This July/August 2022 market update is brought to you by LGT Wealth Management
Global equity markets rebounded in July after one of the worst first halves of a year in memory.
Central banks are facing a tricky balancing act of fighting inflation while wishing to avoid a deep recession. As such, investors interpreted the output from the latest Federal Reserve (Fed) meeting as being an indication that the Fed might not be as aggressive going forward, with rates climbing only moderately higher from these levels.
This perceived ‘policy pivot’ from the Fed supported a rally across government bonds.
Digging deeper into the main events, as was widely expected, the Fed opted for yet another 75bps increase at the July meeting. This was against the background of an inflation print in excess of 9% and a continuing tight labour market.
The day after the July meeting, US GDP data indicated a second quarter of declining GDP, which for some is an indication of recession. However, on a wider measure of economic health, the US is not in a recession yet.
We should note that, while unemployment remains low, the weekly jobless claims data has indicated deteriorating conditions in line with the hiring plans we see from individual companies.
With the Fed acknowledging that rates are close to neutral and policy acts with a lag, the market began to question whether this marked a ‘policy pivot’, leading to a shallower path of rate hikes.
While we are not convinced that they have turned, the Fed has left the door open for a slowing of the pace of rate increases. Despite US CPI for July reporting a slower increase compared to June (at 8.5% year-on-year in July) as inflationary pressures eased on the back of lower fuel prices, strong employment cost data is likely to form a bigger input into the Fed’s decision-making process.
In the UK, one of the main talking points in the Conservative Party leadership election is around taxes, with Liz Truss proposing substantial tax cuts, rather than more targeted fiscal support measures.
If there is a large fiscal stimulus, then the Bank of England (BoE) may have to raise interest rates even more. In its July meeting, as expected, the BoE voted to raise interest rates by 50bps from 1.25% to 1.75%. Rising interest rates with declining real income may lead to downward pressure on broad demand.
The BoE also announced it is set to commence active gilt sales of £10bn per quarter from the end of September, leading to the bank’s balance sheet starting to decline at a faster pace. They have also forecasted the inflation rate to move even higher, with it now expected to peak in excess of 13%, owing mostly to higher energy bills.
Given this enormous hit to real incomes, the BoE is now forecasting a prolonged, but shallow recession.
At the previous European Central Bank (ECB) meeting in June, the ECB stated they would look to end net asset purchases by the end of the second quarter and raise rates at the following two meetings. Back then, they expected to start the hiking cycle with a 0.25% increase, followed by a 0.5% increase in September.
The ECB delivered a hawkish surprise when they moved against this expectation and raised rates by 0.5% in July. Further to that, details of the new Transmission Protection Instrument (TPI) were announced at the July meeting.
In essence, the TPI is there to “close spreads”, to allow the ECB to embark on its rate hiking cycle without excessively raising funding costs for Southern European nations. The programme is in principle unlimited; however, it comes with a lot of strings attached and requires committee approval to be activated.
Therefore, while the vaults of the ECB are clearly full of cash, investors are questioning if all the committee members will agree to provide the necessary codes to unlock it.
Overall, central banks are continuing on their tightening path, albeit at different paces, with the economic data suggesting slowing activity.
The Fed, Bank of England and the European Central Bank all met over July, with the ECB very much being at the start of its hiking cycle, whilst the BoE and The Fed are closer to where they deem it to be neutral.
Investors, much like the Fed, will be keeping an eye on a broad array of economic data, with a particular focus on price pressure indicators. Despite a rally in both equity and bond markets over July, markets will remain uncertain over the coming months, as the economic ramifications of monetary tightening become clearer. With this in mind, investing in well established businesses with strong balance sheets remains as important as ever.
Market View Changes
- No changes
The US Dollar remains the reserve currency of the world and has benefited from its safe haven status.
With the Fed set on an aggressive tightening path relative to other developed markets, we have seen the dollar remain strong relative to most other currencies. The Euro is trading close to parity with the Dollar for the first time in 20 years and the Pound continues to hover around 1.20.
As noted above, the ECB is moving away from negative interest rates, which may offer support to the Euro having been weak since the war in Ukraine. Sterling is caught between global pressures which have the propensity to raise the level of imported inflation and the BoE’s response function.
The supply-side issues that have been the key driver of higher price pressures are set to last longer given China’s continued use of lockdowns and energy market disruption. As such, central banks have responded by recalibrating their policy stance resulting in significant moves across developed market government bonds.
The US and UK bond markets are reflecting most of the expected policy tightening and as such, may provide protection should the growth outlook deteriorate.
Inflation-linked exposure in the UK remains affected more by short-term drivers and given its long average maturity, we remain cautious on the segment.
While its US and German counterparts have moved significantly, they appear to be less sensitive to these factors. Given the sharp repricing across Eurozone sovereigns, reflecting a significant amount of tightening, we feel a neutral stance on German government bonds is warranted.
|Investment Grade Corporate Bonds||◄►|
As central banks are now looking to normalise at a brisk pace, we have seen both government bond yields and credit spreads move higher. The announcement by the BoE to unwind its corporate bond purchases, paired with the Fed embarking on quantitative tightening is likely to weigh on markets. However, given the elevated yields on offer, this is likely to bring support to this market where we are seeing selective opportunities.
|High Yield Credit||◄►|
While default rates have been benign with a muted ratings trajectory, the combination of higher interest rates and central banks’ plans to reduce asset purchases have impacted the broader market. This may continue to weigh on high yield bonds for some time, but we are now starting to see better opportunities. The perceived pivot has pushed credit spreads materially lower during the illiquid summer months. We retain our neutral stance for the time being and continue to stress selectivity.
Emerging Market Debt
|Local currency denominated debt||◄►|
|Hard currency denominated debt||◄►|
With developed market central banks set to tighten policy, this generally weighs on emerging markets. Though, many emerging market central banks have already raised rates substantially, which is likely to result in a much smaller impact than previous hiking cycles.
Should China continue on its easing trajectory, this could provide further support to these economies.
Furthermore, recent upheavals in Peru, Pakistan and Sri Lanka demonstrate the political risks from rising food and energy costs. Sri Lanka defaulted on its debt payments having been hit by a lack of tourist income during the pandemic and now high prices and political unrest.
Therefore, we emphasise that selectivity remains as important as ever, and we retain our neutral stance across this diverse asset class.
So far, the Conservative leadership race has had little impact on the UK market. Early in the year, the FTSE 100 index was buoyed by its exposure to energy, materials, and a weaker pound. Nevertheless, the market continues to trade at valuations that look cheap compared to markets elsewhere in the world. This has spurred takeover interest by overseas buyers, given the opportunity to pick-up companies at discounted prices.
That said, the UK domestic economy faces significant headwinds from higher energy costs and interest rate rises. While much of the index is made up of international companies, the domestic economic situation may weigh on market sentiment. Considering the mix of factors, we recommend a selective approach in this market.
|Europe ex UK Equity||◄►|
The European equity market has been particularly vulnerable to the impact of the war in Ukraine and has seen large moves in both directions driven by the news flow.
On the grounds of valuation, the European market looks relatively attractive, but the risk of higher energy costs, or even rationing are significant headwinds. Furthermore, the recent heatwave has impaired the use of river transport, which remains a key delivery mechanism for German industry.
Overall, Europe’s ability to stimulate in the face of an acute energy crisis is limited by higher interest rates and rising input costs.
The ongoing volatility surrounding inflation and its impact on the long-term discount rate has continued to cause gyrations between cyclical and less-cyclical companies.
In the last month, as expectations have shifted towards lower long term interest rates, this has boosted equity markets, particularly the more growth orientated sectors, such as technology.
While the potential for a slowdown remains elevated given squeezed real incomes, markets are currently focused on the latest earnings season and the performance of individual companies, rather than the economy as a whole. The US market continues to be a source of attractive companies with good long-term prospects, with relatively high self-reliance in terms of energy and food supply.
Unlike other central banks, the Bank of Japan has maintained its easy policy stance, despite it having the worst performing currency in the G10.
Inflation, while above its target, remains well below the levels seen in other developed markets and as such the need to pivot monetary policy has remained less pressing.
While in local terms, its equity performance remains relatively muted, it has underperformed many peers on a Dollar basis. Given moderate valuations and many export-focused companies, Japan could have room to perform should the global economic situation improve.
|Asia ex Japan Equity||▲|
While many countries are emerging from the pandemic, China continues to pursue its zero Covid policy which has seen further lockdowns imposed in major economic centres. To counter the economic effects of continued shutdowns, China has announced several initiatives to loosen monetary and fiscal policy.
Furthermore, the recent flare up across the Taiwan Strait as a result of Nancy Pelosi’s visit could continue to weigh on valuations, given the perceived geopolitical risk.
While the situation in China has weighed on markets across the region, should the status quo persist, it is unlikely to dent long-term prospects. Although the risks of political business interference in China remains high, the valuations look cheap relative to other markets and the lack of sanctions confirm that energy headwinds are less of an issue for some countries in the region. As such, we think the potential for long-term growth is higher than elsewhere.
|Emerging Markets ex Asia Equity||◄►|
Though the rise in commodity prices has a natural benefit for resource rich countries like Brazil, the war in Ukraine has highlighted how extreme the geopolitical risks may be. Food shortages and higher prices threaten political stability; we have already seen this in Peru, Pakistan, and Sri Lanka.
Developing countries need continued foreign investment but events like this deter investors, compounding these risks. Despite this, long-term growth prospects for many emerging markets remain high. Hence, we continue to stress a highly selective approach in this diverse universe, emphasise its volatile nature and maintain our neutral stance.
Hedge Funds/Targeted Absolute Return
Given pronounced movements across interest rate expectations, this will undoubtedly weigh on financing costs which may temper some merger and acquisition (M&A) activity. Conversely, the elevated levels of interest rate volatility may present opportunities elsewhere.
On the regulatory side, geopolitical fronts mean that regulatory intervention has become more commonplace. This has tempered our enthusiasm for event-driven strategies.
More broadly, when allocating to this space, we look for funds that could diversify returns away from the directionality of conventional bonds and equity markets. Nevertheless, we continue to stress the importance of finding the right vehicle and investment manager, which requires extensive due diligence on the strategy and fund.
While we acknowledge the yields on offer may look attractive relative to other sources of income, the outlook for retail and office segments remains uncertain. Central bank policy and lower real incomes may eventually come to weigh on residential property after a strong run during the pandemic years.
We continue to suggest that any exposure to property should be selective and closed-ended over open-ended vehicles are preferred, due to the liquidity mismatch.
The seizing of assets considering Russian sanctions, may weigh on future demand as it undermines the notion of property ownership. Accordingly, it remains important to be selective and not chase the otherwise attractive yield when investing in this asset class.