Both the Fed and the RBA continued to ramp up monetary tightening in July in an effort to curb high inflation rates. Moderating signs of economic growth, however, caused markets to unwind some of the tightening expectations currently priced in. Despite this volatility, equity and credit markets ended the month stronger while yields fell. This improved risk sentiment boosted Australian bond markets, with the Bloomberg AusBond Composite 0+ Yr Index gaining over 3.3% for the month.
The RBA delivered another 50bps increase of the cash rate to 1.35%, but contrary to recent cash-rate increases, yields fell after the decision with mixed economic data during the month. In July, the 3Y yield closed the month at 2.65% (-45bps), and the 10Y yield closed at 3.05% (-60bps).
The labour market continued to be resilient, with 88,400 new jobs added, which pushed the unemployment rate down to 3.5%. Forward-looking labour demand indicators such as job vacancies, job ads and business surveys of employment intentions indicate ongoing near-term strength and upward pressure on wages.
Price increases across the board pushed headline inflation up by 1.8%, corresponding to a 6.1% annualised rate. As measured by the trimmed mean, core inflation rose 1.5% or 4.9% for the year. New dwellings (+5.6%) and automotive fuel (+4.2%) were the leading sectors pushing prices higher.
The money market yields continued to push higher as markets began to price in cash rate expectations for the year ahead. Currently, the futures market is predicting a 3.0% cash rate by year-end 2022 but has tempered expectations for the mid-2023 cash rate, which is now 3.17% (down from 3.75%).
July saw a fair bit of volatility in credit markets but managed to close the month on a firm footing. This is partly due to investors reacting to the second consecutive negative GDP print in the US late in the month and the unwinding of generally bearish bond market positioning at the start of the month.
July 2022 Summary
- Equity markets surged higher despite inflation continuing to climb
- The US Fed delivered a 75bps hike but signalled a focus on data moving forward
- US GDP data came in negative for the second consecutive quarter delivering a technical recession
- US 10Y yields fell by the most in a month since March 2020
- Corporate earnings in the S&P500 cooled off back to last 2020 levels
US Economy
US equity markets all but ignored the second consecutive negative GDP reading in the US, higher than expected inflation data, and an outsized 75bps hike from the US Fed, all while the corporate earnings season began. The tech-heavy Nasdaq 100 performed the best since March 2020, and the S&P 500 wasn't far behind, having its best month since November 2020. Growth equities outperformed Value by a healthy margin, while longer duration assets held up firmly.
Australian Equities
In Australia, the ASX 200 lifted 5.7% for July, closing at 6,945.2 points with all sectors in the green, barring Materials, which was flat. Information Technology (+15.1%) and Real Estate (+12.2%) sectors were up double digits, while financials (+9.2%), consumer discretionary (+8.2%), and health care (+7.6%) sectors were not far behind. IT is still the worst performing sector in the ASX 200 this year, despite the strong month in July.
Overall, the sectors performed well in the third quarter of this year, with Consumer Discretionary stocks leading the way. Technology stocks also showed strong returns, while Energy, Industrials, REITS and Financials all had gains of more than 7%. Basic Materials and Utilities were in the middle of the pack, with returns of 6.1% and 5.5%, respectively, while Communications, Healthcare, and Staples stocks lagged behind with returns below 4%.
The Federal Reserve
The Fed's commitment to bringing inflation down to its target rate has been contradicted by the market, which is now expecting less aggressive rate hikes. Inflation data continues to surprise the topside, with the latest figures showing an annualised rate of 9.1% compared to market estimates of 8.8%. Other inflation data points are beginning to show prices starting to fall, which brings life to the peak inflation narrative.
The economy contracted in the second quarter, with two consecutive negative GDP prints signalling a potential recession. Additionally, services PMI slid into contraction, while manufacturing PMI dropped to its lowest level in two years. Initial jobless claims also increased while consumer credit continued to climb. Overall, the data in the US paints a picture of an economy that is beginning to struggle.
Peak Inflation Narrative
Since the blockbuster US CPI print in May, central banks' reaction functions shifted, leaving the narrative of a temporary inflation spike that would resolve itself post-COVID-19 lockdowns in shambles. Central Banks are now acknowledging that price pressures are coming from the demand side as well, turbocharged by geopolitical tensions, re-opening and massive fiscal policy around the world. Since monetary policy cannot fix problems related to lockdowns, weather, or geopolitics, it attempts to manage the economy by making changes that influence demand.
Reserve Bank of Australia
RBA has started to tighten monetary policy, with the Governor indicating that further accommodative measures are not necessary at present. The exact extent and the economic implications of this shift are yet to be determined. In early July, Markets predicted a cash rate of 3.6% by December, followed by an increase to 4.2% in mid-2023 and then averaging around that level for the next ten years. However, this seems unrealistic as it would require one of the biggest and swiftest tightening cycles during the current inflation-targeting era ending with a neutral cash rate at 4.2%. The RBA's estimate of the natural cash rate is 2.5%. A cash rate of 4.2% would be enough to cause such a significant slowdown that it would trigger the next easing cycle.
Even with the recent drop in interest rate futures, the markets expect a 3.1% rate by December 2021 and a 3.75% rate by mid-2023, according to analysts and will potentially cool off further in the months ahead.
Looking Ahead
The remainder of the Q2 earnings season and vital economic data, like the CPI print, will be seen in August. It's important to remember that the Federal Reserve won't meet again until late September, so rate hikes won't be seen before then. According to the last 50 years' worth of data, August has seen negative equity market returns with an average of -0.13% for the month with 27 out of those 50 years having ended with positive returns while 23 were red. The only month worse performing month than August during this time was September which had an average return of -0.91%.