Investment outlook: July 2022

World share markets declined sharply in the June quarter in response to inflation and interest rate fears as well as the ongoing war in Ukraine. In response to persistently high inflation, central banks in a range of countries, including the US, Australia, the UK and Canada increased official interest rates over the quarter.

Markets remain concerned that to bring inflation down, central banks will be forced to raise interest rates further and faster than previously thought, increasing the risk of a global recession.

All the major developed markets suffered losses, with share markets in Japan and the UK outperforming those in the US and the Eurozone. Share prices in most emerging share markets also suffered significant falls, with only a handful of markets gaining ground, including China, which benefitted from an easing of COVID restrictions. A weaker Australian dollar added to the returns of unhedged developed and emerging markets shares over the June quarter and the year to June 2022.

After managing to deliver a positive return in the March quarter, Australian shares also fell sharply in the June quarter. Of the major industry sectors, only energy and utilities shares produced gains, while shares in the materials and consumer discretionary sectors posted the steepest falls.

Both Australian and global fixed income returns were again sharply negative over the quarter as bond yields rose in response to inflation concerns and increases in official interest rates. Non-government securities underperformed sovereign bond with credit spreads widening significantly, both here in Australia and globally. Higher bond yields also undermined the performance of Australian and global listed real estate securities, which were the performing asset classes over the quarter, as higher bond yields reduce the relative attractiveness of the yields available on property securities.

The challenge facing the world’s central banks is an extraordinarily difficult one. Further cash rate increases, both here in Australia and elsewhere, are almost certain. While there is a risk of recession in a number of economies – partly reflecting the ongoing economic impacts from the war in Ukraine, but also the risk of monetary policy being tightened too aggressively – recession is not inevitable at this point.

We do not design portfolios based on our own or anyone else’s short-term economic, market or geopolitical forecasts. And we have no way of knowing with any certainty how long it will take for the markets’ inflation and interest rate fears to subside. While much of the rise in inflation we have seen over the past year or so is likely to fade (e.g. as supply chain pressures ease and key commodity prices stabilise or decline) this is likely to take some time, and over the medium to longer-term, inflation is likely to be somewhat higher than we saw in the pre-COVID years.

However, our investment team and our external investment managers do seek to capitalise on opportunities that inevitably emerge during times of crisis and heightened market volatility, such as we are currently experiencing.

We have made a number of adjustments to our asset class weights in response to changes in relative value between asset classes over the quarter and will continue to do so as opportunities present. We moved to take advantage of share market weakness by increasing our share allocations during the June quarter, while late in the quarter, we decreased our exposure to commodities following the rapid rise in commodity prices in 2022. And in fixed income, we increased our exposure to non-US fixed income markets where we expect smaller increases in official interest rates and better returns than in the US.

Our share portfolios are deliberately constructed to be much more diversified – across countries and industry sectors - than the major share market indices, a feature which has greatly reduced our exposure to an underperforming US share market and the sharp decline in technology shares in 2022.

In addition, we continue to hold a significant allocation to foreign currencies and increased that exposure early in the June quarter. As the Australian dollar tends to fall sharply during most periods of market stress, a higher allocation to foreign currency is a means of providing additional protection to our diversified portfolios, a position which has boosted performance over the June quarter.

The QSuper account diversified portfolios continue to hold a substantial allocation to alternative assets, particularly the key unlisted asset classes – real estate, infrastructure, private equity and private credit – as well as an exposure to commodities and other alternative investment strategies. These allocations have provided significant diversification benefits, particularly in an environment where both fixed income and shares have delivered negative returns.

During the quarter, our private equity team acquired a significant holding in Forefront Dermatology. This Wisconsin-based company is the largest dermatology provider in the US with over 200 dermatology clinics across 22 states. We also increased our real estate portfolio’s exposure to offshore logistics by acquiring an asset in the UK’s East Midlands region. It is currently fully leased to a major automotive manufacturer and is a key strategic asset as it is the sole UK distribution warehouse for all of its consumer vehicle spare parts. And our private credit team provided a material loan to a property development consortium, secured by real estate assets in Western Sydney, including a 344-hectare parcel of industrial land adjacent to the new Western Sydney airport, which is ideally located next to key infrastructure nodes that will facilitate transport and logistics activities. The loan is also secured by a parcel of residential real estate in the Western Sydney growth corridor, which, once developed, will assist in providing additional housing supply in a supply constrained market.

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Past performance is not a reliable indication of future performance.