The high summer months were much kinder to investors following the shocks of the first half of the year, although the investment weather seems to be turning for the worse again as the holiday season comes to a close and we are faced with the harsher realities of autumn and winter. Not that the overarching investment themes have changed to any great degree. The resurgence of inflation continues to be the dominant factor and it is having a profound influence upon monetary policy. Governments are struggling to find the right balance between short-term expediency and long-term stability in their policy responses at both the geopolitical and domestic levels, while consumers and businesses find themselves increasingly squeezed by rising prices, especially for energy. Meanwhile markets are negotiating that tricky point in the cycle when they are trying to anticipate the more favourable conditions that will eventually evolve at the same time as the current situation continues to deteriorate.
As a reminder of how bad the first half of the year was for investors, this is what we wrote two months ago: “holders of US 10-year Treasury bonds were subject to the worst performance in the first half of a year since 1788. Global equities suffered their first consecutive quarterly reversals since the Great Financial Crisis, with the S&P 500 Index in the United States having its worst start to the year in six decades.” Implicit within those observations is the fact that balanced portfolio investors, who had previously enjoyed a long period of reduced portfolio volatility thanks to the negatively correlated performance of equities and bonds, found themselves with few hiding places. Commodities were the clear winner, although they rarely account for a large percentage of portfolio allocations. And while cash holdings fared well in nominal terms, even beginning to accrue a bit of interest finally, they still failed to keep pace with rising prices.
However, markets experienced “maximum gloom” around the middle of June, after which the MSCI All-Countries World Index embarked on a 13% rally that extended for exactly two months. It is often hard to pin down why markets reverse course in such a manner, especially when there is no explicit shift in policy to drive the change. In retrospect, it is easier to observe that selling pressure from more speculative and leveraged investors was largely exhausted and that sentiment was extremely negative. As we heard someone ask at the time: “Is there anyone left to turn bearish?”
Furthermore, there was an increasingly prevalent view that consumer price inflation in the United States had peaked (at least in terms of the annual rate of increase) and that this would allow the Federal Reserve (Fed) to be less aggressive in tightening monetary policy or even to start to loosen again. There were also signs of resilience in the US employment market and the second quarter corporate earnings season, while not devoid of nasty shocks, was not the disaster that it might have been. The much-hoped-for “soft landing” for the economy was a possibility. Quite quickly the mood shifted to one in which investors were concerned that they might be missing out on a recovery. Once the S&P500 Index had recovered 50% of its lost ground, market historians (or, perhaps more accurately, data miners) quickly circulated analysis showing that such a recovery from an initial decline of 15% or more suggests that the market will not make new lows again in this cycle. Indeed, using nineteen examples extending back to 1946, one investment bank showed that the only time that the market had made new lows following such a rally was in 1974, and that was in response to the Arab oil embargo and consequent energy price shock.
We should add that the usual disclaimer was appended to the table: “Past performance is no guarantee of future results.” Indeed, that is very much how we view the use of such data. It’s an interesting guide to history and probably does encapsulate some sort of persistent investor behaviour, but it must also be interpreted in the light of current circumstances.
It is in the nature of bear markets to have extended countertrend rallies, and last month we commented that this was exactly what was going on. Some interesting analysis on bear market rallies was provided to us by the strategists at Bank of America. They observed that there have been forty-three bear market rallies exceeding 10% for the S&P500 Index since 1929, with the average rally being 17.2% over a period of thirty-nine trading days. The latest rally from mid-June registered a gain of 17.4% over forty-one days. Again, that proves nothing, but does at least suggest that our assertion that we were experiencing a bear market rally was by no means reckless.
The market’s better mood was finally punctured by the build up to and then reality of the annual symposium of the world’s central bankers at Jackson Hole, Wyoming. This event does not always produce fireworks, but it has in the past been the platform for the Fed’s chair to make an impactful policy statement. In 2012, Ben Bernanke dropped heavy hints of the launch of a new round of Quantitative Easing, which set risk markets running higher. Two years ago, Jerome Powell set out the framework for the Fed’s ill-fated flexible average inflation targeting policy, a policy which many believe was one of the causes of the current inflationary malaise because it encouraged the Fed to keep monetary policy too loose for too long.
This year’s speech by Mr Powell turned out to be very short – only eight minutes long – but highly impactful. The message was unequivocal. The Fed is determined to bring inflation back down to its target of 2%, and if that means inflicting some damage on the labour market and the overall economy, so be it. Whether that turns out to be a proper recession or a prolonged period of below-trend growth remains to be seen, but the mood certainly changed for the worse almost immediately. And this is far from being solely a US phenomenon. The representative from the European Central Bank (ECB), Isabel Schnabel, echoed the intention to take forceful monetary policy action. And while Andrew Bailey, Governor of the Bank of England (BoE), was not on this year’s list of speakers, the BoE has also made clear its intent to use more restrictive monetary policy as a weapon to tame inflation.
It is impossible to avoid the conclusion that we are in a period of tightening monetary conditions which also extends to the shrinking of central bank balance sheets. At the very least we believe that this will constitute a headwind for risk assets. But we also know that inflation sows the seeds of its own demise. As the old saying in commodity markets has it, “the best cure for high prices is high prices”. This is because high prices encourage new or alternative supplies while also damping current demand. The biggest risk perceived by the central banks is of longer-term inflation expectations becoming elevated and leading to more persistent demands for higher wages and the risk of a damaging rising wage/price spiral. Employment markets remain historically tight, with the influence of Covid at least partially responsible, and it is hard to see central banks backing down until there is some evidence of more slack appearing.
Packaging all these views together leads us to remain cautious on risk assets such as equities and lower-grade corporate credit, although we are keen to continue to point out that caution is not the same as fear. Inflation is cyclical and there will be an opportunity for the central banks to release the brakes at some point which probably lies within our usual eighteen-month tactical investment horizon. But not yet. Furthermore, equity markets have already sustained a meaningful derating thanks to rising bond yields, although they are still, in aggregate, a long way from being especially cheap from a longer-term historical perspective. We also believe that earnings estimates need to be reduced to some degree. Credit spreads have risen to the point where they can offer some protection to investors’ total returns.
We are also cognizant of the fact that a lot of investors have cash to hand and are almost willing markets to have a precipitous sell-off so that they can collect some bargains, and so even a sharper fall in markets might only provide the briefest window of opportunity to increase equity weightings. The tussle between optimists and pessimists could be lively through to the end of this year and we continue to seek the right moment to increase risk asset weightings again.
Markets – US
The US economy is in a bit of a “twilight zone” at the moment. While official data shows two consecutive quarters of shrinking Gross Domestic Product, unemployment remains exceptionally low at 3.5%. Indeed, overall employment in the economy has returned to pre-pandemic levels. Even allowing for the fact that unemployment is often a lagging indicator of economic activity, this apparent divergence creates a headache for policymakers and investors alike. Does the economy need support or restraint? Thus, the ongoing battle continues between those looking for a Fed “pivot” to looser monetary policy and those looking for even higher rates. There is also a wide range of opinion about inflation. We cannot deny that the year-on-year rise of 8.5% in the headline Consumer Price Index in July was a welcome reduction from June’s 9.1%, and there was also some solace in the fact that the monthly rate was flat. But even if we get flat monthly readings until December, that will still leave the headline rate at 5.4%, which is uncomfortably higher than the Fed’s 2% target and likely to leave workers with lower wages in real terms. Two things are saving the US from an even worse inflation problem, at least relative to the UK and Europe. The first is the fact that the US has far greater energy security and is much less exposed to the squeeze in natural gas and electricity prices being experienced on this side of the Atlantic. The second, and to some degree a consequence of those better terms of trade, is the strength of the dollar, which continues to make new highs in trade-weighted terms.
The timing of the announcement of the new Prime Minister is not friendly to our publication deadline, and therefore we will defer further comment on the outcome for now. Suffice to say that the new PM inherits an extremely unfriendly economic, fiscal and geopolitical situation. Maybe this is one of those elections that, in the longer term, it might be better to have lost! Headline inflation reached 10.1% in July – a figure not seen since 1982. But higher prints are inevitable owing to the baked-in increase in energy prices. Citigroup has posited a scenario in which inflation rises above 18% by the end of this year. Much will depend upon the response of the new PM, but anything that bolsters consumer income might force the BoE to be more aggressive with interest rates. Futures markets currently expect the base rate to top 4% during the first half of 2023. The expectation of higher rates has not supported the pound, but the currency’s weakness does at least bolster the earnings of multinational companies when dollar profits are translated back into sterling.
Europe faces similar problems to the UK in terms of the inflationary impulse of energy prices, not to mention the ravages of what has been described as the worst drought for five hundred years in some regions. Even Germany, with its visceral fear of inflation, reported annual price rises of 8.8% in August. The ECB was exceptionally slow to get off the mark in terms of raising its policy rate and may well have some catching up to do. Even so, futures markets can’t see interest rates rising far above 2%. The euro’s slide to below parity versus the dollar is eye-catching and it reflects the mirror image of the US’s improved terms of trade. At the extreme, manufacturers on the Continent have had to pay as much as ten times the price for their energy as their competitors in the States. Certain industries, including aluminium and fertilizer, have shut production capacity owing to punitive input costs. While a strong tourist season has been supportive to overall activity, a regional recession appears almost inevitable over the winter without a heroic amount of fiscal support.
Turkey and China remain outliers when it comes to prospects for tighter global monetary policy, although for quite different reasons. The former country is engaged in a bizarre policy of cutting interest rates in the face of rampant inflation, all at the behest of populist leader Recep Tayyip Erdogan. Consumer prices are rising at 80% per annum but the 7-day repurchase rate has dropped from 19% to 13% over the last year. Unsurprisingly, the Turkish lira has dropped precipitously in value. One dollar now buys 18.2 lira against 8.3 a year ago. This is economic mismanagement of the first order. Luckily, Turkey is a relatively small component of emerging market indices and poses a limited threat to investors. China, as we outlined last month, cannot really be avoided by anyone with global investment ambitions. It, too, is cutting rates, but from a very different position. Consumer Price Inflation is running at 2.7% and the country is grappling with the self-imposed unwinding of leveraged and speculative positions in its giant real estate market. Another self-imposed headwind is President Xi’s flagship “zero Covid” policy, which continues to require disruptive local and regional lockdowns. Optimistically, one could argue that China has the wherewithal to stimulate its economy at will, although recent changes to policy, including the concept of “common prosperity”, suggest that there will be no return to the debt-fuelled status quo ante. The world eagerly awaits the five-yearly National Party Congress this autumn for news of new policy initiatives.
Global bond markets are subject to a similar tug-of-war as equity markets. On the one hand, sovereign debt could be viewed as a safe haven in the event of economic weakness; on the other, it is vulnerable to persistently strong inflation and also to increased debt issuance by governments trying to ease the pain of the cost-of-living crisis for households and businesses. Thus, we have seen some big swings in yields in recent months. Having started the year below 1%, the 10-year UK Gilt yield rose to 2.65% in mid-June on initial inflation fears before tumbling to 1.80% at the beginning of August as recession concerns grew. However, it has since climbed to a new high 2.80%. One consequence of this is that mortgage rates have also climbed, with a 2-year fixed-rate loan having risen from 1.20% a year ago to 3.5% now. Although the most recent house price and mortgage approval data surprised to the upside, we would expect to see some retrenchment in the housing market.
UK Gilts have delivered a total return of -6.94% over the last three months and -19.66% over the last year. Index-Linked Gilts returned -6.95% and -23.87% over the same respective periods. Emerging Market sovereign bonds produced a total return of +2.38% in sterling over the three months to end August (-0.6% over 12m). Global High Yield bonds delivered +3.33% (-4.7% over 12m) in sterling.
Conclusion and Outlook
These remain extremely challenging times for investors. It is doubtful that anyone currently involved in markets has experienced quite what we are going through right now, with the aftermath of Covid meeting Russia’s invasion of Ukraine at a time when the tectonic plates of global power are grinding against each other. All of this as the world faces difficult demographic challenges and we are trying to deal with the consequences of climate change. While we have maintained a cautious stance this year, the fact that a broad range of assets has produced negative returns has made it impossible to prevent capital losses in balanced portfolios, especially in real terms.
However, we remain confident that our investment process is designed to produce the best risk-adjusted returns that the prevailing environment offers, and, crucially, that it will not expose clients to a permanent loss of wealth. We know that markets are cyclical in their nature and that positive returns lie ahead, eventually. We also believe that attractive opportunities can be presented in stressed market conditions and are constantly on the lookout for them.
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