Another volatile quarter

Global equities were volatile over the March quarter with the MSCI World Ex Australia Index (in AUD) delivering a total return of -8.4 per cent. This was partly driven by appreciation of the Australian dollar with the index returning -5.4 per cent in US dollars. We have also seen a sharper pullback in the technology-heavy NASDAQ. The escalating conflict in Ukraine has raised concern that inflation will remain elevated for longer and economic growth weaker than expected (particularly in Europe). Australian equities outperformed in comparison with the ASX 300 Accumulation Index returning 2.1 per cent for the quarter with the energy and materials sectors leading the charge.

Corporate earnings growth has remained robust and until recently global Purchasing Manager Indices (PMIs) have remained in expansionary territory. Concerns are growing that earnings revisions will turn negative and be a headwind for equity markets moving forward. We have seen GDP forecasts reduced as higher inflation, rising interest rates and weaker economic activity are factored in. While Chinese GDP growth for the December quarter was above expectations, concerns have grown that a target 5.5 per cent in 2022 may be challenging to achieve with a COVID-zero policy. Recent Chinese PMI data has also fallen to post-pandemic lows.

Global GDP growth forecasts have declined

Global shipping data indicates that supply chain disruptions are easing, although the conflict in Ukraine and Russian sanctions have led to a sharp rise in commodity prices including for energy, base metals and grains. Headline inflation in the US increased to an annualised rate of 8.5 per cent in March and core inflation (stripping out food and energy) remains substantially above the US Federal Reserve’s 2 per cent long-term target. With the unemployment rate dropping to 3.6 per cent, a tight labour market is likely to contribute to inflationary pressures.

At long last, a rising rate environment

In March, the US Federal Reserve raised interest rates for the first time since 2018 as it looks to tame inflation and also signalled that it will start reducing its balance sheet. The central bank’s “dot plot” shows that officials expect the Federal Funds Rate to reach 2.8 per cent by the end of 2023. While inflation has been more subdued domestically, the Reserve Bank of Australia has changed its tune and increased the cash rate in August for the first time since 2010. Domestic headline inflation also reached 5.1% in March and has been more broad-based than recent quarters. Fixed income returns have been impacted by rising government bond yields with the Australian 10 year yield reaching 2.8 per cent at the end of the quarter and continuing to rise in April.

Higher Australian inflation has been broad-based

The flow on effect for equities and fixed income

Valuations for equities have improved in absolute terms with the ASX 300 Index now trading on a forward price-to-earnings multiple broadly in line with the 10-year average. However, we may see further compression in valuations as interest rates rise and earnings growth slows. The ‘there is no alternative’ (TINA) argument is also fading as we have seen a convergence in equity market dividend yields and long-term government bond yields.

Yield gap narrowing given rising long-term bond yields

We expect that equity markets will remain volatile over 2022 and are cautious on the outlook given elevated inflation and the risk that central banks may be forced to increase interest rates faster than anticipated during a period when economic growth and corporate earnings are weakening.