Month in review - February 2023

After a strong market advance in January driven by falling inflation and hopes of an end to central bank rate hikes, an improvement in the near-term global economic outlook in February shifted the narrative yet again. While resilient economic data would usually be interpreted as a positive for markets, investors looking forward to the prospect of rate cuts were disappointed to learn that the road back to target inflation was likely longer and harder than they expected. Risk appetite waned as a result, with bond yields rising sharply over the month (as bond prices fell) and declines experienced across most major global share markets. The ongoing uncertainty about the trajectory of inflation and interest rates and their impact on consumers and businesses will likely mean that market volatility will persist in the short term. Nevertheless, the rally in January reminded us that markets are forward-looking and can pivot quickly at any moment. New signals that inflation is moderating and the central bank monetary tightening cycle is nearing an end are likely catalysts for an upswing in returns from bonds and shares.

ECONOMIC REVIEW

Australia

Following a strong start to the year, the Australian economy lost momentum in February. Labour market conditions continued to ease, with employment falling for the second consecutive month and the unemployment rate rising to 3.7%. The Wage Price Index for the December 2022 quarter came in at 3.3% year-on-year, which was benign given the low unemployment rate. The Reserve Bank of Australia (RBA) aims to prevent a wage-price spiral, and the WPI data shows that Australia is not currently facing this issue. Australia's annual CPI inflation rate for January was 7.4%, compared to 8.4% for December and significantly lower than the 8.1% forecasted.

As anticipated, the RBA raised its cash rate by 0.25% to 3.6% in its March meeting, delivering its tenth consecutive rate increase since the tightening cycle began in May 2022. Softer-than-expected economic data had led to market speculation that the RBA would weaken its guidance on future interest rates, and it did not disappoint. The RBA signaled that only one more rate rise was planned, which sent the Australian dollar down and the share market up in early March. The RBA's comments on the labour market suggested that while still tight, conditions had "eased a little." The futures market is now pricing in a peak cash rate of around 4% in October, suggesting one or two more 0.25% rate rises before a potential cut in December.

US

US economic data remains resilient. The January labour market report was much stronger than expected, with the unemployment rate falling back to 3.4%. Retail sales also surprised to the upside in January, posting an increase of 3% month-on-month. Services PMI came in better than expected at 55.1 for February. In its February meeting, the US Federal Reserve (Fed) voted unanimously to raise the federal funds rate by 0.25% to 4.50-4.75% and indicated that policy intervention was starting to work on curbing inflation. Later in the month, Fed Chair Jerome Powell warned that the process of reducing inflation had a long way to go and that rates were likely to peak at a higher point. Inflation data for January confirmed this narrative. Core Personal Consumption Expenditure inflation came in very strong, accelerating 4.7% year-on-year, beating market estimates and the 4.6% reported in December. This was the first increase in core PCE since September 2022 and was a reminder that the road to normal inflation could be bumpy. The futures market is now pricing in 0.25% rate rises at the Fed's next three meetings, and the rate is expected to peak near 5.4% by July.

Europe

Headline inflation fell from 8.6% in December to 8.5% in January, driven by lower energy prices, while core inflation remained at 5.2%. Forward-looking data painted an encouraging picture of the region's economy, with consumer confidence rebounding from extremely low levels in late 2022 and manufacturing and services data reaching 52.3 in February, indicating the strongest expansion of business activity since the middle of last year. The European Central Bank (ECB) raised its key policy rate by 0.50% to 3% in February and confirmed its intention to stay the course in increasing interest rates at a steady pace and keeping them at levels that are sufficiently restrictive to ensure a timely return of inflation to its 2% target. The market expects interest rates to peak at 3.9% by the end of the year.

Asia

Inflation in Japan continued to rise, with year-on-year CPI for January reaching 4.3%, the highest level in the last 40 years. China announced that it would target economic growth of 5% in 2023, up from 3% in 2022, and the post-lockdown re-opening of China is expected to fuel a rapid consumption-driven recovery in the local economy.

ASSET CLASS REVIEW

Australian Shares

Australian shares fell in February, with the S&P/ASX 200 finishing down 2.4%. The utilities sector outperformed, while materials and financials drove the downward pressure. Backward-looking results from the half-year reporting season reflected a resilient economy to date, but cautious outlook statements point to early signs that earnings are beginning to moderate.

Other sectors that posted positive returns were technology (+2.7%), industrials (+1.5%), consumer staples (+1.1%), and communication services (+0.4%). However, the half-year reporting season revealed that while the Australian economy has been resilient so far, net downgrades to forward earnings estimates and cautious outlook statements indicate that earnings are starting to moderate.

Global Shares

Global shares declined in February in local currency terms as resilient economic data suggested a pause in interest rate rises may still be some way off. The MSCI All Country World Hedged Index fell -2.0% in the month, but a sharp rise in the US dollar against the Australian dollar resulted in unhedged global shares gaining +1.5%. Emerging markets (EM) underperformed developed markets as a re-escalation in US-China tensions weighed on sentiment. Interest rate-sensitive sectors like real estate (-5.0%) and utilities (-3.8%) underperformed, as did materials (-3.9%) and energy (-3.9%) as cost pressures and weaker commodity prices weighed on the sectors.

US shares delivered a lacklustre performance in February as investors hit the brakes after January's large rally. The S&P 500 dropped -2.4%. Although earnings declined 2.8% year-on-year, revenue grew 5.3% over the same period, showing that tight labour markets, rising input costs, and higher debt servicing costs have squeezed profit margins.

European shares bucked the global trend, gaining +1.9% as risks of a deep recession decreased, and markets interpreted signs of easing inflation to mean the pace of rate hikes could soon moderate. UK shares also held up well during February, with the FTSE 100 up +1.8% to hit a new record high. However, Chinese shares fell -9.9%, with escalating geopolitical tensions driving some profit-taking after the market's 35% rally from its October 2022 lows.

Property and Infrastructure

A pivot to a higher-for-longer interest rate outlook was a headwind for rate-sensitive global property, with the FTSE EPRA Nareit Developed Index (Hedged) retracing -3.6% in February. Australian property again outperformed global property, with the S&P/ASX 200 A-REIT Index down just -0.3%, possibly reflecting softer inflationary conditions in Australia, which have been lower and taken longer to accelerate than many other countries around the world. Global infrastructure experienced a difficult month, with the FTSE Global Core Infrastructure 50/50 (Hedged) Index falling -4.0% as raised interest rate expectations dampened investor enthusiasm for the asset class.

Fixed Interest

Stubborn inflation and aggressive central bank commentary led to higher yields as fixed interest markets moved to discount further monetary tightening. Against this backdrop, the Australian Fixed Interest market, as measured by the Bloomberg AusBond Composite 0+ Yr Index, fell -1.3% after gains of 2.8% the previous month. Global Fixed Interest didn't fare any better, with the Bloomberg Global Aggregate Index Value Hedged Index giving up -1.8%.

Government bond yields were higher in February, with the 2-Year and 10-Year Australian Government Bond yields ending the month higher at 3.66% and 3.85%. The rise in bond yields created headwinds for fixed interest markets more broadly. Global investment-grade credit went backward as spreads widened, while high yield credit also recorded losses but outperformed investment-grade given that improvements in economic data have reduced credit risk concerns. 

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