Hold the line

Historically, markets have tended to lead the economy which is what we are seeing now...

Market volatility has persisted as markets are continuously recalibrating to price in forward looking inflation and the subsequent impact on interest rates and economic growth. We believe that this market volatility will persist until there is evidence that inflation has peaked and bond yields have stabilised. Bond yields have been rising, with US 10 year treasuries trading above the 3% mark and Australian 10 year bond trading above 4% in mid-June 2022 and we expect yield volatility to continue of over the next six months.

With interest rates rising, there has been increased attention on the risk of recession. The risk of recession has increased as central banks tread the fine line between trying to curb inflation and trying not to strangle economic growth. To date, economic growth remains positive, but some of the cyclical indicators are softening, indicating that the global economy is slowing. The main issue for the central banks is that monetary policy is a very blunt tool and while raising rates will most certainly curb demand, it will do little to address the supply side issues global economies are facing as supply chains remain stressed by the pandemic. A good example is China where the hard stance on Covid lockdowns have essentially brought Chinese ports to a standstill. Additionally, the war in Ukraine has driven commodity prices up including crude oil and agricultural products such as wheat, fertilizer and canola oil. Ukraine and Russia combined contribute 12% of the world’s total calories and are key suppliers of grains to Africa and the middle east. Therefore, whether we head into a recession will be dependent on the two key factors of easing of supply chain issues and central banks not overplaying their cards by raising rates too high. At this stage, our base case for Australia is that we will avoid a recession and if we do go into recession, it will not be a deep recession.

However, it is not all bad news when it comes to recessions and markets. The relationship between market returns and economic growth is inconsistent, meaning that low economic growth does not always mean low market returns and vice versa. Historically, markets have tended to lead the economy which is what we are seeing now as markets seek to price in where interest rates will go to. We have already seen markets fall around 20% as they try to price in inflation and implications on economic growth. Markets have historically recovered strongly from recessionary environments and downmarkets have tended to be short and sharp, followed by a strong rebound.