Investment returns fall due to concerns about global recovery
Commentary on the June quarter by Russell Investments, UniSaver’s investment manager and consultant
Global share markets fell sharply in the June quarter, with the MSCI ACWI Index returning -5.7% in unhedged New Zealand dollar (NZD) terms. Much of the decline was driven by concerns that more aggressive central bank action in the face of persistently high inflation could derail the global recovery. In the US, consumer prices climbed a further 1.0% in May to be 8.6% higher for the year as a sharp rise in the prices paid for energy, gas and food continued to impact the cost of living. The outcome followed the 8.3% gain we saw in the 12 months to 30 April and marked the measure’s largest reading since December 1981. In response, the US Federal Reserve raised interest rates a further 0.75% midway through June. The move, which was the Bank’s biggest rate hike in almost 30 years, came on the heels of a 0.50% increase in early May and sparked fears that higher and faster rate hikes could tip the world’s largest economy (and potentially the global economy) into recession.
Elsewhere, record high inflation in the euro-zone saw the European Central Bank (ECB) confirm that it would raise interest rates when it meets in July, while the Bank of England lifted rates a further 0.25% after UK inflation surged 9.1% in the 12 months to 31 May. Stocks were also impacted by Chinese growth concerns and ongoing uncertainty surrounding the war in Ukraine. Limiting the decline was a series of encouraging US and European earnings updates, including Tesla, Johnson & Johnson and French spirits group Remy Cointreau.
At the country level, all three major US indices – the benchmark S&P 500 Index (-16.4%), the Dow Jones Industrial Average (-10.8%) and the tech-heavy NASDAQ (-22.4%) – fell sharply over the period. Stocks were also lower in Europe (-11.5%), the UK (-4.6%) and Japan (-3.9%), while China (6.2%) recorded good gains as the country finally began to emerge from government-imposed lockdowns.
Global bonds fell in the second quarter, returning -4.5% in hedged NZD terms. Longer-term government bond yields rose (prices fell) as more and more central banks raised interest rates in a bid to tame inflation. Partly offsetting this were the asset class’s traditionally defensive characteristics in the face of ongoing geopolitical uncertainty. In credit markets, spreads on US and European investment-grade and high-yield debt widened amid rising interest rates and recession fears. Hard and local currency emerging markets debt also underperformed.
New Zealand shares
The New Zealand share market fell in the second quarter, returning -10.2%. Contributing to the decline was the Reserve Bank of New Zealand (RBNZ)’s decision to continue raising interest rates in the face of rising inflation; the Bank lifting the official cash rate from 1.00% to 2.00% over the period. Inflation rose 6.9% in the 12 months to 31 March; up on the 5.9% recorded in the previous quarter and the measure’s highest reading since the June quarter of 1990. [Note: the RBNZ raised interest rates a further 0.50% (to 2.50%) following its July meeting.] Stocks were also impacted by news the local economy shrank 0.2% in the first quarter, further declines in business and consumer confidence and weaker commodity prices.
New Zealand fixed income
The New Zealand bond market fell over the period, returning -2.4%. Domestic long-term government bond yields rose (prices fell) as the RBNZ continued to tighten monetary policy in response to rising inflation. Bonds were also impacted by news the unemployment rate remained unchanged at just 3.2% in the March quarter.
The yield on New Zealand 10-year government bonds closed the quarter 64 basis points higher at 3.86%. Meanwhile, credit markets weakened, with spreads continuing to widen throughout the period.
How did markets affect UniSaver’s investment options?
The continuing sell-off in both shares and bonds meant that all of the UniSaver investment options, except for Cash, delivered negative returns over the June quarter. Members in options with significant exposure to growth assets, such as shares, will have seen significant declines in their balances over the first half of 2022. However, this comes after a period of strong performance which means that longer term returns remain positive, with the Conservative, Balanced and Growth options returning 2.2%, 4.0% and 5.2% per annum over the last five years after the deduction of fees and tax.
While we do expect volatility to continue in the short term, markets will bounce back. It is important that members focus on the long term and remain invested in order to benefit from the recovery when it takes place.
It’s been a tough first half of the year and markets have faced a laundry list of concerns. These include new COVID-19 lockdowns and an economic slowdown in China, the Russia/Ukraine war, surging inflation and central-bank tightening.
These issues are at least well understood now by markets. At the beginning of the year, it was unclear how far inflation would surge and how aggressively central banks would respond. There was little expectation that Russia would launch a full-scale invasion of Ukraine. The war has now happened, core inflation looks to be peaking in the U.S. and markets are pricing relatively aggressive tightening paths for most central banks.
Our composite sentiment index is deeply oversold. This provides some reassurance that markets have accounted for the bad news so far and could recover if inflation and growth turn out better than currently feared.
Of course, it’s possible that investors will panic and reach a sell-everything capitulation point. We saw this in March 2020 during the COVID-19 selloff. The lesson from previous market corrections, however, is that periods of panic can provide the best opportunities for longer-term investors.
The main uncertainty is the outlook for the U.S. economy. The pace and magnitude of U.S. Federal Reserve (Fed) tightening creates the risk of a recession by the second half of 2023. A deep recession could trigger a larger equity bear market. We think a slowdown or mild recession are the two most likely outcomes. U.S. household and business balance sheets are in good shape, and these should protect against a more severe downturn.
The bottom line is that investors are worried about rising inflation, slowing growth and the potential for an aggressive Fed to cause a severe recession. We think U.S. core inflation can trend lower over the remainder of the year, but the key question is by how much. A sustained move lower would ease fears around excessive Fed tightening and a deep recession. Until this becomes apparent, however, markets are likely to remain volatile.