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March market update 2022

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By Capital Partners Markets and Investments

When Quarter 1 for the 2022 calendar year came to a close, the results show we had a rocky start to the year.

The Russian invasion of Ukraine continued to dominate headlines, with Russia increasing its offensive despite strong resistance from the Ukrainian military and its people. Despite the ongoing conflict, we have seen most key global equity indices post positive results in March, with the S&P 500 posting a return of 5.21% and the FTSE 100 providing a positive 2.53%. Despite many European countries still having close economic ties with Russia, the European top 50 Index (EURO STOXX 50) also provided a return of 3.63%, showing how resilient markets can be in the face of geopolitical tensions. 

The emerging markets sector suffered during the month, with the MSCI Emerging Markets index posting a drop of 2.06%. This is largely off the back of China struggling to contain recent cases of Covid. Here at home, we saw a strong performance of Australian securities, with the ASX 300 posting a 6.90% return for the month on the back of the banking and resource sectors, which make up a large portion of this Index. This, together with a positive contribution from the technology sector, pushed the Australian market to a 12-month return of 15.21% with an outperformance of 3.66% over the global index.  

Inflationary pressures

A significant issue still impacting global markets has been rising inflationary pressure. This was an issue at the start of the year due to the Covid driven supply-side shortages and has now been exacerbated by the Russian/Ukrainian war. With Russia, a primary exporter of key commodities, such as oil, gas and wheat,  the conflict has pushed up the prices of these commodities and amplified inflationary pressures. Headline inflation in the U.S now sits at 7.9%, and here in Australia, it reached 3.5% in December 2021. 

For investors, inflation does not necessarily lead to poor performance as shares often perform well over the long term due to companies raising prices in line with inflation. However, unexpected inflation can hurt returns over the short term due to economic uncertainty. 

Inflationary pressures also affect other market sectors, and we have seen bond returns drop for the month, with the Global Bond Aggregate index falling by 2.13%. As a result of these inflationary pressures, central banks around the globe have moved to increase interest rates, with the Bank of England raising rates for the third time since December 2021 from 0.1% to 0.75%. In Australia, many economists are banking on a rate hike by June. The Federal Reserve has raised interest rates by 25 basis points to 0.5% during the month in the U.S. This, along with a more hawkish (tighter monetary policy and likely higher interest rates) outlook from the Federal Reserve, pushed bond yields up, with the two-year U.S treasury yield up 150 basis points, the biggest monthly increase since the 1980s. U.S Government bonds have suffered their worst monthly loss in five decades.  

But what does this mean for me and my portfolio?

A bond is essentially an investor (you) loaning money to a company or Government (the issuer) for a specified period. In return, the issuer promises to make interest payments periodically. At maturity, just like a term deposit, the investor receives the initial investment back. The interest payments made are typically dependent on the credit rating of the issuer (credit risk), the cash rate of the region, e.g. Australia’s official cash rate is currently 0.10%, and, expectations of where the cash rate will be during the period of the bond (term risk).  

Bonds are the primary investment product used to provide capital security to a portfolio as bonds are typically less volatile than share markets due to their fixed interest payments and known repayment value. For example, during the Covid-induced market fall of 2020, when shares plummeted in value with the ASX dropping by 35%, bonds continued to provide a positive return. They helped to smooth the ride of market volatility.  

However, with official interest rates trending towards zero for the last few years, the yields on bonds have been at historically low levels. 

As a result of rising inflationary pressure, we have seen central banks worldwide begin to bring forward their expectations of when they will raise interest rates. New bond offerings come with higher yields to attract investors. 

Many of our clients will see negative returns on their Bond investments at the moment. This has been caused by bond markets already incorporating up to 10 rate hikes into the bond prices over the next 18 months. While this may sound good for bonds, as you would expect a higher interest payment in the future, it does have a negative short-term impact, with the existing bonds (that are still paying the lower rate) less attractive than new bond issues. This inverse relationship between bond yields and the capital value of bonds relationship is illustrated in the graph below:  But there is an important consideration in valuing the bonds in your portfolio. 

Bond markets are currently incorporating a significant number of rate hikes over the next 12 months, while the Federal Reserve is on the record saying the rises will be lower and slower than the markets are anticipating. There’s a saying in finance, ‘never bet against the Fed!’ Where the market’s expected rate rises don’t eventuate, (that is the number of interest rate increases is lower than expected, yields will likely fall. When this occurs, the capital value of the bonds rises, recouping previous losses. 

The table below details the performance of bonds over several periods of rising interest rates in the U.S, and shows that for most periods, bonds continued to provide positive returns, despite the short-term impact of rising interest rates. While we are experiencing some short-term volatility due to rate rise expectations we remain comfortable with the role of bond investments in client portfolios. 

A  reassuring statistic to note is that following some of the most significant drawdowns in history for bonds, the average return in the subsequent six months was 4.9% (Obenshain, 2022), with few instances of continued falling bond prices. So, while the recent performance of bonds has been underwhelming, the prudent approach remains to stay invested and ride out the volatility. 

 

Obenshain, Risk-Reward in a Hiking Cycle, Verdad Weekly Research, https://mailchi.mp/verdadcap/risk-reward-in-a-hiking-cycle?e=221be7b330

The information provided on this site is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different and you should seek advice from a financial planner who can consider if these strategies and products are right for you.

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