economic growth and unemployment have been significant. Chart 4 below shows China’s unemployment rate rising to 6.1% by end of April, surpassing levels seen during the first covid wave in Wuhan in early 2020. The cohort that was particularly hit the hardest were urban youth unemployment (16 to 24-year-olds and captures recent high school and University graduates) that climbed to a staggering 18.4% in May, from 13.6% a year earlier. 

 

Chart 5: China Private Credit Growth

Screen_Shot_2022-07-28_at_5.31.10_pm.png

Source: China’s National Bureau of Statistics

 

China’s target GDP growth rate of 5.5% is under immense pressure from the economic slowdown. This has added downward pressure to global commodity prices. In response, China has announced fiscal and monetary stimulus, including large infrastructure projects, lower taxes to induce spending and reduction of lending rates to spur private credit growth. Chart 5 shows private credit growth starting to rise in 2022 as stimulus enters the market and will be key to the recovery story in China. Just 18 months earlier, China had introduced tough measures to reduce credit growth to cool the market and curtail developers. China’s inflation rate of 2.5% is low relative to global peers, but efforts to stimulate the economy could be hampered if high inflation were to be experienced in China. 

The ongoing war caused oil prices to peak around $120 per barrel in early June and resulted in severe supply shocks to food and other commodities.

The Russian-Ukraine war continues to pressure supply chains. The ongoing war caused oil prices to peak around $120 per barrel in early June and resulted in severe supply shocks to food and other commodities. Russia has responded to sanctions by cutting gas supplies to Europe, which has been inflationary. Commodity prices have been steadily increasing since the onset of the war. This has fed through to higher headline inflation numbers globally. It remains uncertain how the conflict will be resolved but until it does, economic sanctions on Russia and its energy exports will continue and suggests commodity supply disruptions will remain for an extended period.

The main risk from labour shortage is that the higher wages to attract workers are then passed onto consumers resulting in higher prices of goods and services

Tight labour markets continue to baffle economists as unemployment rate falls to record levels. Whilst normally a positive signal for the health of an economy, in today’s environment, it presents a problem and may give central banks more reasons to step up rate hikes. Open vacancies have increased and forced wage growth. There are fears this wage growth will fuel inflation further and require significant monetary tightening to control. Chart 6 shows Australian unemployment falling to 3.5% in June, its lowest level since 2008. Australia’s wage price index is increasing rapidly from COVID lows and is currently at 2.4% yoy in March, matching pre-covid levels (refer to chart 7). The main risk from labour shortage is that the higher wages to attract workers are then passed onto consumers resulting in higher prices of goods and services. 

 

Chart 6: AU and US Unemployment rate

Screen_Shot_2022-07-28_at_5.35.44_pm.png 

Source: Australia and US Bureau of statistics

 

Chart 7: Australia Wage Price Index

Screen_Shot_2022-07-28_at_5.37.31_pm.png

Source: Australia and US Bureau of statistics

 

Chart 8: Labour Participation rate

Screen_Shot_2022-07-28_at_5.39.22_pm.png

Source: Australia and US Bureau of statistics

Labor force participation plummeted in the early stages of the pandemic (Refer to Graph 8) as many businesses closed, schools moved online, and individuals isolated due to health concerns. Although economic activity has since rebounded sharply, labor force participation rates remain well below pre-pandemic levels in the US. In Australia, the opposite has occurred, and participation rates are at historical highs. The on-going shortage of migrant workers caused by border restrictions during the pandemic impact supply. Coronavirus health concerns also contributed to less people joining the work force. Economists also believe demographic factors such as slower population growth and an aging population play its part, particularly as ‘baby boomers’ exit the labour market. In addition, political risks have added to the decline in immigration. In the US, the “great resignation”, coined by professor Anthony Klotz to describe the high number of dissatisfied workers who quit their jobs en masse over the past 2 years, has added to the worker shortage. In Australia, Covid related disruptions was the main driver for the 13% less lower number of students entering Australia overall in the past year. These students make up a valuable part of the work force, particularly for casual jobs in retail or hospitality. Australia’s tense relationship with China was also a factor leading to 24% less students arriving specifically from China. It is uncertain how economies will deal with a tight labour market in an inflationary environment and remains a risk to inflation in the near term.

Macro Views

Our global macronomic economic views are set out in the following table:

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Australia

   Screen_Shot_2022-07-28_at_6.18.31_pm.png              

Recent falls in commodity prices from recession fears and China’s slowdowns have hurt Australia’s export sector. The construction sector remains under pressure due to high costs. The RBA has taken a more hawkish stance in the face of rising inflation and quickly brought cash rates up to 1.35% by July, impacting on residential property, particularly in Melbourne and Sydney. China’s slowdown from continuous lockdowns remain a key risk. GDP growth remains strong due to higher commodity prices over the past year, however prices are softening from recession fears.

USA

   Screen_Shot_2022-07-28_at_6.18.31_pm.png            

The Feds are likely to continue to hike rates aggressively. The latest June CPI print of 9.1% was above expectations. US consumer sentiment plunged in early June to the lowest on record due to roaring inflation adding torecession fears. In addition, the surging US dollar is hurting US global tech giant earnings. 

 Europe & UK                    

   Screen_Shot_2022-07-28_at_6.18.06_pm.png            

We expect the Ukraine war and political risks around the European region to continue to pressure global supply chains. Russia has reduced gas supply to Europe and threatened further action due to tough sanctions. The Euro has fallen to historical lows, trading on par with the US for the first time in 20 years. The European Central Bank is conflicted between curbing inflation and cushioning a slowing economy. The recent resignation of Prime Minister Boris Johnston further adds to geopolitical risk in the region.

China

   Screen_Shot_2022-07-28_at_6.18.31_pm.png            

China’s harsh lockdowns have crippled consumer confidence and economic growth. Its Covid-zero policy remains a key risk and is expected to continue. China’s unemployment has been rising and its property market continues to decline. 


 

 

Upside and Downside Case

The following shows the opportunities and risks around our base case. The short-to-medium term outlook still dependent on the outcome of the Ukraine war, the trajectory (and pace) of monetary policy tightening and global inflationary pressures. 

Upside
  • COVID-19: Transition from a pandemic to an endemic disease that can be managed without strict lockdowns in most countries. High levels of vaccination could contribute to more open borders.

  • Oil prices easing from lower demand and higher production output from OPEC help to reduce inflation

  • China announces strong fiscal and monetary stimulus drive consumption and investment, enhancing global growth

  • Inflation reaches its peak and begins to trend downwards resulting in central banks adopting less hawkish stance

Downside
  • Risks to rising inflation resulting in central banks raising rates faster than expected

  • Uncertainty in geopolitics (particularly the Ukraine conflict and instability in the UK)

  • China’s COVID-zero policy continues with immediate threats to global supply chains from additional lockdowns

  • The possibility of more transmissible/more deadly COVID-19 mutations

  • Cost pressures and labour shortage continue to pressure on the construction industry in Australia

  • Slowdown in global growth due to central bank actions can lead to higher unemployment levels

 

Total Portfolio Positioning and Key Implication for Market 

We remain cautious over the near-term and we have tilted towards a more defensive risk position

 The key views drive all client recommendations and covers the main asset classes. Subsector views provide the relative preference between subsectors within an asset class. Not all asset classes are covered in the subsector views chart. Only subsectors where Frontier has an active view are included.

Screen_Shot_2022-07-28_at_7.41.54_pm.png

 Source: Frontier

We retain our negative view on equities and have increased our underweight position to both Australian and Global equities. While valuations have improved due to the recent sell-off, inflation continues to increase. This in turn, will lead to more aggressive tightening from central banks, raising recession risks.

In Australia, conditions have deteriorated further from last quarter. Over the recent months, the faster pace in tightening has put added pressure on the economy and reduced consumer sentiment. The financial sector continues to be impacted by the RBA’s aggressive rate hikes with concerns around higher bad debts and a weakening residential real estate market. Challenges are expected to continue for the construction industry. In addition, commodity prices have weakened recently on the back of recession fears and this is a key risk for the Australian market going forward. 

Headwinds from record inflation, the Russia-Ukraine war and China’s lockdowns continue to place pressure on global equities. We expect a significant interest rate rise as a response by the US Fed during their July meeting which will add further pressure to equity markets.

Headwinds from record inflation, the Russia-Ukraine war and China’s lockdowns continue to place pressure on global equities. We expect a significant interest rate rise as a response by the US Fed during their July meeting which will add further pressure to equity markets. The key risk is ongoing upside surprises on inflation which will add to the risk that central banks have to be more hawkish, and diminishing the expectation for a soft landing. As a result, there are risks of margin compression in future earnings as companies combat profit squeezes from rising input and labour costs in response to higher bond yields. Earnings season will be critical to gauge the health of the US economy with several companies already reporting weaker outlooks amidst softer demand and higher costs.

We moved to a less negative view on government bonds due to bond yields rising significantly over the past quarter, particularly in the shorter end of the curve. We reduced our underweight in fixed income bringing it closer to SAA. We have also moved to a positive view on credit as we see value in the current spread on government bonds. Australian investment grade credit spreads have risen above historical averages and present value at current levels. We look to add to our credit allocation given the opportunity. 

We move to a more negative view on Property and have reduced the listed property allocation. Retail and office property continue to face cyclical (declining rents and increasing vacancies) and structural (working from home and e-commerce) negative impacts. Industrial assets continue to outperform but are now starting to look expensive. In particular, rising bond yields which translates to higher borrowing costs, continue to hurt listed property. Valuations have also fallen materially over the last quarter, with the expected hawkish RBA rate guidance to continue to add pressure to the asset class in the near future. The real estate development exposure within the listed property index is expected to continue to be impacted by soaring construction costs from shortages of raw materials and labour. 

We increase our overweight position in Cash to preserve capital and reduce the overall portfolio volatility.

The AUD appears to be undervalued based on fundamentals. We continue to value the downside protection potential of foreign currency but note that with commodity prices rising and a China stimulating scenario, there will be upward pressure on the AUD. The decline in iron ore prices over the past year contributed to the weakening AUD. We maintain our neutral view on Foreign Currency.

Asset Allocation Views

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Asset Class

Key views

Rationale

Australian equities

Screen_Shot_2022-07-28_at_6.18.31_pm.png

Earnings pressures remain within the financial sector on the back of aggressive RBA rate hikes. The Materials sector face headwinds from recession risks impacting on commodity prices.

Global equities

Screen_Shot_2022-07-28_at_6.18.31_pm.png

Volatility persists with the Ukraine invasion and more aggressive pace of tightening interest rates which could dampen earnings growth. China’s covid-0 policy to pressure supply chains.

Fixed interest - Gov’t Bonds

Screen_Shot_2022-07-28_at_6.18.31_pm.png

Bond yields have risen to reasonable levels, however high inflation still present risks in the near term.

Fixed interest - Credit

Screen_Shot_2022-07-28_at_6.19.09_pm.png

Credit spreads have widened significantly and now present value.

Property - A-REITs

Property - Unlisted

Screen_Shot_2022-07-28_at_6.18.31_pm.png

Rising bond yields continue to weigh on the asset class. Spread above government bonds have compressed significantly.

Cash

Screen_Shot_2022-07-28_at_6.19.09_pm.png

Cash provides capital protection and reduce portfolio volatility.

Foreign Currency

Screen_Shot_2022-07-28_at_6.18.57_pm.png

The AUD continues to look undervalued, driven by high commodity prices and the move higher in interest rate differentials.

  
Disclaimer

CCI Asset Management does not guarantee the repayment of capital or the performance of any product or any particular rate of return referred to in this presentation. The information contained in this presentation is current as at the date of preparation but may be subject to change.

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