(Source: Merlea Macro Matters)

Summary

The global economy continues to be on course of a sharp slowdown, with worsening outlook for the rest of 2022 and below-trend growth forecast for 2023. A looming energy crisis in Europe, surging cost of living, a sharp tightening of global financial conditions, and slowdown in China are major factors driving the dimmed growth outlook for the world. As more economies could fall into recession in 2023, the year ahead will be challenging for businesses and consumers worldwide.

Financial conditions have tightened as central banks continue to hike interest rates. Amid the highly uncertain global environment risks to financial stability have increased substantially.

Major issues facing financial systems include inflation at multi-decade highs, continuing deterioration of the economic outlooks in many regions, and persistent geopolitical risks. To avoid inflationary pressures from becoming entrenched, central banks confronting structural high inflation have had to accelerate monetary policy tightening.

With some price pressures remaining stubbornly high during Q3 2022, inflation forecasts were revised upward for most key countries in Euromonitor International’s Q4 2022 baseline scenario. Consumer price inflation is now expected to surpass 10.0% in emerging and developing markets and 7.5% in advanced economies this year.

What’s more, those in advanced and emerging economies alike also face magnified risks and vulnerabilities across different sectors and regions. Financial vulnerabilities are elevated for governments, many with mounting debt, as well as nonbank financial institutions such as insurers, pension funds, hedge funds and mutual funds. Rising rates have added to stresses for entities with stretched balance sheets. Global markets are showing strains as investors have recently become more risk-averse amid heightened economic and policy uncertainty.

Financial asset prices have fallen as monetary policy has tightened, the economic outlook has deteriorated, recession fears have grown, borrowing in hard currency has become more expensive, and stress in some nonbank financial institutions has accelerated. Bond yields are rising broadly across credit ratings, with borrowing costs for many countries and companies already rising to the highest levels in a decade or more.

The challenging macroeconomic environment is also putting pressure on the global corporate sector. Credit spreads have widened substantially, and high costs are eroding corporate profits. For small firms, bankruptcies have already started to increase because of higher borrowing costs and diminished fiscal support.  Clear communication about policy decisions, commitment to price stability, and the need for further tightening will be crucial to preserve credibility and avoid market volatility.

Bonds

Bond markets have borne the brunt of central bankers being wrongfooted by spiking inflationary pressures – largely caused by historically-tight labour markets, rising commodity prices due to the war in Ukraine, and Covid lockdowns in China, which have further disrupted global supply chains. The end of forward guidance has increased volatility in the fixed-income market, and this is driving volatility across asset classes.

Central banks have shifted away from a regime of providing forward guidance to one where they are now data dependent. This is because of uncertainty around the timing of the expected decline in inflation and how long policy tightening will take to feed through to the real economy.

The market seems to be pricing in sufficiently restrictive policy from central banks. Both the Fed and ECB are now priced to take policy well into restrictive territory. The Fed in its recent meeting had a terminal rate estimate of 4.6%, whereas the market is pricing closer to 5%. This represents the most restrictive Fed policy since the 80’s when comparing to neutral rate estimates. The ECB is now priced to take its policy rate close to 3%, which is in stark contrast to the negative interest-rate policy that has existed since 2014.

US and EUR longer-run inflation expectations, in %

Central banks have regained credibility, with inflation expectations well anchored and the market seems to be pricing in sufficiently restrictive policy from central bank.

Whilst inflation is still elevated today, expectations among both market participants and economists are for inflation to move back towards target over the coming year. This should reduce the risk of higher inflation becoming entrenched, which would lead to even more hawkish policies down the line.

While we think prices are likely to remain elevated in the months ahead, US Treasury Secretary Janet Yellen suggested inflation may have peaked in American economy. With markets aggressively pricing in further Federal Reserve (Fed) monetary tightening, Yellen’s statement indicates value could be returning to the global bond market.

With an extensive tightening path ahead, there is considerable uncertainty as to how the real economy will cope with significantly higher interest rates. Risks remain high. While most of this cycle’s rise in yields is almost certainly behind us, the hard landing question—and the outlook on spread products—remains clouded with risks to the downside. When inflation cools, we see more stability in interest rates. The Fed will slow its pace of rate hikes, and we’ll see weakening in the labour market. With that, there will be a stronger case to add duration exposure, which should prove valuable in a weak economic backdrop and when an eventual pivot toward rate cuts occurs.

Listed Property

The recent market downturn and macroeconomic environment has improved the valuation profile and outlook of Australian Real Estate Investment Trusts (A-REITs), despite concerns about higher interest rates and inflationary pressures. 2022 has been a challenging year for A-REITs, in part due to the sector’s long exposed durations and ensuing price sensitivity to interest rate changes. As such, the sector has been one of the worst performers over this year to date, as interest rates and inflation have crept higher. However, the outlook for A-REITs looks more promising for three main reasons.

Firstly, long dated government bond yields could be close to reaching their peak. Broker consensus is that the expected RBA cash rate increases over the next 12 months have been priced into the Australian Government 10 year. The forecast sees the yield marginally increasing by 23 basis points by December 2022 before falling to 3.14 percent by December 2023 as aggressive monetary tightening dampens economic growth.

Secondly, if the Australian economy enters an environment of sustained inflation and growth such as the period between the end of the dot-com bubble and Global Financial Crisis, REITs are well positioned. During this period Australian CPI year-on-year was 2.9 per cent on average, which is near the RBA’s current upper bound inflation target of 3 per cent. Australian 10-year government bond yields steadily increased over this time, reflecting strong economic growth. REITs historically outperform in this type of environment, as inflation linked rental income outweighs the impact of moderate rising yields on returns. Commercial leases and contracts in office and logistics typically have inflation linked annual increases in rents written into the contract. A-REITs.

A-REIT Price to NTA – historic low

Finally, the recent drawdown in A-REIT performance potentially presents a value opportunity. Price to Adjusted Funds From Operations (AFFO multiple) and price to net tangible assets (NTA) are at a 9-year low and an historic low based on available data. These measures are market convention for valuing REITs and are preferred to metrics such as price to earnings ratios. The A-REIT sector will remain captive to the gyrations of capital markets in the short term. Clearly, if bond yields continue to rise further there could be additional price risk.

However, the recent sell-off in the A-REIT sector has created some attractive buying opportunities. Investors with a longer-term view who can see out the short-term volatility can acquire some of the best real estate in Australia at more attractive prices than they could have three or four months ago.

Australian Equities

Global stock markets are tanking on fears of recessions in the US, the UK and Europe, and the OECD is forecasting recessions in Europe. The good news is there are several reasons to think Australia might be able to escape a global slide into recession – though it will need careful management.  Australia avoided recession during the 1997 Asian financial crisis, we escaped the 2001 US “tech-wreck”, and we avoided the “great recession” during the global financial crisis.

The Australian Dollar made a 2-year low against the US Dollar in September as global central banks ratcheted up their fight against inflation. The pivot toward a far more aggressive stance for the tightening of monetary policy in the second quarter was backed up by outsized hikes in rates in the third quarter by many global central banks.

At the third quarter’s end, the RBA appears to have backed away from ongoing outsized rate rises. The cash rate has been increased substantially in a short period of time. Reflecting this, the RBA decided to increase the cash rate by 25 basis points this month as it assesses the outlook for inflation and economic growth in Australia.

The tightening of monetary policy is to allay fears of inflation becoming entrenched. The last read of Australian year-on-year CPI to the end of the second quarter came in at 6.1%, (currently 7.3%) well above the RBA’s target of 2-3% on average over the business cycle. CPI in other developed markets is notably higher, except for Japan.

The Initial downturn was milder than in other countries

Headwinds from higher energy prices, rising interest rates, a slowing housing market and weakening global growth are expected to see the Australian economy slow over 2022/23.

The Australian economy is continuing to grow solidly, and national income is being boosted by a record level of the terms of trade. The labour market is very tight, and many firms are having difficulty hiring workers. The unemployment rate in August was 3.5 per cent, around the lowest rate in almost 50 years. Job vacancies and job ads are both at very high levels, suggesting a further decline in the unemployment rate over the months ahead.

Beyond that, some increase in the unemployment rate is expected as economic growth slows. Wages growth is continuing to pick up from the low rates of recent years, although it remains lower than in other advanced economies where inflation is higher. Given the tight labour market and the upstream price pressures, the RBA will continue to pay close attention to both the evolution of labour costs and the price-setting behaviour of firms in the period ahead.

Headwinds from higher energy prices, rising interest rates, a slowing housing market and weakening global growth are expected to see the Australian economy slow over 2022/23. We expect year-ended real GDP growth will slow from 3.4% in the June quarter 2022 to 2.6% by the end of 2022/23. Nonetheless, our base case view remains for a soft-landing in the economy.

The economy should benefit from a re-opening of international borders, which will help support the tourism sector and drive a rebound in population growth from just 0.1% in FY2021 to 1.2% in FY2023. The economy should also continue to benefit from elevated commodity prices, which have been supporting corporate profitability and government budgets. A large pipeline of public infrastructure projects should also continue to support construction activity.

RBA’s Statement on Monetary Policy warned of difficult times ahead for Australians and delved into pertinent issues of inflation, wages, and energy prices.

On inflation, RBA’s forecasts through to December 2024 have been upgraded, as businesses pass through higher energy prices, and East coast floods put upward pressure on grocery prices. The RBA’s preferred measure, trimmed mean inflation, is now forecast to peak at 6.50% in December 2022, before falling to 3.75% in December 2023 and further declining to 3.25% by December 2024 or early 2025.

Their inflation forecasts suggest rates staying higher for longer until there are signs of easing towards the 2-3% band target. In the RBA’s statement on wages, they estimate the percentage of jobs that received a wage increase over the past year has increased to circa 80%. They also note that wage increases were particularly strong at the bottom end of the skill distribution, which makes sense, especially as we saw restaurant workers being paid more due to labour shortage. In fact, this is consistent with rising costs to retain talent in every industry, with some being technology, hospitality, finance, and education.

The RBA forecasts wage growth to be 3.75% by mid-2023 and 4% by 2024, which is not great for workers as it will take longer than expected for pay packets to catchup to the cost of living.

With the RBA coming out and flagging higher inflation is going to be present for several years in Australia, we must expect further rate rises. There are risks that the central bank has fallen behind the curve with the cash rate now at 2.85% and well below the Fed and with inflation looking to equalise, the RBA still has a lot more “work to do” in terms of tightening monetary policy. Given there is no meeting in January, the prospects of a 50 bp hike in December cannot be ruled out.

While we expect a soft-landing in the Australian economy, the risks of a recession are high. Our view is that consumer spending should remain resilient given low unemployment, firming wage growth, pent-up demand for services consumption and a likely run-down of elevated savings. However, given the level of household indebtedness in Australia and our exposure to variable rate mortgages, the RBA needs to tread carefully.

Global markets

The past quarter has brought into sharp focus the end of the Great Moderation – and the new regime of heightened economic and market volatility we outlined previously. Markets are grappling with the worsening trade-off policymakers face between growth and inflation.

The UK has been at the epicentre of this trade-off, with the government’s fiscal splurge sparking a rout in domestic assets that forced the Bank of England to intervene and stabilise bond markets. We see little prospects of an economic soft-landing, or inflation falling to target quickly without a significant hit to growth.

We think central banks are set to overtighten policy in the near term causing economic damage – and flare-ups of financial stability risk – that equity markets may not be fully underappreciating yet. We stay underweight developed market equities in our tactical views and prefer high quality credit. We think equities are just starting to price in a worsening macro-outlook. We see more room for equities to fall as prices are still not fully reflecting the combination of recessionary risks and higher interest rates. Consensus earnings expectations for this year and next still appear too optimistic to us given the growth backdrop.

The U.S. dollar’s strength – a sign of shaky risk appetite – has tightened financial conditions globally. We think relatively attractive valuations in credit, particularly investment grade, and relatively healthy corporate balance sheets suggest credit is better placed to weather a recession than equities.

America

Markets continue to be more concerned now as to where the terminal rate is going to settle as well as the pace of tightening. I think there is less risk with what the Fed will do here in December, with 50 bps priced in and with the signal this week that the door is open to “recalibration, given the significant pace of tightening” that has occurred this year Fed funds futures are now implying an expected peak rate above 5.1% in May and June next year.

The lift in the US yield curve with rates rising across the board for 2yr to 30yr bonds is however a concern in terms of the durability of the rally. The yield on the key US 10-year benchmark is approaching the record high of 4.20%. If yields on the curve continue to rise, then this poses the biggest threat to the relief rally which got underway last month.

As the Fed works to cool inflation by tamping down economic activity, investors are also watching for the world’s largest economy to enter a recession next year. The US growth outlook matters more for the dollar going forwards than where US bond yields go next. A meandering dollar is likely to last for some time, before other economies’ economic prospects improve, at which point the dollar will start to fall back.

The labour market remained robust in October, in the final glimpse at the state of the economy before the midterm elections.
Although the unemployment rate rose, Americans are still seeing rapid wage gains.

Key jobs data exceeded expectations but revealed some cracks pointing to a peak in employment. The key unemployment rate finally rose to 3.7% from 3.5% in September while wage inflation dropped to 4.7% from 5% in the prior month. Despite the figures referred to above, we are seeing a growing number of firms cut jobs, or at least freeze hiring, especially in tech. Last week just a few notable company announcements included ride-share firm Lyft saying it will trim 13% of its workforce and payments company Stripe cutting 14%. Even though it’s a more unique situation, after his takeover of Twitter, Elon Musk cut roughly the workforce in half with a mass firing on 4^th November.

Mr Powell, emphasised the message that the “risk of doing too much, outweighs the risk of doing too little” in the fight to bring inflation down but also said that “a slower pace of rate hikes could come as soon as December.” This echoes about the “needs of the many outweighing those of the few,” as far as inflation is concerned and its adverse economic impact on the lower socioeconomic demographic.

Our preferred base case scenario, whereby the Fed remains unflinching in the fight to contain inflation but accommodates the markets with a signal that rate hike trajectory is likely to plateau in the new year. If the Fed does the opposite and remains quiet on the tightening path front, then all bets are off, the markets will likely take this outcome negatively, and the rebound rally will likely stall.

Recent data doesn’t really change the game plan for the Fed, with traders viewing a 50 bp hike in December with 75 bps still possible. The weaker greenback provided the impetus for a significant rally in commodities, precious metals, and oil and mining shares around the world. Investor hopes were again reignited that the US Federal Reserve might ease up on monetary policy tightening.

Europe

Storm clouds continue to gather for the global economy. The Bank of England put in the largest rate hike since the 1980s lifting the key rate 75bps to 3% and warned that the UK could be in for the longest recession in more than a century. Meanwhile, European Central Bank President Christine Lagarde warned that a “mild recession” is possible, but that it wouldn’t be sufficient to stem soaring prices.

The S&P Global Eurozone Services PMI came in at 48.6 in October, little changed from the 48.8 reading in September and still indicating a contraction in services activity, for a third month in a row. New orders were lower for a fourth month and output fell the most since February 2021. Input and output inflation eased. There was a slight improvement in sentiment.

Combining the services PMI with the earlier reported manufacturing numbers and the composite PMI for the Eurozone declined to a 23-month low of 47.3 in October with falls for both manufacturing and services.  Separately, German factory orders fell more than expected in September, falling 4% monthly, following a 2% decline in August. Economists were expecting a smaller 0.5% decline and the figures added to recession worries as Europe’s largest economy.

United Kingdom

On the domestic data front, construction activity in the UK continued to expand in October, but new orders fell for the first time in over two years. The S&P Global/CIPS construction PMI came in at 53.2, up from 52.3 in September and above expectations of 50.5. it was the strongest headline reading since May with strong activity linked to new project starts and a robust pipeline of unfinished work. However, the forward-looking survey indicators highlight that growth will be harder to achieve in the coming months as rising borrowing costs, economic uncertainty and cost constraints all had a negative influence on order books in October. The reduction in total new work was the first since May 2020 and this fuelled increased concerns about longer-term tender opportunities. According to the BRC-Nielsen IQ Shop Price Index, shop price inflation rose to 6.6% in October from 5.7% in September, the highest since the survey began in 2005.UK food inflation hit 11.6%, rising from 10.6% in September, and is at a record high. Fresh food inflation hit 13.3% (12.1% in September), while ‘ambient food’ inflation increased to 9.4% from 8.6%. Inflation is broad-based with non-food inflation also reading a series high of 4.1%, up from 3.3% in September.

Helen Dickinson, chief executive of the British Retail Consortium, said: “It has been a difficult month for consumers, who not only faced an increase in their energy bills, but also a more expensive shopping basket. Prices were pushed up by because of the significant input cost pressures faced by retailers due to rising commodity and energy prices and a tight labour market.”  Dickinson concluded, “While some supply chain costs are beginning to fall, this is more than offset by the cost of energy, meaning a difficult time ahead for retailers and households alike.”

Japan

Bank of Japan minutes from the past meeting showed significant attention on the weak yen and potential for this to hurt households and small companies. Members agreed the Japanese economy was improving but other central bank actions could hurt the global economy. One member did say the central bank will need to eventually communicate an exit strategy from ultra-loose monetary policy.

On this page, interesting were comments from Bank of Japan Governor Haruhiko Kuroda on Wednesday the central bank’s yield curve control (YCC) policy could be tweaked in the future, but not now. “If achievement of our 2% inflation target comes into sight, making yield curve control more flexible could become an option,” Mr Kuroda told parliament. I think this will likely be on the agenda quickly after Kuroda’s tenure ends in April next year.

On the local data side, the au Jibun Bank Japan Services PMI came in at 53.2 in October, strengthening from 52.2 in September. It was the second month of expansion in the sector and the strongest since June, as the Nationwide Travel Discount Programme was renewed. New orders grew for the second month, foreign orders were higher, and employment grew the most in five months. On the pricing front, input costs rose at a near-record pace and selling prices also rose materially. Sentiment improved to a 4-month high. Japan’s service sector expanded at a faster pace in October amid stronger upturns in activity and jobs.

Survey respondents suggested that the latest improvement was primarily underpinned by the growth within the tourism industry and the subsequent strengthening in demand conditions. Restrictions on foreign tourism have now been lifted and the government’s recent launch of the Nationwide Travel Discount Programme has promoted domestic travel. As tourism volumes continue to increase in the coming months, we can hope to see continued improvement in the business conditions across Japan’s service sector. Combined with the earlier reported manufacturing PMI, the Composite PMI came in at 51.8, improving from 51.0 in September and was the highest reading since June.

Japan’s relatively low-inflation environment will likely spare it from the contractionary effects that other countries will experience as interest rates climb higher. In the near term, government programs and improvements in the auto sector will support consumer spending and manufacturing, respectively. Japan’s exposure to China should support exports next year, but the expected global slowdown will ultimately create headwinds to its economic recovery.

We continue to believe that the combination of a weak currency and rising domestic inflationary expectations will have positive implications for the Japanese economy and equity market. The weaker yen is positive for corporate earnings, but it also positions Japan favourably vis-à-vis its export industry competitors. Expectations of rising inflation may lead to greater domestic investment and consumption over the medium term, which in many cases still suffer from a deflationary mindset.

China

For China, the third quarter has also been marked by greater tensions with the United States and Taiwan, and we expect further strain ahead. China stepped up its military exercises close to Taiwan following US Speaker of the House of Representatives Nancy Pelosi’s visit in August, and any future foreign shows of support for Taiwan will likely also bring stronger military responses than in the past.

Although China is unlikely to regularly conduct missile tests near Taiwan, or routinely close nearby waters to commercial traffic as it did in August, such actions will probably become less unusual. Beijing may also choose to pursue political interference in Taiwan; boycott substitutable Taiwanese exports and imports; and sanction Taiwanese and other foreign politicians, NGOs, and businesses that it deems supporters of “Taiwan independence.”

Just as intensifying geopolitical tensions have defined market conditions this year, I believe this will also prove true for 2023. President Xi has made it very clear as to what China’s position is. Next year is unlikely to see a change on the policy front and if anything, China’s departure from being “pro-growth” to a more centrally planned economy raises the risks that Xi has ‘other priorities’.

We continue to see China’s economy and stumbling economic reboot as a key risk to global growth. Markets will have to navigate these risks, which we are seeing coming through in the likes of iron ore prices which are trading near two-year lows. Oil has also struggled, defying tight market conditions.

While China’s zero-COVID policy has clearly been a drag on the country’s economic growth, a dramatic shift away from the policy during this five-month leadership transition is unlikely. For Xi, the political and health costs of a severe outbreak significantly outweigh any foreign or domestic discontent with the policy. When the leadership transition is completed in March of next year, China should be in a better position regarding vaccination of the elderly and treatment stockpiles. However, delays on these efforts remain possible, which could prolong the commitment to zero-COVID and potentially delay an economic recovery.

China has stepped up its economic stimulus with a further $146 billion in funding to bolster growth. It’s expected to be mainly used in infrastructure projects and to support local governments The additional stimulus is part of the growing acknowledgement from top authorities and industry leaders in China that the nation’s economy is still struggling, as it continues to be battered by COVID lockdowns, a downward spiralling property sector, and drought-induced power shortages that have paralysed several key factories.

Emerging markets

Emerging markets declined and underperformed developed markets as investors continued to face an underlying destructive mix of high inflation and uncertainties around long term economic growth. Central banks within the region continued to tighten their monetary policies to control high inflation. Although, across emerging markets, there are faint signs of the rate tightening cycle coming to an end. In September alone, 10 out of 18 central banks delivered 600 bps of rate hikes in September, well below the monthly tally of 800-plus basis points in both June and July.

On the commodities front, concerns over the economic outlook were reflected in oil prices, with the price of brent crude oil falling to its lowest level since January. This was reflected in commodity rich regions, including Latin America. At a regional level, Emerging Asia was the biggest decliner, followed by Emerging Europe, Middle East, and Africa (EMEA) and Latin America, with all sectors ending the month in negative territory. In general, emerging market equities continue to face pressure from dollar appreciation and a weak US equity market. However, US breakeven inflation rates are declining, with the Fed expected to pivot and cut rates in 2023. We will inevitably see weaker US employment numbers and, as a result, a weaker dollar. In the long run, this will be supportive for emerging markets.

Commodities

Most commodity prices have retreated from their peaks in the aftermath of the post-pandemic demand surge and war in Ukraine. The decline has been driven by a sharp global growth slowdown and concerns about an impending global recession. However, individual commodities have seen divergent trends amid differences in supply conditions and their response to softening demand.

Commodity prices remain elevated in many countries in domestic currency terms as their currencies have depreciated. For example, from February 2022 to September 2022, the price of Brent crude oil in U.S. dollars fell nearly 6 percent. Yet, because of currency depreciations, almost 60 percent of oil-importing emerging market and developing economies saw an increase in domestic-currency oil prices during this period. Nearly 90 percent of these economies also saw a larger increase in wheat prices in local currency terms compared to the rise in U.S. dollars.

Energy

Brent crude oil prices fell sharply during 2022Q3, with prices in September 2022 averaging 25 percent below their June highs. The fall reflects concerns about an impending global recession, continued pandemic restrictions in China, and substantial releases from strategic reserves. Oil prices saw a partial rebound in October as OPEC+ members agreed to cut their production targets by 2 million barrels per day. Oil prices are expected to average $92/bbl in 2023, close to current levels. The main downside risk is a global economic recession, which could lead to weaker demand. Upside risks relate to supply issues, including weaker-than-expected U.S. production or lower production among OPEC+ European natural gas reached an all-time high of $70/mmbtu in August 2022 due to aggressive actions by several European countries to import liquefied natural gas to rebuild inventories and compensate for reduced flows of gas from Russia. Prices in Japan and the U.S. also saw large increases. European prices subsequently dropped as inventories filled and consumers reduced their consumption in response to higher prices and warmer-than-usual weather. Natural gas prices are expected to ease in 2023 as demand weakens. However, the outlook will depend on the severity of the winter in Europe. A colder-than-expected winter could result in very low inventory levels by the end of the winter and would prove difficult to refill in 2023.

Gold

Most precious metal prices have fallen since March in response to weak investment and physical demand owing to the strength of the U.S. dollar and higher interest rates. These factors have outweighed the positive impact of safe-haven demand related to the war in Ukraine and rising inflation.

Agriculture commodities

Food commodity prices declined in 2022Q3 from their all-time highs in April. The decline has been caused by larger-than-expected edible and oilseed global supplies during the ongoing season, the UN-brokered agreement that allowed Ukrainian grains to reach global markets and deteriorating global growth prospects. Grain supplies will be lower this season, however, due to a projected decline in maize supplies, in response weather-related lower yields in the United States and the European Union.