Macro
The second quarter took the baton from Q1 and didn’t look back as markets and economic data continued to deteriorate. Peak inflation fear was compounded by the threat of recession to give investors plenty to worry about.
Inflation continued its rampage across the western world, hitting 40-year highs in the UK and US and the highest level in Europe since the inception of the Euro. Although labour markets have generally been strong and wage growth okay, the cost of living pressures of rising energy and food prices have sent consumer confidence down across the board and in some cases to all-time lows.
Chart 1. The US University of Michigan Consumer Sentiment Index has fallen to an all-time low
Source; Barclays Research, University of Michigan, Haver Analytics. 23/06/22
Last quarter we said that central bankers had gone from a canter to a gallop towards policy normalisation. This quarter things have gone from a gallop to a charge. The US Federal Reserve firstly carried out a 50 basis point hike in May, the largest increase since May 2000, and then proceeded to trump that in June, raising interest rates by 75 basis points.
Despite the biggest rate hike since 1994, words have spoken even louder than actions in Q2. Fed Chair J Powell confirmed a sea change in US Central Bank policy by confirming his “unconditional” commitment to price stability, implying knock-on economic effects will be ignored when contemplating further rate hikes. The Fed’s pivot to be the most aggressive global central bank has troubled investors who had come to consider the US as impervious to economic crises elsewhere, be it Europe, Africa, Latin America or Asia.
The market reaction has been to rapidly price an aggressive US interest rate hiking cycle, implying upwards of ten quarter point increases this year from just one at the beginning of the year. In the UK, rates have already risen to the highest level in 13 years and are forecast to continue to climb to 2% by year-end and the ECB are set to begin raising interest rates in Q3 for the first time since 2011.
It appears as though this could be the peak of both Central Bank hawkishness and market fear of inflation. Ironically, as the market has been fretting about rising inflation, the core measure of more ‘sticky’ inflationary components has rolled over in the UK and the US since peaking earlier this year.
Charts 2 and 3. Core CPI inflation (Right) has peaked and declined in the last few months
A slowing housing market in the US, weak retail sales figures and early warning signs from initial jobless claims could signal to the Fed that rate hikes are having the desired effect and lead to a relaxation in the hawkish stance.
Elsewhere, the macro picture is less gloomy. Inflation has been more muted in Asia and many countries are further through tightening cycles, if not already loosening policy.
Retail sales have risen for three consecutive months in Japan after Golden Week holiday celebrations were able to go ahead free of Covid restrictions for the first time since 2019. The one point of concern has been that the currency has come under extreme pressure as investors are questioning whether the Bank of Japan can have their wish of keeping interest rates at 0.1% or whether they will need to bow to market pressure and raise them, like the UK had to in 1992.
In China, various Covid outbreaks in major cities led to harsh lockdowns that damaged economic activity. However, progress has been made and most restrictions were lifted at the beginning of June. By the end of the month Shanghai had reported zero locally transmitted cases for the first time since March.
The lockdown-induced slowdown compounded last year’s regulatory and policy driven decline and raised calls for stimulus. These calls were answered and improvements in Industrial Production, Retail Sales, Fixed Investment, and PMI activity surveys suggest the effects are already being felt. A further boost came from the relaxation of some quarantine rules for travellers, perhaps highlighting growing fatigue with the Government’s strict zero-Covid policy.
Markets
Table 1. Performance of assets in Q2 2022 (all figures in base currency)
It is fair to say that markets in the first half of 2022 have not been for the faint hearted. Unless you have been invested in Crude Oil, it has been difficult to avoid a bloody nose. It has not just been the scope, but also the magnitude of losses as almost all asset classes sold off en masse plunging various indices into bear market territory at least temporarily (S&P, Nasdaq and FTSE 250 to name a few).
To put some of the H1 moves into context, the MSCI World index fell the most since its creation in 1990, the S&P 500 fell the most since 1970, the Nasdaq had its worst half ever down nearly 30%, European and Asian equity indices dropped over 15%, Italian bonds were down around 25%, Emerging Market debt declined nearly 20% and according to Deutsche Bank, US 10 year Treasury bonds had their worst first half since 1788 (no, that is not a typo)!
Much of the pain this quarter was felt in April, which saw the worst month on record for the Global Bond index and the biggest fall for US large cap stocks since March 2020. The combination of elevated inflation, Chinese lockdowns and rising recessionary fears all contributed to the decline in financial assets. Commodities were also dragged into the fray by global slowdown concerns as many industrial metals fell between 20% and 40% including Copper, which suffered its biggest quarterly slump since 2011.
Yet again in the UK large caps outperformed their smaller brethren, widening the performance gap year-to-date to over 20%. Many believe that the UK and the Eurozone are already in the midst of a recession, induced by the effects of rising energy and food prices. Consumer confidence and money supply (in Europe) are examples of two prominent leading economic indicators that are now implying a slowdown in activity surveys (PMIs). This tends to lead earnings downwards. However, as Chart 4 highlights, these concerns are increasingly priced into multiples.
Higher valued, interest rate sensitive assets extended their Q1 malaise, bearing the brunt of the multiple de-rating that has reduced most markets to a discount versus history.
Chart 4. Most equity markets are now at discounts to historical averages, with the exceptions of the US and Switzerland
Using forward P/E ratios as a guide against the 2021 high P/E and the 20 year median P/E
Other than oil, which continued to rise as the Russian invasion of Ukraine continued and tensions over European energy imports built, one of few outliers was the US Dollar, gaining the most in a quarter since 2016. It once again proved to be a true safe haven asset as others (Gold and the Japanese Yen) failed around it. A peaking in Fed rate hike expectations could lead to a peaking in US Dollar strength which should act as a tailwind to Emerging Market equity exposures as American exports cheapen and more foreign cash flows into these markets.
Chart 5. Expectations for Fed funds rate in December vs US Dollar Index (DXY)
If expectations for US interest rate hikes have peaked, Fed funds futures will fall and the dollar could follow
An equity market anomaly was China, which continued to dance to its own tune and ended the quarter the right side of the volatility it exhibited throughout. The local A-Shares market finished the quarter up nearly 5%, despite having been down 11% at one point in April.
A more remarkable exception has been the performance of the Russian Ruble. Despite the ongoing conflict in Ukraine and having defaulted on external sovereign debt for the first time since 1918, it has climbed to a 7 year high and is the best performing currency globally this year, up around 45%.
Although multiples have contracted, earnings are yet to reflect the market’s recessionary concerns. Whilst several Covid beneficiaries have warned on profits, along with some large US retailers such as Walmart and Target, the majority of companies have maintained forecasts. Earnings expectations are still largely positive and have actually been upgraded in the US, UK and Europe so far this year. We would expect this trend to come under pressure in the upcoming quarter. As such, earnings downgrades in Q3 could well cause the next leg down in share prices, as depicted in the chart below.
Chart 6. The US is yet to price in a recession, earnings are still to be downgraded
Chart shows the contribution to S&P price return of both P/E multiple expansion and earnings expectation
Positioning*
Developed market government bonds returned to our radar in Q2, a rare occurrence over the last 5 years. Nonetheless, it has provided us with the opportunity to add to US short and medium dated Treasuries, a useful hedge against recession after the worst half of performance for at least 50 years caused yields to rise to more attractive levels.
On the contrary, we exited our position in Chinese fixed income, which has held up remarkably well but would be vulnerable to a depreciation in the Renminbi. The gap between Chinese bond yields and those in US reversed in the quarter, with the US 10 year yield now above 3% and the Chinese equivalent below. We believe the risk-reward on offer now favours the US, although we will be on the lookout for an opportune time to re-enter the Chinese bond market.
We tended to be more incremental with any portfolio changes in the equity portion of portfolios during Q2. In general this was exercising caution, we removed some duration (interest rate sensitivity) in April and then proceeded to trim cyclical exposures in Japan and the US after both had delivered positive absolute (and very good relative) returns so far this year. The most notable addition was an allocation to European Healthcare, increasing our defensive exposure in a sector that boasts reasonable valuations and long term structural earnings growth.
We also used the intra-quarter volatility in China to top up our position, adding on weakness and benefitting from the rebound in May and June. Early last year we expressed caution on Chinese equities as Monetary and Government policy were restrictive and valuations elevated. The reverse is now the case, valuations are now attractive and policy has turned supportive.
We remain reluctant to ‘fight the Fed’ and they have made clear their intention to reign in price increases in the US, almost at any cost. It is one of the few markets still at a valuation premium to history, with earnings at record highs. As such we remain underweight and particularly cautious on cyclicals.
Outlook
We went into the year wary of the risks likely to affect markets and unfortunately several of those mentioned in the excerpt below from our Q4 commentary have manifested themselves.
The result of such an abundance of risk has been both bonds and equities falling in tandem. It is never comfortable to be managing portfolios when markets are down, however, it is of some solace that we have been able to outperform peers and the benchmark. We have regularly stressed that we will strive to protect capital better than our competitors in a down market and are reassured to have done so in the first half of the year.
Looking forward, the good news is that periods of market turbulence like that which we have witnessed so far this year are rarely followed by further drawdowns on a 6 to 12 month view.
As we saw in China recently, the market is likely to bottom well before the real economy. Notwithstanding several bouts of volatility, this could well happen in the next quarter and we will look to take advantage of opportunities as the risk-reward payoff tilts in our favour. We continue to be hopeful that, in absolute terms, there is money to be made in markets between now and the end of 2022.
Kind regards,
Jack Byerley – Deputy Portfolio Manager
5th July 2022
*Positioning section is a guide based and some model portfolios may not have participated in every trade given risk and asset allocation. To view information on the trades undertaken throughout the quarter, please login to our client portal, available at whirelandplc.com