Last December we wrote, ‘we view the prospects for 2022 as somewhat less cloud-free than 2021’. As understatements go, that might be eligible for a prize. Even before Russia’s invasion of Ukraine, life was showing signs of getting much more difficult for investors. If 2021 was a stroll in the park, this year has been an expedition up the north face of the Eiger. In this note we briefly outline the issues and explore why markets have reacted as they have. We then explain our actions to date and what we expect for the remainder of the year.
The Issues
1. Inflation
Our sense that investment markets were going to get trickier dates back to November 2021 when it became evident that
the world economy had developed a nasty dose of inflation alongside its post-covid recovery (Figure 1). In an absurdly short interval, policymakers’ view of inflation went from benign neglect to compulsive obsession. The parallel might be with a doctor changing his prognosis from, ‘you’ll be fine in a couple of days’ to, ‘I suggest you update your will as soon as possible’. In the all-important American economy, we went from being told by the US central bank (the Fed) to expect no interest rate increases at all in 2022 to, most recently, an expectation of nine quarter-point hikes, or their equivalent, this year alone. This is the fastest pace of tightening this century and arguably the fastest policy about-turn ever.
Wasn’t it obvious that inflation was likely to prove a problem? Clearly not to the Fed – or to the bond markets. Both adhered to the view (as did we) that covid had boosted the demand for some goods and flattened it for some services but that time, and the super-competitive nature of the global economy, would sort this out in due course. It now looks likely that the authorities in western economies badly over- egged the pudding in terms of overly generous monetary and fiscal support to address the covid-related economic dislocation. As we witnessed in 2020 and 2021, this had the effect of sending assets prices soaring. Unhelpfully, we can now see that it also meaningfully changed workers’ wage expectations and embedded rising prices into the wider economy.
So, higher interest rates were on the cards as 2022 dawned. However, the real challenge since, and the issue that has triggered so much volatility in markets, is that the Fed is now scheduling aggressive interest rate rises into what appears to be an already slowing economy. Fed chairman, Jay Powell, is pleading that the US economy is strong enough to withstand higher interest rates. Investors suspect it cannot – and, in reality, Mr Powell has little credibility in making such claims. The inflation genie is out of the bottle, and he has to get on with the job of putting it back in. For now, the Fed’s unequivocal focus is on achieving a return to price stability, irrespective of the subsequent impact serial interest rate hikes may have on consumers, corporations and economic growth.
2. Russia and Ukraine
Russia’s invasion of Ukraine is, first and foremost, a humanitarian tragedy. Additionally, from the central banker’s perspective, it makes the growth/inflation challenge much, much worse. Energy prices have risen sharply in response to actual and potential supply disruption – as has the price of wheat and a multitude of other commodities key to global supply chains. These challenges will stretch into the medium term with, for example, the disruption from western Europe ending its reliance on Russian energy likely to endure for years rather than months. In short, Mr Powell’s job of bringing down inflation, without collapsing growth has become a whole lot harder.
3. China
China’s zero tolerance covid policy, which seemed so successful early in the pandemic now looks, at this stage of the pandemic, to be misplaced. Widespread total- lockdowns are damaging the economy. Interruptions in the flow of manufactured goods from China also, of course, further exacerbate supply chain dislocations – adding more inflationary pressures to importing countries’ economies.
Separately, under the banner of achieving common prosperity, the Chinese authorities have been busy imposing greater regulation in several areas of their economy. They were unhappy with the power of some of the new internet companies, with rising property prices and access to education and healthcare. In short, they do not believe that the benefits of China’s strong growth are being distributed fairly. Their measures hit some businesses very hard, for example Alibaba, the e-commerce platform once valued at almost $1trn, has seen its share price fall by close to three- quarters. Understandably, international investors have begun to question whether they had not hugely underestimated the risks of investing in Chinese stocks.
How have markets responded to these issues?
As we’ve written elsewhere, very low interest rates are catnip for asset prices. Unsurprisingly, the opposite is also true. The extraordinary recovery in stock markets from March 2020 onwards (long before vaccines had been developed to address the virus) was driven by interest rate reductions along with increases in the quantity of money (QE) and fiscal support for consumers and companies. At the beginning of the year all were due to go into reverse. Now, however, Mr Powell’s volte-face in response to the continuing inflation surprise means that this reversal is no longer likely to be gradual and pragmatic. Increasingly, markets are facing up to the prospects of a greater number of rate hikes being delivered more quickly – and the slowdown in growth this is likely to bring. As a result, Equity markets have had a torrid time in 2022 thus far.
However, there is a more malign thread here. Low interest rates tempt companies and consumers to take on debt. If they take on too much or misjudge the pace or magnitude
of future rate hikes, they are rarely able to simply pay down the debt – some companies default or need to reschedule payments. For individuals, credit card defaults rise, or mortgage payments are missed. We have been amazed to watch the US mortgage rate balloon from 2.7% to 5.6% in a matter of months, with little commentary on what this might do to consumer spending, or indeed the housing market. In short, debt is easy to take on when interest rates are low, and difficult to shed as they increase. We suspect that lurking in corners of the financial system, perhaps in private equity, high yield bonds or leveraged asset backed funds, there are structures which will not be able to survive a prolonged period of higher interest rates. The fact that the world is now much more indebted underpins our (admittedly much too optimistic) presumption that interest rates could not rise far – as they would cause overleveraged consumers and companies to quickly keel over, producing a deep recession or prolonged period of stagnation.
In our view it is growing concern regarding the latter that is now rattling equity markets. In recent weeks, a nasty correction in share prices is threatening to morph into a full-scale rout. Investors fear that the conflict between (i) central banks, determined to squeeze out inflation through aggressive rate hikes, (ii) an already slowing economy and (iii) a heavily indebted financial system, will not end well.
The experience of bond markets this year requires comment as, in our view, it provides a clue as to what happens next. At the start of the year government bond yields rose steeply as investors demanded higher yields to compensate them for higher inflation and rising interest rates with little concern about the likely impact on economic growth. As faster, larger interest rate increases came into view, the pace of the bond market sell-off quickened. By early May the key US 10-year Treasury bond, was yielding 3.12% – more than double its 1.5% level at the start of the year. This is an extraordinarily sharp move –with bond prices falling as yields rise, investors have suffered significant losses on their fixed income holdings as well as their equities (Figure 2). Thanks to inflation, and the response from central banks in terms of aggressive increases in interest rates, bonds have not proven to be the haven investors expect them to be in volatile times.
In response to rapidly changing interest rate expectations, currency markets have also been highly volatile. As the Fed has ramped up its rate hiking rhetoric the appeal of the US dollar has increased. Other central banks have less scope to raise interest rates, making the US dollar relatively more attractive. For example, Japan has little by way of inflation and so no need to increase interest rates. In continental Europe (and indeed the UK) the proximity to the war in Ukraine and the resulting impact on energy supplies, and therefore growth, make substantial interest rate increases much less likely. As a result, investors have flocked to the US currency preferring higher interest rates, a comparatively stronger economy, and the safe haven status of the world’s reserve currency. The US dollar has appreciated hugely. Over 2022 to date, it has gained almost 10% against sterling, close to 9% against the euro and over 12% against the Japanese yen.
Action taken – Portfolio repositioning
Last December, in accordance with our view that the investment landscape was likely to be more challenging, we began to de-risk portfolios, selling one of our strongly performing core global equity funds and reinvesting into a fund with the flexibility to adjust its equity exposure and invest in other asset classes.
In March, in response to bond yields that seemed at risk of rising far further than we had believed likely, we switched our long-dated corporate bond fund into a short-dated counterpart. The latter, thanks to the sharp repricing of short- dated bonds, now offered an attractive yield with far less capital risk if, as has turned out to be the case, bond yields continued to rise.
Finally, last month, we took advantage of what we regarded as an inexplicable and unjustified rally in equity markets through March to remove another global equity fund from portfolios. This time, the proceeds were split between more short-dated corporate bonds and a strategic bond fund which, in our view, has the potential to add value with bond yields already at elevated levels.
What next for economies, policy and financial markets?
For a dozen or so years central banks tried and failed to generate the modest level of price increases required by their mandates. Armed with this knowledge, in 2020 they went all out to support the lockdown-ravaged economies. This time they succeeded in creating an inflation monster. They now accept that this must be tamed over the coming months and years. It will be achieved through a rapid reversal of the policy accommodation doled out in 2020, and as much further tightening as is necessary. Fed chairman, Jay Powell, would love us to believe that this can be accomplished without economic pain. In truth, he has made a dreadful mess of monetary policy – and has little option but to move ahead with interest rate increases and hope for the best on growth.
Regarding financial markets, we believe that equity and bond markets are speaking different languages at present. As mentioned above, the huge increase in yields suggests that bond investors remain optimistic that economic growth can endure, despite much higher interest rates. By contrast, investors in equities have come to the view that economic growth will slow, bearing down on corporate earnings and making equities less attractive relative to other assets.
Our conviction is that the equity market is right; economic growth, even in the US, will slow sharply from here. We believe this is already showing up in the data. This suggests that Mr Powell will not get far into his interest rate hiking cycle before he is forced to pause by weakening growth. At this point, the inflation challenge should ease, as pricing power among workers and firms evaporates, and bond yields should fall back as assumptions about how far interest rates need to rise are revised lower.
Considering where portfolios should be positioned for the months ahead, unsurprisingly in light of the above, for now we remain cautious. We are undertaking a fresh review of the equity and bond holdings underlying our favoured funds with the aim of re-examining their resilience in the face of a weakening economic picture. We are also mindful that valuations have moved meaningfully and that it is almost always wrong to become more cautious as markets fall. Finally, we are drawing up watchlists of areas of interest. There are likely to be opportunities to add back to risk assets later in the year.
