This article has been written by an expert contributor, Kerry Craig, Global Market Strategist, J.P. Morgan Asset Management.
Goldilocks beats the bears
The resilience in global economy spurred equity markets higher in the second quarter. However, central banks leaned into the hawkish narrative and market expectations whipsawed from rate cuts to multiple further rate hikes in 2023. The result was mixed for assets over the quarter. Developed market equities delivered a 7.3% gain and strongly outperformed emerging markets (1.8%). Meanwhile, higher bond yields led to losses in fixed income markets and the Global Aggregate Bond Index fell by 1.5% (total returns in local currency).
The second quarter got off to a rocky start as potential fragility in the U.S. banking system and contagion risk gripped markets. However, the financial stability risks faded as the banking fallout was isolated. There are still lingering concerns on the impact from commercial real estate valuations on bank balance sheets that require monitoring.
The moderating bank risk and uneventful passing of the debt ceiling the U.S. meant market focus returned to the inflation outlook. Headline inflation fell further in the second quarter due to lower commodity prices and favourable base effects from a year ago, while core rates of inflation have been slower to abate. Core inflation in Australia was 6.2% in the first quarter and even in the U.S., the core rate of inflation was 5.3% in June.
Persistent inflation resulted in central banks taking policy rates higher after a brief pause. The Reserve Bank of Australia (RBA) surprised with a 25bps hike in June, the Fed added 25bps, the European Central Bank and the Bank of England a further 50bps. Yields were quick to respond, as 10-year yields rose by 18bps in the U.S. to 3.81%, 42bps in Australia to 4.02% and a remarkable 89bps in the UK to 4.41% over the quarter.
Equity markets seemed to largely discount the inflation and rate risk and continued to march higher. The S&P 500 rose 8.7% and Japan’s TOPIX was 14.4% higher for the quarter. The divergent policy path of the Bank of Japan and other central banks is weakening the yen and supporting foreign earnings for Japanese companies. While still very low bond yields and increased focus on governance is supporting Japanese equity valuations. European markets were more subdued and the Stoxx 600 was up 3.1%, while the local Australian market lagged with a 1.8% gain.
The bears may have been beaten back in the second quarter, but the two-way risks around the economy and markets does not build a strong case for a goldilocks outlook for the second half. A balanced approach to markets and quality bias to portfolios remains prudent.
Economy:
- The RBA raised the cash rate by 25bps at its June meeting and left the rate unchanged in July at 4.1%. Since the start of the year, the cash rate has increased 375bps compared to a year ago. The intent to move higher is clear but the data out of Australia is mixed and the full impact on consumers still be felt.
- Still, consumers have been showing signs of life. Retail sales increased by a larger than expected 0.7% month-over-month (m/m) in May and June consumer confidence ticked higher. But the confidence level is materially weaker and well off its peak in 2021. Business confidence moved lower in May.
- The weakness in consumer confidence contrasts the tight labour market and wage growth that is edging higher. 76,000 jobs were added in May and the unemployment rate dropped to 3.6% even as the participation rate ticked higher. However, job vacancies have stabilized at high levels, suggesting that labour demand may start to soften.
- The housing market is showing early signs of turning despite expectations for further rate hikes. House prices have historically only started to increase when the central bank cuts rates. However, house prices have risen m/m for the past three months and are only 6% from the recent peak.
- The global Purchasing Managers Index for manufacturing continues to weaken across the world illustrating the pressures on the global goods cycle and the downside risk to growth.
Equities:
- Australian equities gained in June and rose by 1.8%, offsetting prior month’s losses the put the ASX 200 up 1.0% for the quarter. Large cap performance was much better and small cap Australian stocks lagged with a 0.0% return on the month and -0.5% for the quarter.
- Emerging market equity performance was held back by weakness in China. The MSCI EM index gained 1.8% on the quarter but Chinese shares fell by 1.1%. This is reflected in the 1.1% decline in Asia ex-Japan equities for the quarter. Japan bucked the trend with a 14.4% gain in the second quarter and 7.5% return for June.
- Sector performance in Australia was mixed over the last three months, however, the technology sector was a standout and followed global peers. The technology sector was up 21% on the quarter, well ahead of the next closest sector of utilities (4.4%), given the global enthusiasm for AI related names. Energy (3.6%) and industrials (3.1%) were the next best performers, while healthcare (-3.2%), materials (-2.6%) and consumer discretionary (-1.9%) posted losses for the quarter (price returns only).
- The improvement in equity performance so far this year has not been driven by rising earnings expectations but higher multiples. Price-to-earnings valuations have risen in all markets and are above average in the U.S at 19.1x. However, for many other markets, including Australia, valuation metrics remain in line with long run averages.
Fixed income:
- The Australian yield curve inverted last quarter as the 2-year yield rose more than the 10-year yield. This move has long been associated with a recession, however, the signaling effect of an inverted yield curve has been played down in recent months. The U.S. curve remains deeply inverted as well.
- Australian bond yields are now again higher than those in the U.S., and government bond yield are again back to being near their highest levels in a decade.
- Credit markets posted positive returns for the quarter, with the higher yields on offer in investment grade and high yield bonds offsetting the spread widening effects. The global high yield market returned 1.5% for the quarter and global investment grade 0.1%. Emerging market bonds have been a surprising outperformer with a 1.5% gain as local currency bond spreads continued to narrow.
Other assets:
- Commodity prices were weaker in the second quarter. The price of Brent oil fell by 5.4%, even as it gained in June (4.1%).
- Gold was also weaker on the month (-2.7%) and quarter (-3.4%). Higher rates are a headwind to the performance of the yellow metal, although the relationship has been tested.
- The U.S. dollar was down 1.4% on the month but gained 0.4% on the quarter based on the broader DXY index. Against the U.S. dollar the Australian dollar fell 0.6% for the quarter but made up for earlier loss with a 2.9% gain in June.
Kerry is responsible for communicating the latest market and economic views from J.P. Morgan Asset Management’s Global Market Insights Strategy Team. With more than 10 years’ experience, Kerry provides valuable insights and perspectives on the economy and markets to investors. As a frequent commentator on Bloomberg, CNBC, the AFR and the wider financial press, Kerry is able to explain complex economic and market issues in a language that investors understand.
Prior to making an investment decision, retail investors should seek advice from their financial adviser. This document is intended as general information only.