We’re going on a bear hunt

The global economy lost momentum in July as goods demand faded and inflation readings for June pushed new highs. The U.S. economy technically fell into recession, and the eurozone is not far behind. Despite all this, risk assets posted strong returns over the month and the MSCI World index gained 8% while Global High Yield bonds returned 6.0% on the month.

The link between economic weakness and market strength was the repricing of the rate outlook from the U.S. Federal Reserve (Fed) and views that June represented both the peak in inflation and peak in hawkishness. This sets up a policy outlook which may be more balanced between growth and inflation and could see the pace of magnitude of rate hikes from the Fed and other central banks taper over the coming months.

However, the weakness in economic data created a defensive lead rally in equities and growth stocks more broadly. Global growth stocks rose 11.5% over the month and their higher weighting in U.S. equity markets lifted the S&P 500 by 9.2%.

Two quarters of negative growth in the U.S. mean that it meets the media friendly definition of being in a recession. However, broader definitions by National Bureau of Economic Research, which capture other aspects of economic momentum, suggest it is not. Importantly, the labour market strength is at odds with their definition.

While there is a strong possibility that the 2Q real GDP figure for the U.S. will be revised higher in the coming quarters, this does not change the tenuous growth outlook for the U.S. and global economy as inflation pressures bite and goods demand has dropped sharply weighing on forward-looking business surveys. Meanwhile, China continued suppression of the COVID outbreaks and housing market risks have created a new cloud over what should have been a stronger second half. The silver lining of the weaker demand is that supply chains have improved materially as supply was able to catch up with the demand.

The economic effects of tighter central bank policy became a reality in July, however, equity and credit markets had priced in a significant level of economic risk heading into the second half of the year. The potential easing-up on policy tightening means that risk assets were able to deliver positive returns. There remains significant economic headwinds that could dampen spirits once again and suggests cautious positioning in what may end up as a short-lived bear market rally. 

Economy:

• The Reserve Bank of Australia (RBA) and the U.S. Fed delivered on market expectations as each increased policy rates by 50bps in their last meetings, but the size of rate hikes is likely to be smaller from here given the growth risks. The RBA’s assessment that inflation is still on the rise suggests there is more to come. Just like the Fed, the RBA is watching the data closely and both these central banks become more reactive in setting policy.
• Headline Consumer Price Index inflation for the second quarter in Australia rose by 6.1% and the core rate of inflation by 4.6% year-over-year (y/y). This put the headline rate of inflation at the same rate as the prior peak in 2001. Three factors continue to drive inflation in Australia, food, energy and building costs for housing.
  (GTM AUS page 7)
• The housing market remains in focus in Australia as activity continues to slide. The elevated leverage in the housing market and the impact on consumption from both the wealth effect and lowering of disposable income is a risk to the economic outlook. New housing loan commitments fell 4.4% month-over-month (m/m) in June.
• Meanwhile, in July, house prices declined at the fastest pace from their recent peak since the 1983 housing cycle as national house price fell a further 1.4% m/m in July and are now 2.6% lower than their peak. The market historically does not tend to turn until the RBA starts to cut interest rates.
  (GTM AUS page 10, 11)
• The unemployment rate in Australia dropped sharply to 3.5% in June and was well ahead of expectations. While the labour market is undoubtedly strong, the decline in the unemployment rate may have more to do with the reduction in job-shedding, as employers hoard staff to cover unexpected staff shortages, rather than increased new hiring.
  (GTM AUS page 8)
• Global business surveys have softened materially in July as global goods demand has softened. The global Purchasing Managers’ Index (PMI) has fallen to 51.1 and not far above the key threshold of 50 which separates expansion from contraction in the economy. European PMIs fell into contraction territory. The sub-indices of the PMI relating to inventory levels and supplier delivery times have improved in recent months and point to an improvement in global supply chains which should ease inflationary pressures.
  (GTM AUS page 15)

Equities:

• The ASX 200 rose 5.8% in July with every sector except Materials (-0.7%), Information Technology (15.2%) and Real Estate (12.1%) showing the strongest gains.
  (GTM AUS page 35)
• The “not bad, less good” U.S. earnings season helped to lift the U.S. equity market in July. With three quarters of the S&P 500 having reported earnings per share growth is tracking 2.3% y/y, but a much lower -8.9% y/y excluding energy.
• Meanwhile, the August reporting season in Australia is likely to share a similar trend given the pressure on consumers and the positive impact on net interest margins of banks as yields rise. Energy sector performance will likely distort headline earnings growth figures. Corporate guidance may lead to further earnings downgrades.

Fixed income:

• The improvement in investor sentiment and positioning for lower growth was evident in the bond market. The Australian 10-year government bond yield fell 60bps to 3.06% at the month end. Meanwhile, the U.S. 10-year Treasury yield came in 33bps to 2.64%.
  (GTM AUS page 50)
• Credit spreads narrowed over the month and the recession risks have not seen the credit market capitulate offering a better risk-adjusted reward in our view.
  (GTM AUS page 51)

Other assets:

• Commodity prices fell across the board over July as demand prospects weakened but also as further sanctions against Russian oil were delayed. The price of Brent oil fell to USD 110 per barrel.
  (GTM AUS page 62)
• Meanwhile, iron ore prices experienced another month of falls to USD 107 as shipments from Brazil increased. The price of gold was notably weaker this time moving in line with moderating inflation expectations rather than rising rate views.
  (GTM AUS page 64)
• The Australian dollar recorded a modest 1.5% gain against the U.S. dollar getting back to USD 0.70. The bigger currency news was the euro dipping below parity to the U.S. dollar as gas shortages and recession fears hit the currency. The euro recovered as the European Central Bank raised interest rate by 50bps, initiating the first rate hike in 11 years.