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Overview
Equities and bonds continue to come under pressure from rising interest rates and persistent inflation.
Fears of a recession continue to fester, although corporate profits have remained robust so far.
Within equities, large performance differentials exist. Energy companies remain the standout in 2022, and growth‐oriented stocks the laggards. Within bonds, short‐dated bonds are holding up, while those sensitive to interest rates and credit risks have struggled.
Looking ahead, improving yields and valuations are a positive development for investors in pursuit of their long‐term goals.
Global shares
For just the second time in 40 years, bonds and stocks both posted losses for two consecutive quarters. This is an obvious concern for investors as they weigh four key developments: 1) an inflationary squeeze, 2) rising interest rates, 3) recessionary preconditions, and 4) tightening corporate profit margins.
Of the four developments, the primary driver of the 2022 downturn continues to be inflation and the consequential reset in investor expectations. In this regard, uncomfortably high and persistent inflation has spurred central banks to raise interest rates, while the war in Ukraine pushes up energy prices, tangling supply chains and casting a cloud over the global economy. Prominently, the U.S. Federal Reserve raised rates in May and June by a combined 125 basis points (1.25%) and promised more hikes until inflation shrinks toward the 2% goal.
The MSCI World Ex‐Australia NR Index retreated ‐14.4% over the quarter in local currency terms, reducing the 12 month return to ‐11.2%. In Australian dollar terms, quarterly returns were ‐8.4% due to the falling Australian dollar, reflected also in the 12 month return of ‐6.5%.
While producing a negative quarter at ‐2.7%, Energy is still the standout positive performer over the year, returning 36.8% in local currency terms over the last 12 months. Losses were largest in the Consumer Discretionary and Information Technology returning ‐22.0% and ‐21.0% in local currency terms, respectively. All remaining sectors returned in the red over the quarter: Communication Services (‐18.2%), Materials (‐16.2%), Industrials (‐13.7%), Financials (‐13.8%), Real Estate (‐13.1%), Health Care (‐5.4%), Utilities (‐5.4%), Consumer Staples (‐3.8%) all measured in local currency terms.
U.S. shares ended the quarter returning ‐16.1% in local currency terms. The Federal Reserve again noted the strength of several economic activity indicators in the U.S., with labour market conditions improving, though implications from Russia’s invasion of Ukraine remain uncertain. Over 12 months, U.S. shares returned ‐10.6%. Europe ex‐UK and the U.K. returned ‐10.8% and ‐2.9% in local currency terms, respectively.
Australian shares
Australian shares had a challenging quarter in line with global indices, with the ASX200 index returning ‐
11.9%. While all sectors produced negative returns, I.T, Consumer Discretionary and A‐REITS were hit the hardest and returned ‐26.3%, ‐17.5%, and ‐15.6%, respectively.
Key stats (ASX 200) (12‐month returns in brackets): ‐11.9% (‐6.5%).
Bonds
Bond yields increased over the quarter (the U.S. 10‐year bond yield finished around 3.0%), with inflation in the U.S. continuing its upward trajectory. This saw declines in the global benchmark index.
Key stats in local currency terms, (12‐month returns in brackets): Australia: ‐3.8% (‐10.5%); Global: ‐ 8.2% (‐15.2%).
Global property & infrastructure
Domestic and global listed property & infrastructure sold off alongside global equities, albeit less
Key stats (in AUD terms) (12‐month returns in brackets): Australian listed property: ‐17.49% (‐11.22%); Global listed property: ‐15.6 (‐10.4%); Global listed infrastructure: ‐4.9% (+9.4%).
Currencies
The U.S. dollar appreciated against most major currencies given the sharp rises in the Federal Funds rate.
Changes to the Balanced Portfolio over the June quarter
In International equities, we started building allocation to U.S. healthcare and selectively added to Consumer Staples. These sectors offer a more defensive profile and tend to be able to weather inflationary periods better than most sectors. We also started building an allocation to U.S. technology (via the communication sector) which has sold off considerably since the beginning of the year and is offering better value. In Europe, we also broadened out our financials exposure by adding to insurers. To fund these changes, we reduced exposure to Energy and sold out of European telecoms.
Positioning & Outlook
For all the attention on stocks, bonds are perhaps the bigger story. The asset class saw its worst quarter in over 20 years, from January 2022 to March 2022.
Typically, investors seek out bonds for their defensive nature and certainty of income and the potential to provide protection and diversification in periods of stress. Such outcomes can normally be expected over the longer term. However, over the shorter‐term bonds can deliver disappointing outcomes where returns are negative and/or when share markets are falling. Unfortunately, recent developments have resulted in such outcomes for most bond markets, and it is worth understanding the drivers of these moves and the implications for defensive portfolios moving forward.
Since the lows in bond yields in late 2020, bond yields in Australia and the U.S. have risen by 2% resulting in losses of more than 10%. The two primary reasons for the poor returns in bond markets has been the sharp rise in inflation as well as strong economic growth as the world recovered from the depths of the COVID crash. In response to these developments central banks around the world have indicated the need to push interest rates higher. Consequently, bond markets have looked to account for these future moves seeing yields push materially higher from their near all‐time lows.
In recent years we have held an underweight position to Australian and international bonds due to the low yields on offer. This has served to cushion against the falling bond prices. Bond markets today are in a much better position to provide:
Better future protection against a risk‐off scenario – should we face another economic downturn, this will likely be accompanied by higher bond prices. With higher yields on offer, they can fall further and provide better protection.
Broad index returns over the last 12 months were as follows:
‐ Australian equities ‐6.5%
‐ Global equities (local currency) ‐11.3%
‐ Chinese equities ‐30.8%
‐ Australian bonds ‐10.5%
‐ Global listed property ‐10.4%
‐ Global listed infrastructure +9.4%
Looking ahead, it is important to remember a wide range of outcomes is possible. Our role is to construct portfolios that help members reach their long‐term goals. In every situation, the right approach is to view the future probabilistically and think long‐term.
As advocates of great investing, we must collectively resist impulse. Accepting volatility is a prerequisite for good returns in any market, but today’s market arguably requires greater care than usual. In our view, this necessitates us to target the best assets with careful sizing and diversification.
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Past returns are no guarantee of future performance, and investment returns of less than one year should not be relied upon as any guide to future performance.