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Inflation gives investors pause for thought as markets anticipate another interest rate hike

 

This August/September 2022 market update is brought to you by LGT Vestra

 

Our thoughts are with the Royal Family, the country and the Commonwealth, following the sad news of the passing of Her Majesty Queen Elizabeth II, marking the end of an era.

During the earlier part of the third quarter, equity markets rallied on the belief that the Federal Reserve (Fed) had pivoted and would be adopting a more cautious path of rate hikes. These expectations proved to be too complacent as a tight labour market raised fears of more persistent inflation.

Fed Chair, Jay Powell, reiterated the Fed’s commitment to tackling inflation at the closely watched economic symposium in Jackson Hole. Chair Powell recalled the fight his predecessor, Paul Volker, had with inflation in the 1970s and 1980s who raised interest rates dramatically, despite a recession and high unemployment. By acting aggressively now, Powell hopes to avoid the need for higher rates later.

The latest inflation print gave investors pause for thought as core price pressures increased more than expected, cementing the prospect of a further 0.75% hike by the Fed at its next meeting. Furthermore, with price increases being this broad based, markets are expecting the Fed to take interest rates in excess of 4%.

Given the hawkish rhetoric from central banks, the second half of August saw equity markets pull back. As further interest hikes were being priced in, this fed through to growth-oriented stocks, whose value lies in future earnings, bearing the brunt of the market pull back.

Sentiment was further impacted by the threat to halt natural gas supplies to Europe, potentially risking some rationing in the winter, which would curtail manufacturing output and make a recession highly likely. The combination of these effects led the US dollar to reach a 20 year high against peers.

The European Central Bank (ECB) raised interest rates by a record 0.75% in its September meeting and signalled that there is more monetary tightening to come to tackle inflation. The challenge facing the ECB is arguably greater, as most of the inflation is supply driven and cannot be easily remedied by higher interest rates.

The hawkishness of the Fed is forcing their hand somewhat – if they do not keep up then the euro will weaken further and increase imported inflation.

Following her appointment, prime minister Liz Truss has acted swiftly to address the energy crisis. Her plan to cap energy costs at an average of £2,500 per household for the next two years, combined with Rishi Sunak’s £400 support package, will go some way towards easing the worst pressures on households this winter.

Furthermore, she announced a cap on energy prices for businesses for the next six months providing some much-needed support.

The final cost of these measures will depend on the wholesale energy prices over the next two years, but may be between £100 and £200 billion, substantially more than the £70 billion furlough scheme.

She continues to reject the suggestion of a windfall tax; hence these measures are expected to be funded from additional borrowing. The cost of this package is substantial and yet the new prime minister is also promising tax cuts to boost the economy.

The hope will be that by boosting the economy, we will increase the total tax revenue to fund it. Such tax cuts may mean that despite the reduction in peak inflation, the Bank of England (BoE) may still have to raise rates more and hold them high for longer. In addition, the rise in borrowing increases the supply of gilts, pushing longer dated interest rates higher.

While the challenges in Europe, the UK, and the US are interlinked, they are very different. With the US economy slowing, the key will be to what extent and how quickly inflation rolls over and where interest rates end up. In Europe and the UK things look worse, but assets are much cheaper and policy response to higher energy prices, while expensive, should help the private sector navigate a difficult winter.

Against this backdrop, we note that investor sentiment has been poor and that a lot of the risks have been well flagged. As such, over the longer term, we continue to advocate that investing in quality cash generative businesses with strong pricing power will help investors navigate the uncertainty. Furthermore, higher bond yields offer investors the chance to lock in interesting income opportunities.

Market View Changes

  • No changes

Currencies

US dollar ◄►
Sterling ◄►
Euro ◄►

 

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 1.15.

As noted above, the ECB is increasing rates at a swift pace, 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, deficit spending and the BoE’s response function.

Fixed Income

Government Bonds Conventional Inflation-Linked
UK Gilts ◄►
US Treasuries ◄► ◄►
German Bunds ◄► ◄►

 

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 government intervention, 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. 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 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.

Equities

UK Equity ◄►
 

The FTSE 100 index has been 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. Newly appointed prime minister Truss’ plans to cap energy prices will make the pinch on consumer wallets less acute. 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.

The upcoming Italian elections will be a key litmus test of the ECB’s new policy tools and ability to control financial conditions across the Eurozone. Europe’s ability to cushion the impact of the acute energy crisis is limited by higher interest rates and rising input costs.

US Equity ◄►
 

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.

While the potential for a slowdown remains elevated, recent declines in petrol prices have boosted consumer sentiment and production bottlenecks appear to have eased at a time when input costs are moderating.

While this is pushing the Fed further, the US consumer continues to be resilient. The US market remains a source of attractive companies with good long-term prospects and with relatively high self-reliance in terms of energy and food supply.

Japan Equity ◄►

 

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-19 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.

While the property market remains a source of concern in China, given its ability to control its domestic affairs, the long-term growth opportunities in China remain. Although the risk of political business interference in China remains high, the valuations look cheap relative to other markets and the lack of sanctions on Russia 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.

Alternative Investments

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 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.

Property

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.

 

 

 

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