Political fault lines – both international and domestic – widened during the third quarter of 2022, providing an increasingly uncertain backdrop for investors. The war in Ukraine became further entrenched, with the country launching a counter-offensive in September, while Russia’s President Putin annexed four Ukrainian regions, called up 300,000 reservists, and continued to squeeze European gas supplies. Elsewhere, a controversial visit by US House of Representatives Speaker Nancy Pelosi to Taiwan in early August served to heighten tensions between the US and China, with the latter carrying out a week of intense military exercises in response. Meanwhile, growing political instability saw far-right parties make significant electoral gains in Italy and Sweden, and the new UK government’s plans for unfunded tax cuts proved highly controversial.
Over July and the first half of August, equity markets proved remarkably sanguine in the face of such troubles, seeing a reversal of the broad index declines witnessed in the first half of the year, as weaker economic data, coupled with signs that inflation could be peaking, led investors to consider the prospect of a slowdown in the pace of monetary tightening. However, the rally turned into a sell-off as it became increasingly clear that the US Federal Reserve (Fed) remained committed to bringing inflation down to target. The minutes of the Fed’s July meeting, released on August 17, reflected a discussion about the need to keep interest rates at levels that would restrict the US economy “for some time”,1 while Fed Chair Jay Powell’s speech at the Jackson Hole Economic Symposium on August 26 reiterated the Fed’s willingness to “keep at it until the job is done”.2
On September 13, US stocks suffered their worst daily sell-off since the height of the Covid-19 pandemic in June 2020 after data from the Bureau of Labor Statistics showed that consumer price inflation had increased unexpectedly in August.3 The Fed’s announcement of a third consecutive 0.75 percentage point increase in interest rates on September 21,4 coupled with a gloomy set of economic projections which forecast higher unemployment and lower growth, piled further pressure on equity markets, which saw quarterly declines across all major regions in local-currency terms – US stocks registering their longest streak of quarterly losses since the market collapse precipitated by the global financial crisis in 2008.5 US Treasuries also came under stress during the quarter, with 10-year yields up around 85 basis points.6
In an environment of monetary tightening and geopolitical tensions, the strength of the US dollar, given its perceived status as a safe haven, was a notable feature, with the greenback making its fifth straight quarterly gain and reaching its highest level in more than 20 years.7 However, the surging dollar led to stress in Asia, where the Japanese finance ministry intervened in the foreign-exchange markets to prop up the yen for the first time since 1998, while the People’s Bank of China worked to stem the pace of the renminbi’s depreciation.
US Dollar/Sterling Rate
Source: FactSet, October 2022.
In the UK, meanwhile, sterling briefly hit a record low against the dollar in late September after new Chancellor Kwasi Kwarteng moved to put in place the largest tax cuts for 50 years against a backdrop of sharply rising borrowing costs. The government’s plans unleashed turmoil in the gilts (UK government bond) market, putting some defined-benefit pension schemes, which had hedged their exposure to yields, under pressure to liquidate assets at short notice. This activity further accelerated the bond market sell-off and raised government borrowing costs. This led the Bank of England to warn of a “material risk to UK financial stability”, to suspend its program to sell gilts, and instead urgently to commence temporary purchases of long-dated UK government bonds.8
In fixed income, government bonds, as represented by the JP Morgan Global Government Bond Index, produced a negative return of -7.2% in US-dollar terms (-20.3% over nine months). Corporate bonds, as represented by the ICE BofA Global Corporate Index, returned -6.6% over the quarter (-21.0% over the year to date).9
All major equity markets saw declines over the quarter, and in the case of international markets the falls were amplified by the strength of the US dollar. North American equities returned -4.8% over the quarter (-24.5% over the year to date), while Japanese equities delivered a negative return of -7.5% (-26.1%) in US dollar-terms. European equities declined by -10.1% over the quarter (-28.4% over nine months), UK equities returned -10.8% (-18.6%), and emerging-market equities delivered a negative return of -11.4% in US-dollar terms (-26.9% over the year to date). Asia Pacific ex Japan equities, meanwhile, returned -12.6% (-26.2% over nine months).10
Gold delivered a negative return of -8.1% in US-dollar terms over the quarter (-8.8% over the year to date).11
US President Joe Biden celebrated the passage through Congress of his flagship economic package – the Inflation Reduction Act – in August, although with the consumer price index currently at over 8% (year on year), the Fed’s 2% inflation target could prove elusive for some time. The bill incorporates the most substantial federal investment so far to help fight climate change, as well as caps on prescription drug charges and measures to increase the tax bill on large corporations, including a 1% tax on share buybacks.12
Opponents of the legislation, including the Business Roundtable, which represents large US blue-chip companies, have argued that the government should not be imposing tax increases at a time when the economy faces a downturn. Data published by the US Department of Commerce in July indicated that the US economy had shrunk for two consecutive quarters, a measure often used to define a recession.13 However, employment data has so far remained robust. Although job growth slowed in August, the US still added more than 300,000 new positions, and total jobs exceeded the February 2020 pre-pandemic peak for the first time,14 while employers have struggled with labor shortages.
US Total Non-Farm Employment
Source: FactSet, October 2022.
The 10-day mourning period that followed the death of Queen Elizabeth II on September 8 allowed the UK to reflect on her remarkable 70-year reign, providing a temporary respite from a summer of fractious political debate and extensive strike action. However, the ‘mini budget’ unveiled by new Prime Minister Liz Truss’s government in late September, which was promoted as growth-stimulating, provoked a widespread backlash.
Market reaction to energy price-cap measures announced earlier in the month, along with the expected reversal of tax increases brought in by the previous administration, had been relatively muted as a degree of fiscal loosening had been anticipated. But the fiscal statement on September 23 delivered a shock to UK financial markets and sent the pound tumbling, as further unfunded tax cuts for the highest earners (subsequently reversed in early October) and steeper-than-expected cuts in corporation tax rates added to the debt burden with an uncertain growth payback.
Following the fall in sterling, several lenders temporarily halted mortgage offers for new customers. The Bank of England now faces difficult choices, as failing to increase the pace of tightening could put further pressure on the pound, while raising rates to levels now being priced in would be likely to further stifle economic demand.
In Europe, the European Central Bank (ECB) pressed ahead with its 75-basis-point interest-rate rise in September, which took the benchmark deposit rate into positive territory for the first time since 2011.15 Inflation in the eurozone reached a record 10% year on year in September.16 Energy prices have continued to soar, rising 40.8% year on year in September, as Russia has gradually increased the restrictions on gas supplies to the region following its invasion of Ukraine. In response, at the end of September the European Union agreed a windfall levy on fossil-fuel companies and a mandatory reduction in peak energy consumption.17 However, the bloc has so far failed to agree on whether and how to cap wholesale gas prices.
ECB Deposit Rate
%
Source: FactSet, October 2022.
Economic data for the eurozone has so far remained fairly resilient, with GDP rising by 0.8% in the second quarter and the ECB forecasting growth of 3.1% for 2022 as a whole. However, the central bank expects the economy to stagnate heading into 2023 and, should the energy crisis worsen significantly, its downside scenario indicates the eurozone economy could shrink next year. Some of the risks which would lead to this scenario, such as Russia stopping gas flows via the Nord Stream 1 pipeline, have already materialized.
At its September 22 meeting, the Bank of Japan (BoJ) decided to make no change to its ultra-accommodative monetary policies, which include still-negative interest rates.18 This makes the country very much an outlier, with even the (previously inactive) Swiss National Bank deciding to move rates into positive territory on the same day. As a result of the BoJ’s ‘dovish’ policy stance, the yen fell further against the US dollar, prompting the Japanese finance ministry to intervene in order to stem its slide. While such intervention may slow the currency’s depreciation, it appears unlikely that it will prevent the yen from falling further over the longer term, given widening divergence in financial conditions between Japan and other developed economies.
Japan’s inflation, while still very low in comparison to price rises in Europe and the US, reached 2.8% in August, exceeding the central bank’s 2% target for the fifth consecutive month because of pricing pressure from raw materials and the continued weakness of the yen.19 Highlighting that the country is not immune from the global energy crisis, Prime Minister Fumio Kishida announced in August that he would accelerate the restart of nuclear reactors and study the construction of new plants, providing a potential boost for the country’s nuclear energy industry.
China’s government has been preparing for the important 20th National Congress in mid-October, which should confirm President Xi Jinping’s appointment for a historic third term. The country’s economy, which only expanded 0.4% during the second quarter,20 remained heavily constrained during the summer months owing to the government’s continuing zero-Covid policy, which at times has seen up to 15% of the economy under some form of lockdown. The People’s Bank of China reduced its medium-term lending rate in August in an attempt to boost growth.21
While the central bank also sought to stimulate the stricken property sector, problems have persisted. With construction of many unfinished homes having stalled, a growing number of consumers have decided to boycott their mortgage payments.22
There may be scope for additional stimulus after the October Congress, but a return to pre-pandemic levels of growth appears unlikely owing to the difficult domestic and global economic backdrop, as well as technology restrictions imposed by the US.
INVESTMENT IMPLICATIONS
Over recent months it has become increasingly apparent that financial-market participants need to face up to a new regime. For years, investors were accustomed to low inflation and low interest rates, with interventionist central banks helping to maintain abundant liquidity and keep market volatility low. This led to a ramping up of asset prices across a broad spectrum. However, after experiencing a rerating of assets in a disinflationary world for many years, we are now witnessing a derating of asset prices in an inflationary environment.
One key factor driving this regime change has been deglobalization. While a natural consequence of the pandemic has been the desire of economies to shorten supply lines and achieve greater self-sufficiency in goods and services, the shift began well before 2020, with initiatives such as former US President Donald Trump’s ‘America First’ vision. The conflict in Ukraine, with the imposition of sanctions and halting of trade with Russia, has seemingly provided the final blow to the multi-decade move towards easier global trade, but various other rivalries are developing as countries vie for supremacy in areas such as technology, security and resources. In particular, as the US government steps up its technology restrictions on China, the sense of economic containment is likely to become more acute and could lead to further regional tensions. A less efficient global system, with fewer goods crossing borders, will inevitably lead to higher costs for many key commodities.
One key implication of a higher-inflation regime is that central banks now have less flexibility to stimulate economies through interest-rate cuts and liquidity injections, which is likely to cause higher volatility and shorter business cycles than we have become accustomed to. Furthermore, at the same time as central banks have started to tighten policy, Western economies have typically continued to pursue a path of fiscal largesse and government intervention in markets. One example of this has been in energy markets where European governments have stepped in to cap prices. This will add to budgetary costs for governments, bring down the headline rate of inflation and help to preserve consumer purchasing power. However, it may mean that core inflation remains more stubbornly elevated, and that interest rates will need to remain higher for longer.
The backdrop of rising interest rates and high inflation has meant that this year has so far been an extremely challenging one for bond investors. However, with yields having risen significantly, and inflation nearing a peak in some markets at least, the asset class may start to appear more attractive on a long-term view, particularly as a source of income.
In their efforts to tame inflation, central banks may end up sending economies into recession. While employment figures are currently strong in most major economies, unemployment is likely to rise in the coming months as companies adjust to the changing macroeconomic backdrop. Should this occur and the economic outlook weaken meaningfully, safe-haven assets such as developed-market government bonds are likely to have greater appeal where they have priced in higher interest rates than those which prevail. With yields having risen significantly from near-zero levels, we believe there should be greater potential to generate total returns.
With financing more expensive, costs rising and employees seeking higher wages, the backdrop is likely to be increasingly challenging for many companies, with defaults likely to pick up. Against such a backdrop, investors in corporate bonds will need to exercise caution.
Bond investors may be able to take advantage of investing in economies which are following diverging paths in areas such as interest-rate cycles, energy prices and housing markets. For example, as Europe is suffering more than the US from higher energy costs, its economic growth appears more likely to falter, meaning that bond yields may struggle to rise to the same extent as in the US, potentially providing richer pickings for investors. Similarly, economies such as Australia, the UK and Canada, which are more reliant on their residential property markets and vulnerable to faltering house prices, are likely to see the effects of interest-rate rises sooner.
MSCI AC World Index
Total return, in local currencies
Source: FactSet, October 2022.
While it is possible that, following the market falls of the last few months, much of the bad news has been priced in, global equity investors may have to endure more pain before things start to get better. Until now, the outlook for the forthcoming earnings season has remained broadly positive, but investors will need to tread carefully as further downgrades are likely to be realized before the backdrop improves.
Over this year, there has been a significant rotation in markets, and leadership has shifted from companies with growth characteristics to income or ‘value’ stocks. However, the relative valuation of income stocks has remained largely unchanged, even though the dividend recovery that began in late 2020 looks set to continue on the back of improved company balance sheets and low payout ratios. When these factors are considered alongside the strong demand for income, driven by the world’s ageing populations and the currently attractive spread over bond yields, we believe there should be scope for further outperformance.
One area which may offer compelling longer-term potential for structural growth is the health-care sector. The US federal government and payers (whether insurers or self-funded employers) are becoming attuned to how delivery of care is changing, and such change could offer rewards to investors looking for differentiated returns. Elsewhere, concerns around energy security are likely to accelerate the shift to alternative sources of energy over the medium and longer term, augmented by additional investment in oil and gas to ensure the security of the transition. There may be opportunities associated with this transition, in particular in relation to the building, transport and industrial sectors.
When life seems hard, the courageous do not lie down and accept defeat; instead, they are all the more determined to struggle for a better future.
Elizabeth II (April 21, 1926 – September 8, 2022), former Queen of the United Kingdom
1 Fed officials signal restrictive rates may be needed ‘for some time’, Financial Times, , August 17, 2022
2 Jerome H. Powell, speech at ‘Reassessing Constraints on the Economy and Policy,’ an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 26, 2022
3 Rising inflation sparks fears of hard landing for US economy, Financial Times, September 13, 2022
4 Jay powell refuses to rule out US recession after third 0.75 percentage point rate rise, Financial Times, September 21, 2022
5 US stocks record longest run of quarterly declines since 2008 crisis, Financial Times, 30 September 2022
6 Source: FactSet, September 30, 2022
7 Source: FactSet, September 30, 2022
8 Bank of England announces gilt market operation, Bank of England, September 22, 2022
9 Bond market returns sourced from FactSet, October 1, 2022
10 Equity market returns sourced from FactSet, October 1, 2022 (All US-dollar total returns, MSCI index series)
11 Gold bullion returns sourced from FactSet, October 1, 2022
12 US Senate passes Joe Biden’s flagship economic package, Financial Times, August 7, 2022
13 US economy shrinks for second consecutive quarter, Financial Times,, July 28, 2022
14 Slower pace of US jobs growth offers some relief for the Fed, Financial Times, September 2, 2022
15 ECB raises rates by 75 basis points and promises more to come, Financial Times, September 8, 2022
16 Eurozone inflation hits record 10% as energy prices continue to soar, Financial Times, September 30, 2022
17 EU agrees windfall tax on energy firms, BBC, September 30, 2022
18 Japan intervenes to shore up yen as ‘reverse currency wars’ deepen, Financial Times, September 22, 2022
19 Japan’s inflation hits near 8-year high, stays above BOJ’s target, Reuters, September 20, 2022
20 China narrowly misses second-quarter contraction as zero-Covid batters economy, Financial Times, July 15, 2022
21 China cuts lending rate as economic data disappoint and Covid cases rise, Financial Times, August 15, 2022
22 China’s central bank seeks to mobilise $148bn bailout for real estate projects, Financial Times, July 28, 2022
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