Since our last “Market Movements” update in May, financial markets have continued to be volatile.
Following a brief rally in risk assets during July and early August, markets have continued their fall. Though we take a long-term approach to investing, it is still important for us to understand and have a view of the medium-term outlook. We hope this note provides a thorough update on global markets, our expectations going forwards, and an update on our investment strategies.
Inflation, interest rates, and growth
With world changing events occurring on a seemingly daily basis, it can be difficult to pin-point exactly what is impacting global markets the most. Ultimately, we see three main factors that are behind the current economic environment.
The first of these is persistently higher inflation which is currently running at 9.9%, 10%, and 9.1% in the UK, Europe, and the US respectively. The causes behind the spike in global inflation are widely known (see our earlier article for a reminder – here) however, following a decade of low and stable inflation, this new inflationary environment has disturbed markets. Arguably, it is higher inflation that is the main cause behind the next two factors.
The second main factor is higher interest rates. To combat higher inflation central banks have doubled down on their hawkish rhetoric by aggressively raising interest rates. So far this year interest rates in the UK, Europe, and US have increased by 1.50%, 1.25%, and 3.00% respectively. In the US, markets are now expecting a terminal interest rate (the peak at which rates are expected to climb before they need to be cut) to reach 4.6% in 2023. This suggests there might still be some way to go, and it is likely the UK and Europe will follow suit.
The final factor is slowing economic growth. Partly as a product of higher inflation and interest rates, global growth has slowed significantly following the post-COVID rebound (6.1% annual GDP growth in 2021). A portion of this slowdown is a normalisation from last year’s unsustainably high rate however, the Ukraine crisis, supply chain issues, and strict lockdowns in China have also had an impact on economic activity.
It’s not all doom and gloom
Ultimately, with a backdrop of higher inflation, rising interest rates, and slowing global growth, it is hard to argue that the outlook for markets is positive. However, it is perhaps not as bad as one might expect, and with much of the bad news reflected in prices already, there is always the potential for surprises on the upside.
For example, even if it remains above central banks’ target rates of 2%, we still expect inflation to fall towards the end of 2022 and first half of 2023. There is now evidence that supply pressures are showing signs of easing. The Global Container Freight Index (FBX), which tracks the price of global shipping and is a leading indicator of inflation, has fallen significantly and is now back to its January 2022 level.
In addition, many commodity prices have also fallen from their peak. Oil, natural gas, copper, aluminium, and many agricultural raw materials are trading considerably lower than they were three months ago, and some are even lower than where they were at the start of the year.
Even if prices stand still and remain at their current level from here, the rate of inflation will gradually fall over the next 12 months as it is calculated using the current price compared to the price of one year ago.
Central banks were caught off guard by the rate of inflation this year and have now made bringing this under control their number one priority regardless of the outcome. Though initially behind the curve, interest rates have now moved up further and faster than any other tightening cycle in history and many feel central banks should pause to see what the impact of this is.
Where interest rates go from here is anyone’s guess (even central banks have a poor record of forecasting their own moves). However, there are some factors that suggest they might not continue the same trajectory, and we could see rates cut sooner than many expect.
Higher prices are already cooling economic demand as the higher cost-of-living impacts consumer spending. Growth rates have slowed and, as described above, inflation seems to be moderating. Therefore, though central banks have outlined their commitment to continuing raising rates, if these trends continue, they might be forced to pause or even reverse course next year.
If the global economy continues on the same trajectory, a recession in Europe and the UK looks inevitable, and probable in the US. The “R” word tends to invoke memories of 2008 or 2001 however, we must remember that not all recessions are created equally, and neither are their impacts on markets.
Firstly, any economic slowdown will likely be relatively modest (especially when compared to the 2008 GFC and 2020 pandemic). This is a cyclical cooling of demand rather than a structural bear market caused by a banking crisis and rapid deleveraging, or a pandemic-induced growth shock.
Naturally, inflation will come down as demand drops, in turn reducing the pressure on household finances and providing central banks with the option of cutting interest rates if needed. Furthermore, private sector balance sheets are strong, banks have healthy balance sheets following post-2008 adjustments to regulation and, households’ savings are still relatively high.
Governments have also become more willing to step in with fiscal support (the UK’s furlough scheme and energy price caps being examples of this) to help with the cost of living and therefore, suggests that consumer spending and in turn company profitability may decrease, but is unlikely to collapse.
Clearly, the current, and arguably nearer term, economic environment is not particularly encouraging from an investment perspective. Some would rather move to cash, accepting the guaranteed loss through inflation, than experience the volatility of markets during a period like this.
The danger here, and a particular quote that comes to mind is that over the long term, “the biggest risk of all is not taking one”. As we have said before, accepting short-term volatility is the price investors pay for long-term positive returns.
Markets have already been volatile with both stocks and bonds significantly cheaper than they were at the start of the year. Those adding to their portfolio, or who have the ability to do so, will no doubt benefit from here. While those who are fully invested can still benefit from rebalancing and the diversification of alternative asset classes.
Though a considerable amount of the bad news is already priced into markets, we believe there are a few factors and signals that we would like to see before we would expect an improvement in market conditions.
Saying that, at this point, it wouldn’t take much good news, or even for news to be slightly less bad, to see a sharp rally in equities. It’s also worth noting that this is the ninth time since 1950 that the US market has fallen by in excess of 25%. When we look at the eight other times this has happened, the average returns over the next one, three, and five-years have been 21%, 37%, and 83% respectively.
Another consideration is that the “hope phase” (the start of a new bull market) nearly always begins during a recession when the economy is still weak, and pessimism is at its greatest. On an annualised basis, this phase tends to be the strongest (but shortest) and accounts for around two-thirds of a bull market’s returns.
From our perspective, we currently have a neutral position within portfolios, though plan to initiate a tactical rebalance in the coming months to manage portfolio drift, maintain the intended allocation of our strategies, and set portfolios up to benefit from the potential upcoming rally. However, this could change depending on how the situation develops.
Bonds (historically a good diversifier) have not provided as much protection this year as in the past. Due to starting yields, for the last five years, we have been structurally underweight when compared to a traditional 60/40 portfolio (60% equity and 40% bonds). Regardless, they still play an important role in portfolio construction, and more recently, as yields have risen (yields move inversely to price), future return expectations have increased making this asset class more attractive now on a relative basis than it has been for some time.
Our allocation to alternatives (c. 15% of portfolios) has been a valuable diversifier and generator of returns with one particular fund up over 27% year to date. Other holdings in our alternative allocation have also protected portfolios, or at the very least dampened volatility.
Another boost to returns has been our decision not to hedge overseas equity currency exposure. This has worked particularly well this year as sterling has fallen around 20% against the US dollar. US equities, our largest equity allocation and valued in US dollars, have fallen almost 20% during the year however, the strength of the dollar versus sterling has mitigated almost all of this.
Though currencies can fluctuate, sterling is typically seen as a “risk on” currency so, when there is a period of global equity volatility, it tends to weaken. As sterling investors, this creates a natural hedge in overseas equity exposure as any fall in the overseas equity is limited by its currency increasing in value versus sterling. Recently, we have seen an extreme example of this with the turmoil in sterling following the mini-budget.
Ultimately, long-term investments require a long-term view, and it is important not to shorten one’s time horizon during periods of volatility.
It is impossible to predict what will happen however, it is hard to be negative about the longer-term outlook when we consider all the human ingenuity, the constant drive for improvement, and the technological and scientific advances happening every day.
We still believe that the best way to take advantage of all of this is to remain invested in a suitably diversified portfolio while maintaining an appropriate time horizon.
In the meantime, we will continue to manage our strategies in line with our investment process which has the main aim of generating long-term returns for our clients.
By Jonty Brooks
General Disclosures: This article is based on current public information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such. The information, opinions, estimates and forecasts contained herein are as of the date hereof and are subject to change without prior notification. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. The price and value of investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.