Following six months of selling since the New Year, financial markets rallied in July. Both equity and bond markets posted gains, with the two markets continuing to show a high level of correlation. Equities rose over 5% in the month, paring some of the more extreme losses seen in June. While markets continue to be concerned by inflation, monetary policy, energy prices and the prospect of a recession, attractive valuations, and some signs of these issues moderating encouraged investors.
With recession risks increasingly being considered, markets are now beginning to price in the prospect of rate cuts next year, although near-term rate hikes are still expected. The Federal Reserve once again increased rates by 0.75%, taking the headline interest rate to 2.25-2.5%. The pace of increases is now expected to slow at the remaining three meetings of this year, following which, rates are forecast to plateau. For bonds, fewer expected rate rises and a weak economic outlook lessen the potential for higher yields. However, persistently high inflation may upset this outlook.
Forward looking economic indicators have continued to deteriorate. Surveys on management expectations, inventory data as well as reporting by companies, all point to a rapidly decelerating global economy. High energy prices have weakened consumer confidence, particularly in Europe, which is already having an impact on demand. It is likely that company earnings will be affected in the second half of the year, which have up until now remained robust. There is therefore some justification for the lower market valuations that are now on offer.
Within equity markets, it has been those areas that have been most impacted by rising yields through the course of the year that rallied the hardest in July. Higher growth companies, who’s share prices benefit from lower bond yields, saw particularly strong rises. Commodity shares lagged, as many underlying commodity prices weakened on the recessionary outlook. The month once again illustrated how fast market favourites can change.
Concerns over the Chinese property market have once again emerged, with the highly indebted developer Evergrande failing to meet a deadline at the end of July to restructure part of its debt pile. The issue, made worse by the lockdowns seen this year in China, has been compounded by recent mortgage boycotts. Consumers are concerned that developers will not complete their homes, and the actions are leading to lenders increasingly restricting availability for such mortgages. This has the potential to further pressure development and overall property pricing. Given the scale of the market and the debt outstanding, this is unlikely to be an issue that will be resolved in the near term.
Looking forward, peaking inflation and a moderation in monetary tightening may be enough to support equity markets, that are already at low headline valuations. However, with potential uncertainty in earnings and the extent of any recession, more volatility is highly anticipated.