17 May Monthly Commentary: May 2024

Market Trends: Rate cut expectations scaled back

Both equity and bond markets weakened in April due to a significant rebound in bond yields. Bond yields rose as sticky inflation and resilient economic growth caused markets to further scale back the degree of expected rate cuts later this year in the United States and Australia.

In Australia, the market moved to price in a small chance of another rate rise by year-end. In the United States, only one rate cut is now expected this year compared to expectations for 6 rate cuts at the start of the year.

Bond yields are still below their peaks of late 2023, but their recent retracement has dented the equity market bull run especially given already stretched valuations. Sustained further gains seem to require a decent decline in bond yields (without a recession) or further gain in forward earnings.

With inflation still expected to decline, and central banks still expected to eventually cut interest rates, the market outlook remains encouraging – though the risk of a continued short-run equity market correction remains high.

Our hypothetical balanced portfolio fell by 2.4% in April, reflecting weakness in both growth and defensive assets in the face of higher bond yields. Confirmation from the Federal Reserve that
recent higher-than-expected inflation results had likely delayed rate cuts was a major highlight of the month, along with an escalation in hostilities between Israel and Iran.

Defensive assets fell 1.6%, reflecting weaker Australian and global fixed-rate bond returns as bond yields moved higher. Gold price held firm, rising 2.5% in March.

Growth assets fell 3.1%, with global equities in unhedged AUD terms declining 2.8%. The trend in global equities has been upward since bottoming in late 2022.

The rebound in bond yields produced a 7.6% decline in the interest-rate sensitive local listed property sector, while Australian equities fell 2.9%. The trend in the relative performance of Australian equities remains downward since early 2023. Relative returns for Australian versus global bonds has been choppy over the past year.

Global Bonds

The Bloomberg Global Aggregate Bond Index (AUD hedged) lost 1.7% in April, reflecting a large rebound in global bonds yields. The 3rd consecutive higher-than-expected US CPI inflation report and more hawkish Fed commentary saw US 10-year bond yields rise 0.48% to 4.68%. The market moved from expecting three US rate cuts later this year to only one.

German and Japanese bond yields move higher in sympathy, though less so – with markets still anticipating the European Central Bank could cut rates as early as June.

High-yield bond spreads remained reasonably contained, with a moderate increase in emerging market spreads yet small decline in the high-yield corporate bond spread.

All up, the yield-to-maturity on the Bloomberg Global Aggregate Index increased by 0.31% to 4.06% p.a.

Global Equities

Higher bond yields and Middle East tensions contributed to a decline in the MSCI AllCountry World Equity Return Index of 2.8% in April on an unhedged (local currency) basis, following a 3.4% gain in March. Thanks to still bullish earnings expectations, forward earnings rose a solid 1.9% in the month, with most of the decline in equity returns coming from a decline in the forward-PE ratio from 17.9 to 17.1.

Despite the decline in the PE ratio, the rise in bond yields still led to a further narrowing in the equity risk premium to relatively tight 1.15% – the lowest level since the mid-2000s. That said, the equity risk premium could reflect a return to pre-GFC levels when bond yields were last around current levels on a sustained basis.

In unhedged AUD terms, global equities declined by 2.8%, thanks to a broad steadiness in global currencies versus the AUD. On an unhedged basis, global equities have returned 19.5% over the past year.

Given the tight equity risk premium, global equities remain vulnerable to higher bond yields in the short-term. Barring the US Federal Reserve returning to a tightening bias, however, we may be nearing the peak in bond yields in the current sell-off.

Global Sector/Factor Trends

Strength in gold prices contributed to continued strength in global mining stocks in April, with MNRS’ index returning a further 6.3%! Other value exposures such as agriculture (FOOD), energy (FUEL) and financials (BNKS) declined in value, but held up better than the more growth exposed areas such as NASDAQ-100 (NDQ) and global quality (HQLT).

Delayed US rate cut hopes and relative value considerations have potentially contributed to the recent new interest in value over growth/quality exposures. Whether this is the start of a new trend remains to be seen, as the US still seems likely to cut interest rates late this year – or early next year – in line with ongoing declines in inflation.

Global Regional Trends

Non-US equity exposures generally outperformed the US again in April, with the S&P 500 declining by 4.1% – or a little more than the global benchmark.

The more defensive UK market (H100) held up best, with a 2.7% return, while Japanese equities (HJPN) produced a small positive gain of 0.3%.

The relative underperformance of European equities (HEUR) also appears to be bottoming out, which bodes well for a broadening in the global equity rally. Australian relative performance, however, remains in a downtrend, while it’s too early to conclude the UK’s underperformance is behind us.

Australian Cash and Bonds

The Bloomberg Australian Bond Composite Index declined by 2.0% in April, reflecting a rebound in local bond yields. Cash returns, according to the Bloomberg Bank Bill Index, lifted
another 0.4%.

The rebound in bond yields reflected both higher global rates plus the removal of local rate cut expectations for this year following a higher-than-expected Q1 CPI report. The market is now pricing a modest risk (20%) of a year-end rate hike.

Fixed-rate bonds have experienced choppy sideways performance against cash since the peak in bond yields in October last year.

Corporate credit spreads, meanwhile, continue to narrow, which is supportive of corporate bond outperformance over government bonds.

Australian Equities

Hurt by higher bond yields, the S&P/ASX 200 Return Index declined by 2.9% in April after a 3.3% gain in March. The market ended the month, however, still above the trading range it was stuck in for the previous few years.

Forward earnings were flat in the month, with a small downtick in year-ahead earnings expectations. Returns declined due to a 3% fall in the forward PE ratio to 16.2. That said, given the large rebound in bond yields, the equity-risk premium still managed to decline further to 1.75%.

As with global markets, the equity risk premium appears low by the standards of recent years – but is not out of line with pre-GFC levels when bond yields were last around current levels on a sustained basis.

Despite the recent setback, rising corporate earnings and an eventual lowering in bond yields bodes well for the local equity market.

Australian Equity Themes

It was largely a sea of red among our selected Australian equity ETFs in April, though resource (QRE) managed to eke out a small return of 0.5%.

Over the past six to 12 months, technology (ATEC), financials (QFN) and quality (AQLT) have tended to outperform, whereas resources (QRE) has tended to underperform.

This article was originally produced by David Bassanese from BetaShares. You can read the full article here.

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