The Month Ahead

June was another challenging month for investors, as the world’s central banks continued to raise interest rates in an attempt to rein in inflation. The US Federal Reserve (‘the Fed’) announced an aggressive 75 basis points rate hike – its biggest increase to the fed funds rate since 1994.

Most key global equity indices have fallen a further 5% in June, noting that there are still a few days left to go. In terms of sector performance, technology stocks initially underperformed as higher interest rates weighed negatively on company valuations, but later staged a recovery.

Bond markets also saw mixed performances. Yields initially spiked higher following the big moves from central banks, but later drifted off their peaks as the prospect of recession saw some renewed demand for ‘safe haven’ assets and as expectations for rate hikes reduced a bit.

As has been the theme for most of the year, inflation, interest rates, central bank policy and economic growth all remain at the forefront of our discussions here at ANZ Investments. With this in mind, here’s a look at what lies ahead in July.

While financial markets had expected interest rates to rise this year, investors did not expect central banks to move as quickly and aggressively as they have, which explains their weaker performance of late.

Hard as it is, market falls are part and parcel of investing and our portfolios may deliver negative returns from time to time. While both bond and equities have struggled against this backdrop of rising interest rates, markets are forward-looking, and have now priced-in most of the expected tightening in monetary policy for this year. Because of this, long-term forward return expectations for bonds and equities have improved.

The Fed is widely expected to raise the fed funds rate by a further 75 basis points at its meeting late in July. Jerome Powell, Chair of the Fed, recently reiterated that the central bank is determined to bring down inflation and has the ability to make that happen.

“At the Fed, we understand the hardship high inflation is causing. We are strongly committed to bringing inflation back down, and we are moving expeditiously to do so,” said Powell.

According to the CME FedWatch Tool, which tracks interest rate probability of the fed funds rate, as at 29 June, there is now a greater than 80% chance of another 75 basis point hike.

Meanwhile, the European Central Bank has prepared the market for a 25 basis point hike in July. It’s worth bearing in mind that the region’s benchmark interest rate remains in negative territory (at -0.50%) and the central bank has yet to tighten monetary policy. The latest inflation reading showed that inflation is running red hot at 8.1% for the year to May. An even higher reading in June may increase pressure on the central bank to go ahead with a bigger move.

Inflation data will remain a focus for key central banks in the lead up to their July meetings. As well as the Fed and the ECB, the Bank of Canada and the Bank of Japan are also due to make interest rates decisions. Looking forward we see three possible scenarios for inflation and markets:

• If inflation accelerates from here, central bankers and markets may price more rate hikes. This would mean more pain for bond and equity markets, but given the amount of rate hikes already priced in, we don’t think this is likely.
• If inflation peaks and starts falling meaningfully, we think central bankers will slow down the pace of tightening rather than keep hiking and risk pushing the economy into recession. If a recession is avoided, this would be supportive for bonds and equities.
• If the economy is tipped into recession, expectations for further interest rate hikes would reduce, which may be good for bond returns, but not for equity returns.

Where inflation goes from here is very much in the balance, and arguably raising interest rates does not resolve many of the underlying drivers of inflation. Countering inflationary pressures are, for example, Germany restarting their coal powered stations to bring energy prices down, signs that global shipping disruptions are easing and, in the US, declining used car prices and a pick-up in retail discounting.

However, inflation could remain elevated as a result of rising prices for services, rising wages, higher rent and elevated food prices.

In New Zealand, attention will be on the release of second quarter inflation data on 18 July, which is expected to remain elevated at around 7% (annual rate). Anecdotally, we are seeing ongoing price rises in the building and materials sector, while the price of petrol at the pump certainly isn’t helping the situation. Offsetting these inflationary pressures could be a slowdown in consumer spending, driven by a worsening outlook for the economy.

Elsewhere, June’s business and consumer confidence readings will be ones to watch, especially as it follows a much-cooler first quarter – with GDP data showing that the economy shrank 0.2% in the first three months of the year. Weaker readings could signal tougher times ahead for the New Zealand economy. The Reserve Bank of New Zealand meets again on 13 July and policymakers will decide whether to continue with sizeable 50 basis point hikes, or slow the pace to a more moderate 25 basis points. As at 29 June, markets are pricing in a 50 basis point hike.