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Market Update – July ’22

Economy – Engineered Serendipity

As widely expected, the RBA lifted the cash rate 50bps to 1.85 per cent at the August meeting. Going forward, our preference is for 40bps in September, albeit the RBA to date has preferred normalised numbers such as 25bp/50bp increments. This would signal a gradual slowing from the 50bp quantum and provide a sequencing signal to subsequent movements of 25bps in October, November, and December. We view the move back to normalised interest rate levels, i.e. 2.25 per cent for September, enabling simpler communication to the general public and media outlets. Prioritising broader levels of understanding and communication at this juncture is warranted. Nevertheless, a neutral real cash rate of anything below 1.5 per cent is analytically indefensible. Yet, we see more and more commentary regarding this point with questionable estimation assumptions and empirically unqualified methods of determining neutral real rates.

The debate about whether the US is in recession or when it will has recently flared. In Q2, real GDP declined 0.9% on a seasonally adjusted, annualised basis. The US has experienced two consecutive quarters of negative GDP growth. The White House preemptively argued that this is not a recession. Jerome Powell weighed in, explicitly stating that the US is not in recession. The US National Bureau of Economic Research (NBER) argues that a recession is “a significant decline in economic activity spread across the market, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”. Despite the arbitrary nature of this continuous debate, the simple facts are growth will be low and slow for some time, yet shallow.

So what did the GDP data tell us? Many aspects of the data were negative in real terms. These include expenditure on goods, private investment, and changes in private inventories. An increase in services offset the decline in goods expenditure. Net exports also increased. These factors suggest that consumers have become stretched. This is consistent with inventory buildups at major retailers, such as Target. Thus, the GDP data is not positive, even if we do not technically label it a recession. The GDP data notwithstanding, there are still some positive signs in the economy that offset the negativity. These include low unemployment, albeit on consistently low participation rates. The average consumer still has high savings levels despite a significant draw down from historically high levels. The savings rate has fallen to 5.1% from circa 23 per cent, and there is considerable heterogeneity in savings across consumers.

GDP data is not the only evidence of a slowdown in activity/growth. Two out of five New York and Philadelphia Fed surveys available at the time of writing reveal a weakness in new orders and falling supplier delivery times. This reflects the easing in supply chain disruptions. Input price inflation is also fading, consistent with the decline in commodity prices. There is a high probability that headline inflation has now peaked, but core CPI may remain elevated and sticky.

What does this mean for government yields? The Federal Reserve increased the policy rate by another 75 bps to a level of 2.5 per cent. The Fed had indicated they would take the policy rate to at least 3.5 per cent. However, Jerome Powell enlivened the neutral rate discussion, implying a possible slow down in the pace of Fed Fund hikes. The yield curve has steadily become more inverted: the 10-year yield is now around 26 bps below the 2-year yield.

Australia’s CPI inflation rose to 6.1%, with core CPI increasing 4.9% y/y. This is significantly below the CPI inflation of 9.1% in the US. However, upgraded forecasts by the RBA have Australia’s CPI inflation rate peaking at 7.75% and then moderating to much lower levels. This has created significant concerns at the regulatory and consumer level. Indeed, it has manifested in significant industrial unrest, which could weigh on economic growth.

The Eurozone inflation rate is now 8.6 per cent. However, there is significant heterogeneity. The lowest reading was 6.1% in Malta, and the highest was 22 per cent in Estonia. Germany’s inflation rate was 8.2 per cent. However, inflation could accelerate due to Russia’s willingness to weaponise its gas/energy supply. Russia is already engaging in supply “gaming” and creating significant uncertainty around supply. Europe’s economy has fallen further behind the US and Australia. The growth outlook for Europe is incredibly challenging due to the energy induced slowdown in activity. There is now a very high probability of the EU going into recession. Despite this, the ECB has increased its policy rate for the first time in 11 years, raising the policy rate by 50bps to 0%. The ECB has indicated that it will most likely raise rates again in September, either by 25 bps or 50 bps. The Eurozone has significant inflation challenges along with fragmentation and structural inadequacies. These points will be front of mind for investors for some time. Disparity within Europe is still a defining feature, with the yield on 10-year Italian bonds now at 3.04 per cent compared to German bunds, now at 0.81 per cent. The EU’s fragmentation measures, namely the Transmission Protection Instrument (TPI), aims to ameliorate much of this.

Still, regulated solutions appear to be having long-term adverse effects on the willingness of sovereigns to return to a firmer fiscal footing. The TPI enables “the Eurosystem to make secondary market purchases of securities issued in jurisdictions experiencing a deterioration in financing conditions not warranted by country-specific fundamentals”. However, should Italy’s economy be more adversely impacted than Germany’s in any specific situation, it is unclear if or how the TPI would resolve the situation.

Markets – Directional Arrows of Progress

Throughout July, corporate spreads tightened substantially across high yield and investment grade in Europe and the US. The tightening in Europe proceeded despite being at year-to-date wides of 626bps in high yield and 126bps in investment grade in the middle of the month. Interest rates were higher across most G7 economies, with the Fed raising the target rate for fed funds by 75bps for the second consecutive time to 2.50 per cent during its July meeting. A 50bp hike is fully priced for the September meeting, with a 75bp hike now at a 74 per cent probability. Inflation continued to rise over the twelve months to June 2022, with the CPI print of 6.1 per cent. Cross market volatility continued to reduce throughout July, with the VIX closing at 21.33 per cent in the US and the Australian VIX finishing at 15.3 per cent.

Inflation-linked bonds and real yields increased over the month, with the US 10-year real yield decreasing -by 56bps to close the month at 0.09 per cent. There was significant capital structure volatility experienced throughout July. Senior EUR financials tightened -19.1bps, our preferred proxy for senior preferred. European high yield tightened significantly by -41.2bps with elevated at-the-money (atm) volatility of 59 per cent. European Investment grade (IG) tightened by -70bps with elevated atm volatility of 61 per cent. AUS ITRX tightened slightly by -6.7bps. Similarly, in the US, investment grade tightened by -20bps with elevated atm volatility of 53 per cent. US high yield tightened significantly to 471bp (down -108bp) with atm volatility of 53 per cent. EUR Financials SUB tightened -41bps. Across bond ETFs, IBOXX (Corporate Investment Grade) and HYG (Corporate High Yield) closed up by 4.1 per cent and 6.2 per cent.

Australian government bond yields were lower over the month: the 3-year yield decreased -0.46bps (from 3.12 per cent to 2.66 per cent), and the 10-year yield decreased -0.60bps (from 3.66 per cent to 3.06 per cent).

Fixed Income Fund Performance

Credit quality is high, and the probability of default remains low on the cash bond portfolio. Given the backdrop and the repricing of risk, we are constructive on fund performance from October onwards. Positioning over July has benefitted from a deterioration in fundamentals in Europe and curve positions in Australia and the US. We see significant opportunities to add selective exposures across rates, inflation, credit, and geographical opportunities are now more prevalent. The market is still undergoing a recalibration of risk as the official/public sector steps away from public markets. Consequently, we expect high levels of volatility to remain a feature.

Christian Baylis

Christian Baylis

Christian has a Ph.D in Econometrics. He is a highly regarded Australian-based manager with broad experience across global fixed income and derivatives strategies.

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