Markets finished the month with another down week (about -3% for most markets), leaving equity markets down around 10% for the month and around 5% for the quarter. That pretty much takes us back to the lows of mid-June for equity markets and, not coincidentally, the highs of long-term interest rates seen at the same time in June. One thing that has changed in the last three months is that medium term inflation exceptions have actually edged down (despite the currently high inflation data), while the rate rises that are expected to be needed to make inflation fall have been revised upwards. This gets quite convoluted and more than a bit circular, but the end result is that year real (after inflation) expected rates of interest spiked in the last quarter. Credit markets and the plumbing of the financial system are particularly sensitive to real interest rates, and it was perhaps significant that signs of financial stress started to emerge last week, particularly in the UK. There is a broad consensus that the policy announcements by the incoming Truss leadership were ill-conceived, but the Conservative Party was also arguably unlucky to be the first in the firing line as the world considered what the first thing to ‘break’ in the current hiking cycle might be. It turned out to be the Pound and the UK Gilt (government bond) market, which both fell sharply a week or so ago and continued to exhibit volatility during the last week. This then exposed frailties in the UK pension system (via funds using derivative structures to match future pension liabilities) and amongst some of the large insurance companies with exposure to illiquid credit instruments. Given that banks are better capitalised and more risk averse than they were before the GFC, investors have wondered where the risk might be hiding in this cycle and many feel that this latest episode has provided some vital clues.

In local currency terms the UK, Australian and Japanese markets have been a relative oasis of calm this year and even last quarter. However, after taking into account the strength of the US Dollar the differences are less marked and in fact with the US Dollar appreciating by 7% against the Aussie Dollar over the last three months, unhedged Australian investor’s US investments ended up level for the quarter.  Southeast Asia, Europe and the US have been moving in tandem in recent months, with China leading the way down while India and Latin America have provided unusual stability and are actually up strongly for the quarter, especially on an unhedged basis (their respective currencies have also proven resilient having been forced to head off their own inflation woes in 2021). Australian equities also had a relatively good quarter after a reasonably strong earnings season where strong dividends from the banks and miners especially trumped concerns over the economic outlook. At the other end of the ledger, real estate trusts, utilities, and other interest rate sensitive stocks like Transurban were down by about 15% a piece.                    

Once again though, the action last week and indeed over the quarter was emanating in bond markets. Last week actually saw a little respite as credit spreads firmed and yields started to fall in response to the Bank of England’s emergency measures. It probably also helped that some of the Federal Reserve at least acknowledged the impact that the US hiking cycle might be having overseas and that that could in turn hurt the US.  In that sense truly bad news has again provided some respite for markets and the question now will be whether the current lack of liquidity in bond markets is just bad enough to convince central banks to pause or whether something else has to break first.  

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