Market update - quarter ended 30 September 2022

The key story for the September quarter was the pronounced tightening of financial conditions driven by expectations for a more aggressive global rate hike cycle. As markets interpreted some nascent peak inflation developments as leading to a 2023 policy pivot (which at one point during the quarter featured around 70bp of easing), US Federal Reserve (Fed) officials began to push back with “higher-for-longer” messaging as the quarter progressed. Markets were surprised by Fed Chair Powell’s comments in September that the odds of a soft landing are diminishing to the extent that monetary policy needs to be more restrictive for longer and his acknowledgement of the uncertainty around whether the tightening process will lead to a recession, and if so, how deep that recession would be.

Over the quarter, the Fed raised the Fed Funds rate by 1.5% via two back-to-back 75bp hikes and is also engaged in its own quantitative tightening (QT) program, having shrunk its balance sheet by about US$332 billion since March 2022 and this process is currently continuing at a rate of US$95 billion a month. The Fed is committed to continuing to raise rates until it brings the US inflation rate (currently 8.3%) back towards its target of 2%. In the process, however, a very strong US dollar and the pace of increase in US rates are exporting inflation and volatility to the rest of the world.

UK’s budget dominated the headlines in the last week of the quarter in the face of unprecedented criticism from the International Monetary Fund, the White House, Germany, France and other EU nations, questioning the UK budget’s unfunded tax cuts, lack of a detailed plan to bring UK public finances back on a sustainable footing, hints of more tax cuts and the UK Chancellor’s dismissive reaction to wild market moves. UK gilts (government bonds) and Sterling sold off sharply after media reports highlighted the potential fallout on household finances and firms from a sharp rise in borrowing costs. These concerns then spilled over into rising stress in the UK pension fund market as a result of margin calls on liability driven investment strategies, which led to further selling of gilts.

These developments triggered intervention from the Bank of England (BoE) to stabilise the currency and gilts by announcing a temporary buying operation in longer dated gilts and a temporary postponement of its QT program.

Eurozone inflation hit 10% (y/y) in September for the first time, largely due to an energy price surge of 40% which intensified pressure on the European Central Bank (ECB) to signal a more restrictive monetary policy via large rate hikes at a faster pace than previously projected. European countries also agreed to impose emergency levies on energy firms' windfall profits, and began talks on their next move to tackle Europe's energy crunch – potentially a bloc-wide gas price cap. However, according to some analysts, a broad price cap is complex to launch and poses risks to energy security.

Geopolitical tensions ratcheted up as Ukraine fared well in its counter-offensive helped by the ongoing supply of Western military equipment which consequently led to Russian President Putin announcing a partial military mobilization in Russia, putting the country’s people and economy on a wartime footing. Putin further declared four occupied areas of Ukraine as Russian, following staged referendums that were sharply rebuked by the West. Also towards quarter-end, three offshore lines of the Nord Stream

gas pipeline system on the bed of the Baltic Sea sustained "unprecedented" damage, with NATO formally saying it was sabotage. Russia has denied responsibility and instead suggested that the West (US) was to blame without submitting any proof. Restoring gas flows in the medium term appears improbable. Almost immediately, the EU began expediting new sanctions against Russia. Separately, the rhetoric between the US and China over Taiwan further heated up.

This quarter also saw the US dollar strengthen to the highest level in over 20 years. Japan’s central bank, the Bank of Japan (BoJ) intervened in FX markets in September for the first time since 1998 to slow the Japanese Yen’s slide to a 24-year low by selling nearly US$20billion. However, the BoJ Governor’s comments that he won’t raise rates for a while as he sought stable inflation did not help the Yen’s weakening trend amid a continued strengthening of the US dollar.

On the domestic front, New Zealand Q2 GDP at 1.7% was stronger than market expectations. The economy benefited from the loosening of COVID restrictions over the quarter and the reopening of the border. The unemployment rate ticked up slightly to 3.3% while the housing market saw a downturn as the median house price fell 5.9% from $850,000 in June 2022 to $800,000 in August 2022.  The Reserve Bank of New Zealand (RBNZ) hiked the OCR to 3% from 2% via two 50 bp hikes over the quarter. The RBNZ has indicated that further tightening of monetary policy was required as core inflation is still much too high and the labour market too tight. Financial markets are pricing a peak OCR close to 5.00% by mid-2023 (from a peak OCR of 4% by 2022-year-end). 

While the global tightening cycle and high inflation dominated the bearish narrative in the September quarter, also weighing on risk sentiment were concerns that slowing global growth would in turn lead to negative earnings estimates ahead of the upcoming reporting season.

There were however some positive developments that supported the view that inflation has peaked, despite worries about structural inflation pressures and the ability of the global economy to withstand the ferocity of the tightening cycle. These were: a three month plus stretch of declines in US gasoline prices, a softening of inflation components of several of the regional manufacturing surveys in September, a fall in apartment rents for the first time in nearly two years in July and lumber prices back to pre-COVID levels. Additionally, companies have flagged easing labour shortages and supply chain constraints. Some analysts have pointed out that depressed sentiment and positioning indicators have flagged contrarian buy signals.