What was causing market volatility in the second quarter of 2022?

Both for the June quarter and year-to-date, what has been most challenging for investors has been the positive correlation between risk assets (equities) and normally defensive bonds (i.e. both falling at the same time). From an asset class perspective, the largest contributor to negative absolute returns over the period came from international equities, followed by Australasian equities and then followed by international fixed interest.

The key drivers were:

(1)    The ongoing Russia-Ukraine conflict and repercussions on energy and food prices,

(2)   Global Central Banks’ aggressive interest rate hiking, and

(3)   Covid-19 driven lockdowns in China. 

The lack of resolution to the ongoing Russia- Ukraine crisis and China’s zero-COVID policy have exacerbated global supply chain and inflationary problems. With the current inflation rate in many regions higher than it’s been since the early 1980s, market expectations for inflation in the next 12 months are still very high (about 5% in the US and 6% in the Eurozone) and above target two years ahead. Central bank policymakers are therefore on a mission to restore credibility and re-anchor inflation expectations at any cost whatsoever. What’s unique about this tightening phase is that it is occurring in just about every region/ country (with China a notable exception) and it’s not just interest rate hikes by Central Banks but also unwinding of the balance-sheet purchases made over the last few years.

In the last two weeks of the June quarter, however, the recession narrative replaced the inflation narrative as the key driver for markets as fears rose that Central Banks will end up tightening too aggressively. As it is, financial conditions have tightened substantially over the quarter, as reflected in a decline in both IPO issuance in equity markets and high yield bond issuance. Further, higher input costs (labour, raw materials, transportation) and cost of funding for most companies is impacting earnings growth. The coincident surge in gasoline prices and mortgage rates has also begun to impact consumers as they tackle a decline in their purchasing power. Most recent consumer sentiment surveys have also seen a fall.

Many market strategists are of the view that inflation pressures should ease gradually, as supply disruptions abate, growth slows, and energy prices flatten out. At the end of the quarter, financial markets were increasingly factoring in the US Federal Reserve pivoting to an easing stance in late 2023. Markets’ pricing for the high point in the projected Fed Funds' interest rate (terminal or peak rate) was around 3.5% at quarter-end vs more than 4% at one point in May.

China removed its widespread Covid-19 lockdowns, but has already seen some setbacks, thus far confined to local or neighbourhood levels. To prevent “Shanghai-like” lockdowns from recurring, policymakers have pivoted from mass to regular testing. The rationale is to detect fresh infections early and thus quickly ring-fence any outbreaks. Production growth in China has turned slightly positive and policymakers have unveiled various initiatives with a strong focus on credit support.

On the domestic front, NZ GDP data confirmed that the economy was weak in the first quarter on the back of Omicron related restrictions. While some economic indicators suggest a bounce-back in the June quarter, Westpac’s survey of consumer confidence fell to record lows with higher interest rates, falling house prices and increased costs of living. ANZ’s business outlook also indicated poor levels of confidence and activity.