INVESTMENTS  |  Market COMMENTARY 

Domestic markets & economic update

FY20, FY21 and FY22 have all marked volatile years for markets, at least compared to what we were used to prior to the emergence of COVID. The VIX (Volatility Index) now regularly hovers at levels seen in the wake of the dotcom crash.

25 July 2022

The best news for FY22 was that we didn’t end the year at home. With Australia no longer in lockdown and international travel gathering pace, 2022 has seen many Australians embracing the return of our freedoms.

However, markets are struggling to return to normal with an uncertain economic backdrop. Inflation has emerged at levels not seen in decades as demand for commodities returned, but supply struggled to keep up as frictions in supply chains and depleted inventory levels quickly lead to shortages. This has had a knock-on effect to other parts of the economy.

While we are embracing our freedoms, markets in FY22 have struggled to address a return to normality.

Historic falls in safe-haven bond assets

In the first half of FY22 markets were resilient, subscribing to the narrative that inflation would be temporary. But as war erupted in Ukraine, floods stretched across Australia’s east coast and droughts affected the Americas, inflation continued to surge. Central banks reacted and have attempted to contain it by embarking on an aggressive campaign of increasing interest rates – this resulted in some of the largest historical falls in perceived safe-haven bond assets since the early 90s. Australian government bonds have fallen more than 10% over the last year.

This decline in safe-haven assets lead to perplexing performance in FY22, with all risk profiles impacted and conservative assets declining in value by just as much as riskier options for most of the year.

While there is still limited evidence that central bank action is taming inflation, their actions have quickly changed the market narrative. Yield curves initially steepened quickly, then inverted – suggesting that to be successful central banks will have to tip economies into recession to quell demand and with it, inflation.

The flight to certainty: Cash and equity markets

Equity markets have been hit by a combination of rising costs of capital and declining growth expectations late in FY22. More typical patterns of performance re-emerged in the last month of FY22 with conservative asset allocations outperforming growth again, but the concern for future growth expectations has left investors with nowhere to hide except cash (which is almost certain to decline in real terms), and some fossil fuel companies.

Commodities and the road to net-zero

Even sectors like iron ore in Australia, which rose to around US$160 per tonne in March as supply was cut globally following Russia’s invasion of Ukraine, have seen a significant decline in value recently – with prices now $105 per tonne in early July 2022.

Forecasting where-to-from-here is just as difficult as ever, but we do take comfort in some emerging trends.

Since the 1970s oil crisis, the world has worked hard to reduce its dependence on oil, with each unit of GDP requiring fewer barrels of oil. The current crisis is likely to see that trend accelerate, and while energy security is driving some hard choices, corporate commitments to net-zero and electoral appetite for environmental change remain firm.

This long-term trend away from energy price-driven inflation has been a positive, but shortages in other areas of global dependence has left us concerned that high levels of inflation could persist. One example is semi-conductors; despite huge advances in computing power, it takes just as much silicon per unit of GDP today as it did decades ago. With the initial stages of this year’s inflation spike characterised by chip shortages, we were concerned that there were few substitutes and little prospect of declining demand to limit its impact on inflation. However, it has recently emerged that after over $100bn of investment into improving supply, the semi-conductor market is swinging back to excess supply and inflationary pressure is easing.

Our watch points for the next 12 months remain soft commodities as sources of inflation.

The year ahead

The inflationary fire is far from put out, but with elevated levels of employment and people returning to the workforce, we hope it can be effectively managed. Central banks, while acting aggressively, are still only predicted to remove the extraordinary levels of stimulus applied in recent years. Investment in the right areas can assist to ease inflationary pressure. Our watch points for the next 12 months remain soft commodities as sources of inflation; we will rest easier if the supply of major agricultural commodities can be maintained globally.