Following is a quick update on the current market turmoil, courtesy of our asset consultant team – Oreana Portfolio Advisory Service.
In this Perspective, we answer some questions and provide some guidance through this challenging episode.
Please do not hesitate to contact your adviser should you wish to discuss.
Key points: Market turmoil
Global equity and fixed income markets are in bear-market territory.
Covid19 and the Ukraine war are challenges. But central bank reactions to elevated inflation are driving most of the damage.
Investors are pricing policy rates close to 4.0% in both the US and Australia.
Central banks are targeting a soft-landing for the economy. But a recession remains a risk.
Government bond yields have surged and are offering downside protection and income for the first time in several years.
Volatile conditions are likely here for the near-term. Being aware of the potential range of outcomes is important for investors.
Markets are in turmoil.
Global financial markets have had a brutally challenging start to the year. There have been few places to hide. Global equities are in a bear market – down more than 20% year-to-date. Global fixed income, typically used in a defensive part of the portfolio, is down 15% (Table 1). Diversified portfolios of equities and bonds have lost value year-to-date.
We expect these returns to impact many clients diversified portfolios and this will be evident in the upcoming June 2022 client portfolio statements.
Top 5 Questions being asked today
1. Why are markets so volatile?
We have discussed at length the challenges of Covid 19 and the Ukraine war facing the global economy. These inflationary forces have driven inflation well above central bank targets. Inflation reached a new 40-year peak in the US in May. Australian inflation sits well above the 3% upper target. And the Reserve Bank of Australia expects it to move higher.
High inflation has left central banks scrambling to reverse ultra-accommodative monetary policy. Rate hikes under way in the US and Australia. Markets now expect the policy rate to be close to 4% by year-end in both economies. That is a very rapid increase from the start of 2022, where rates were just 0.1% and 0.25% in Australia and the US respectively (Chart 1).
2. How high can interest rates go?
Rate hikes will impact inflation through demand, wages and house prices. Central banks want to lean against this type of inflation. They have limited control over supply side inflation – the rise in food, commodities and energy as a result of Covid19 and the Ukraine war.
Rate hikes also operate with a lag. This can be between 6 and 24 months. Central banks will want to hike enough to ensure they are controlling inflationary pressure through 2023, but not so much they cause a recession. Rates will go higher than the 0.85% and 1.00% currently in Australia and the US. But we think they will not go so high as the markets have predicted this year.
3. What is the risk of a global recession and/or one here in Australia?
There is a very narrow landing strip for central banks to achieve a “soft landing”. Central banks have almost always caused a recession when they hike rates. But it is possible to achieve a soft-landing for a period of time. A soft landing would involve:
rates moving higher, albeit less than markets are pricing,
inflation moving back towards central bank targets, around 2.5%,
growth slowing to around trend, and
jobs growth slowing from elevated levels.
The most likely alternative scenario is a hard landing. A hard landing would cause a recession over the next 18 months. A hard landing is a scenario where:
rates move above market expectations,
inflation remains elevated for a period of time,
growth falls below trend, and
the unemployment rate moves higher from current low levels.
The 20% decline in equities is a signal that investors currently expect around a 50% chance of a recession over the next 18 months. We think that probability is too high. The US economy remains robust. Banks and households have repaired their balance sheets. Jobs growth is strong. In Australia, the economy is enjoying a strong terms of trade boost thanks to elevated commodity prices. The unemployment rate is at historic lows. We think both economies are some way off a recession.
4. What should I do with my fixed income portfolio, it is down around 10% over the last year?
Higher central bank policy rates will slow growth. But the shift higher in rates is increasing the attractiveness of government bonds. A 10-year government bond is now yielding around 4.0% in Australia and 3.5% in the US (Chart 2).
In April, we shared our view that bonds play several roles in a portfolio. These include capital preservation, income, diversification and as a potential downside risk hedge. Bonds can also provide some capital appreciation.
At current government bond yield levels, investors can now access relatively attractive income, as well as gaining downside protection against a recession. This is the first time that has happened in our view since 2019.
5. How long will this volatility persist, should I buy the dips?
The near-term outlook is particularly challenging right now. Central banks globally are looking to remove some of the extraordinary monetary policy stimulus provided over the past decade. Inflation is elevated due to supply side constraints and solid demand. Both growth and defensive assets have been beaten down. This is a difficult path to navigate for investors.
There is a risk of growth slowing in the medium-term. But recession is by no means predestined. Monetary policy support has been successfully removed in the past. Soft landings have been achieved. While markets have become extremely pessimistic about the outlook, there may be light at the end of the tunnel. And despite the challenging start to the year, opportunities are starting to arise for long-term investors.
We think it is important to avoid knee-jerk reactions within diversified portfolios. Please get in contact with us if you would like to discuss further.
Norman Sinclair – MFinPlan, AFP ASIC No. 249943.
Kyle Medson – CFP, BCom (FinPlan & Inv) ASIC No. 328912 SFG Capital Holdings Pty Ltd trading as Sinclair Financial Group, ABN 42 609 798 469
Authorised Representative of Oreana Financial Services Limited
ABN 91 607 515 122, Australian Financial Services Licensee No. 482234
Registered Office Level 7, 484 St Kilda Road Melbourne, Victoria 3004 Australia
This advice may not be suitable to you because it contains general advice that has not been tailored to your personal circumstances. Please seek personal financial advice prior to acting on this information. Investment Performance: Past performance is not a reliable guide to future returns as future returns may differ from and be more or less volatile than past returns.
This email, including any attachments may contain information that is confidential, commercially sensitive and may be subject to legal privilege. If you are not the intended recipient you must not read, use, disseminate, distribute or copy any part of this email, disclose its contents to any other party, or take any action in reliance on it. If you have received this email in error, please contact the sender immediately and delete this email.
Sinclair Financial Group does not warrant that this email, or any attachments are free from viruses or other defects. Please ensure that you check them for viruses and defects prior to opening any attachments. Thank you.