Green light, red light

The go, go, go of markets in January quickly turned to no, no, no in February. The reversal in risk sentiment was driven by a more resilient growth outlook in many parts of the world. While this may normally have been good news, it comes at a cost of potentially stickier inflation which fueled the higher for longer narrative. The result was a sharp rise in bond yields over the month and equity markets which suffered some of their largest weekly losses this year. The Barclays Global Agg bond index fell 3.3%, developed market equities by -1.5% and emerging market equities by -4.6% (total returns in local currency).

The consensus view heading into 2023 was for a recession around the world. The energy crisis in Europe would lead to energy rationing, weak business investment and a heavily restrained consumer. In the U.S., the fiscal induced sugar high was coming to an end and rising costs of living was to curb consumption. Meanwhile, China was expected to struggle as it slowly edged out from the heavy blanked of mobility restrictions.

What materialised was a warmer European winter and an economy that was able to diversify its energy imports. A U.S. consumer that has continued to spend in the face of rising costs and strong labour market, and Chinese policy makers throwing the covers off the economy as COVID restrictions quickly went to zero.

All of this has led to a surprising resilience in the global economy and stronger than expected economic data and means the odds of an imminent recession have declined.

The downside is that stronger demand means inflation pressures will be slower to abate and rates must either get more restrictive or stay restrictive for longer. Central banks have leaned into their hawkish messaging and markets responded by lifting the terminal rate higher across central banks policies, and reduced the probability of rates being cut this year.

The increased risk of a central bank induced recession caused by a policy overshoot does not create a favourable environment for either equities or the higher credit risk parts of the fixed income market. The back-up in bond yields may offer some scope to increase duration positions at more attractive prices but added uncertainty around the rates outlook, which may add to volatility in the  bond market.

The high degree of economic and market uncertainty suggest an up in quality bias in portfolios. However, the reset in prices from January’s strong run create new investment opportunities when the policy fog does clear.

Economy:

• The RBA’s February meeting minutes and speeches from Governor Lowe carried on the hawkish tone from the early February meeting statement where the RBA increased the cash rate 25bps. The notion that the RBA may be set for a pause that was outlined in only December of last year was quickly squashed as the debate centred on either a 25 or 50bps rate hike. We see the RBA hiking rates by another 25bps at each of the March and April meetings.
  (GTM AUS page 56)
• Contrasting the inflation fears was the weaker than expected wage growth for the final quarter of 2022. Wages increased 0.8% quarter-over-quarter (q/q) or 3.4% year-over-year (y/y). This was a benign outcome given the unemployment rate was at a 50 year low in December 2022.
• Similarly, the jobs figures for January were also weaker than expected as the unemployment rate rose to 3.7% and employment growth declined for the second consecutive month. January is a difficult month for data given the impact of COVID and the restrictions that have been in place in January of prior years.
  (GTM AUS page 8)
• Australia retail sales jumped by 1.9% month-over-month (m/m) (or 7.5% y/y) for January. The monthly series has been lumpy given the effect of November sales, Christmas spending season and holiday distorted January. Overall, the trend is softening.
  (GTM AUS page 8)
• The pace of house price decline moderated in February. At the national level house prices are just over 9% from their peak, but capital city prices only fell by 0.1% on the month and house prices actually rose in Sydney. Auction clearances have also improved. However, given the lagged impact of rate hikes there is likely to be more price pressures to come in the housing market.
  (GTM AUS page 10)
• The Purchasing Managers’ Indices improved in February suggesting more economic stability to come. Across the developed world the compositive index (manufacturing and services) rose above the threshold that suggests an expansion in economic activity. The improvement was driven by the services segment of the economy, as the manufacturing sector – while improving – is still feeling the impact from the slowing global goods cycle.
  (GTM AUS page 15)

Equities:

• The ASX 200 dropped 2.4% over the month, matching the decline in the U.S. S&P 500, but underperforming the gains made in European markets. The MSCI Europe index gained 1.4%. EM suffered as the rally stalled out and Asian ex-Japan equities fell 5.0%.
  (GTM AUS page 36)
  
• At the sector level the market was split. Utilities was the strongest performer (3.4%), followed by IT (2.7%), industrials (1.5%) and consumer staples (1.1%). At the other end of the scale the materials sector fell 6.6%, while financials declined by 3.1% (total returns in local currency).
• Valuations have crept higher over the month, but most markets are broadly in line with historical averages. Valuations are being supported not by a rising price in the price-to-earnings ratio, but rather the fall in earnings expectations over the coming year.
  (GTM AUS page 37/38)
• As earnings wrap up across both the U.S. and Australia some consistent themes emerged. Overall companies delivered revenue figures that were consistent with market expectations but earnings that were much lower. This illustrates the benefit in higher nominal growth that has supported sales but the increasing difficulty of passing on rising input costs which have eaten into profit margins.

Fixed income:

• Government bond yield reversed all of their January decline in February. The yield on the U.S. 10-year Treasury rose by 39bps to 3.94% and above where it started the year. The yield on the Australian 10-year government bond yield increased by a smaller 30bps to 3.86%.
  (GTM AUS page 53)
• The rise in yields created a headwind for fixed income markets more broadly. Global high yield bonds returned -1.2% for the month, and global investment grade bonds recorded a 3.2% loss (local currency returns).
  (GTM AUS page 50)

Other assets:

• The price of Brent crude oil was buffeted over the month as is trade between US$78-86 per barrel. Concerns around an escalation in the Ukraine war and renewed Chinese demand pulled and pushed on the price.  It ended the month at US$82 a decline of 1.2%.
  (GTM AUS page 64)
• Repricing the rates outlook created a favourable tailwind to the U.S. dollar and the dollar index gained 2.5% on the month. The euro (-2.4%), sterling (-1.7%) and aussie dollar (-4.3%) were all weaker against the greenback.
  (GTM AUS page 69)