The week that was

Another mostly positive week for shares left markets in positive territory for March despite, or perhaps even because of the war in Ukraine, with Australia, the best performing market up by almost 6%. This was mostly thanks to Energy stocks and in Australia’s case Iron Ore prices as well as the other commodities that we produce. The local banks also made a meaningfully positive contribution as the economic outlook for Australia seemed to brighten - a combination of gathering economic momentum due to reopening as well as the prospect of being one of only a few commodity-rich democracies. The quarter was nevertheless the worst in 2 years with overseas markets down around 5%, Australia flat and the UK’s FTSE 100 the best performing major market behind gold, with returns of 2% and 4% respectively.

The one constant was the bond market, with yields rising consistently throughout the period except for a brief dip at the onset of the war. Mounting inflation pressures that, have only been exacerbated by the Ukraine War, have made it increasingly obvious that the Federal Reserve and other central banks are likely to have little choice but to ramp up rates quicker than they would have otherwise liked amidst a fragile recovery and even the growing prospect of an imminent recession.

Popular gauges that use metrics like energy prices and the slope of the yield curve put the probability of a recession sometime this year at around 50% which makes the stock market’s resilience all the more surprising. A so-called inverted yield curve (which the bond market has been flirting with in recent weeks) means longer-term yields are lower than short term yields, implying that rates are expected to fall in the future in response to very weak economic activity.

The initial falls in January and early February are most likely related to rising interest rates and inflation expectations in the context of moderating growth (higher rates mean the value in today’s money of future cash flows becomes less).

The strength of markets in March on the other hand is perplexing many market watchers. Prominent explanations include the flow effects of rotation out of particularly in inflation-sensitive fixed income bonds into equities and maybe a sense of geopolitical relief that Xi Jinping might have become less likely to launch his own assault on Taiwan. The first explanation is supported by the performance of global sectors which saw typically defensive stocks like utilities, consumer staples and healthcare perform especially well. The latter explanation is also supported by the bounce in large and influential Chinese tech stocks in recent weeks although other emerging markets have done even better (Brazil is up some 15% this year).

Relative to their risk profile therefore bond investors have had the worst of it this year as government bonds have fallen by similar amounts to global equity markets and high grade fixed income credit has actually performed worse (down by 8-9%) as it has been subject to both interest rate rises and (so far) modest increases in credit spreads. In March 2020 similar falls were experienced but it was mainly due to corporate credit concerns. For government bond investors you would have to go back to the early 1980’s to have experienced anything similar in terms of short-term losses. That makes the lacklustre returns of minus 2-3% from many of the more actively managed diversified and floating rate bond funds since the beginning of the year a little more palatable.

In a similar vein active management appears to have made a decent comeback this year, at least protecting on the downside to some degree. The following chart shows the average return for multi-asset funds in from the Financial Express universe for risk profiles ranging from conservative to aggressive. The red lines show a similar range of funds managed by a prominent index manager. After the recent bounce in markets most actively managed funds were down by almost 3%, regardless of risk profile, while the passively managed funds were down by 3.8% to 4.6%.  The broad-based weakness in bonds meant that Balanced option underperformed the actively managed equivalent by almost 2%, after fees, in just three months. Index funds have had a very good run for more than 10 years which this doesn't yet make up for but it is still a significant reversal in a short space of time and is perhaps worth keeping an eye on.