Summary
Rates of inflation rose further in the second quarter and continued to take hold in a broadening range of goods and services. Although certain to rise even more in the months ahead, we are confident that inflation will ease in 2023. The key questions are what level inflation will fall to, especially if a wage price spiral has become established, and what the cost will be in economic terms, due to the cost-of-living squeeze and the degree to which interest rates need to be raised to bring inflation under control. Will stagflation morph into recession? The tightrope on which central banks are treading as they navigate a path between the perils of inflation and recession grows ever narrower.
It was another wretched quarter for investors in bond markets as accelerating inflation caused bond yields to rise again and prices to fall further. Paradoxically, index-linked gilts, in which both interest payments and the final repayment of capital are linked to inflation, performed even worse than conventional UK gilts, whilst corporate bonds were undermined by fears of recession. Although high rates of inflation are likely to continue to act as a headwind to bond markets, 10-year gilt yields have risen significantly (from 0.1% in August 2020 to 2.2% at the end of June 2022). There is now at least some scope for yields to fall, and prices therefore to rise, if the economic slowdown deteriorates into recession.
Global stock market indices fell sharply in the second quarter, pincered between rising bond yields and mounting fears of recession. The UK and Japanese markets proved the most resilient, the former supported by its heavy weightings in energy and other multinational companies which benefit from a weak pound. Although bond yields could rise further, the outlook for stock markets probably now depends on the severity of the economic slowdown and its impact on corporate profits. In portfolios which are composed of actively managed funds, we are emphasising exposure to high quality companies with strong balance sheets and robust revenues.
Macro Highlights
The monthly readings of inflation and the consequent actions of central banks continued to dominate the direction of financial markets and the sentiment of investors in the second quarter of the year. It seems tragically laughable that it was only last summer that the Bank of England and US Federal Reserve were dismissing the first stirrings of inflation after years of dormancy as transitory. At first confined largely to oil and gas markets, inflation now seems to be evident in almost all goods and services and, although exacerbated by these events, it can no longer be blamed solely on the conflict in Ukraine and COVID-lockdowns in China. At the time of the last quarterly commentary, the rate of CPI inflation in the UK stood at 6.2% (for the year to the end of February) and was forecast to rise by the Office of Budget Responsibility, the UK’s fiscal watchdog, to 8.7% in the final quarter of 2022. The latest CPI inflation rate (for the year to the end of May) stands at 9.1% and the Bank of England is now forecasting that it will exceed 11% in October. The ‘old’ Retail Prices Index, which many regard as a truer measure of the cost of living, already stands at 11.7%. In the US, hopes that inflation had peaked after dipping slightly in April were dashed after it rose to a 40-year high of 8.6% in May, with the price of groceries up by 11.9% over the year. In Germany, where the scars of hyperinflation in the 1920s Weimar Republic continue to frame a national obsession with controlling inflation, prices rose by 7.6% in the year to June, up from 5.1% just four months earlier.
We have no quarrel with the consensus that rates of inflation will begin to fall at the end of this year and in 2023. This is because an inflation rate is a rolling one-year measure and the so-called base effects of the initial surge in demand following the easing of COVID restrictions in Western economies will have worked their way through the calculations. Instead of wondering about where inflation will peak, it is more important to assess the degree to which it is becoming embedded and where it will settle. The Bank of England’s projection that the rate of inflation in the UK will be back close to its target of 2% in 2024 seems wishful thinking! The key is what happens to wages. Unsurprisingly, as the cost-of-living spirals workers are seeking higher wages to compensate. But this means higher costs for companies which then seek to protect their margins by raising prices. And so a wage price spiral is formed. No wonder central banks are urging restraint in wage demands. However, unemployment rates are back to pre-COVID record lows and job vacancies currently far exceed the number of those looking for work in both the UK and the US. In the UK this is due in no small part to Brexit and the exodus of foreign workers. In the US, the exceptional gains in bond, stock, and property markets since 2008’s global financial crisis (fuelled, ironically, by years of money printing and negligible interest rates) have enabled millions of older workers to leave the workforce early in what has been dubbed the Great Retirement. For now at least, therefore, workers have the upper hand and calls for restraint in wage demands seem likely to fall on deaf ears.
The US and UK central banks are adopting very different approaches in their efforts to conquer inflation. By increasing interest rates by 0.75% in its June meeting, the US Federal Reserve is clearly taking an aggressive stance, confident that a buoyant labour market and the strength of consumer and corporate balance sheets will cushion the economic slowdown and hopefully avert a recession. It is widely expected that interest rates will be increased again at each of the US central bank’s meetings over the next year, reaching 3.75% in 2023. In contrast, even though interest rates in the UK have been increased five times since December (compared to just three in the US), the Bank of England is treading much more cautiously, choosing to increase interest rates by much smaller increments of 0.25% (to 1.25% in June). With the UK inflation rate heading for double digits, the Bank of England has understandably been widely criticised for not being bolder. It is clearly pinning its strategy on the cost-of-living squeeze itself reducing demand and thus easing inflationary pressures. It may also be because the Bank is mindful that the UK economy, which is also having to absorb higher taxes, is in a much more fragile state than the US economy. Nevertheless, it is still expected that interest rates in the UK will reach 2.75% in 2023. The Bank of England’s timidity is likely to cause the pound to remain weak, making imports more expensive and only adding to inflation.
Even in the US it is already apparent that economic growth is faltering as rising interest rates and falling incomes in real terms are weighing on consumers. Indeed, it could be argued that much of the developed world is already experiencing stagflation (lacklustre economic growth coupled with high inflation). The growing risk of this morphing into recession in 2022 or 2023 is clearly linked to just how high interest rates need to rise to tame the inflation beast. This seems more likely in the UK and Europe, the latter due to the bloc’s trading links with Russia and dependence on Russian energy, and least likely in the US. In the last two commentaries, we have used the analogy of central banks walking a tightrope, with inflation on one side and recession on the other. That tightrope is getting ever thinner.
Bonds
Against a backdrop of raging inflation and rising interest rates, investors in bond markets endured another wretched quarter. As a reminder, inflation is the nemesis of most bond markets because it erodes the value in real terms of interest payments and the final repayment of capital when a bond matures and is repaid, both of which are fixed. Thus, when inflation is rising the price of a bond will usually fall (and its yield therefore rise) in order to compensate.
Indices recording the returns of the conventional UK government gilt market were down another 7% in the second quarter of the year, taking the loss since the beginning of the year to 14%. So much for the safety of government bonds. The losses arose as surging inflation caused 10-year gilt yields to reset from 1.6% to 2.2% during the quarter and from just under 1% since the beginning of the year. It is extraordinary to remember that 10-year gilts yielded just under 0.1% as recently as August 2020. Rising yields and tumbling prices are not just a UK phenomenon. In the US, 10-year Treasury yields rose from 2.3% to 3.0% in the quarter (and from 1.5% at the beginning of the year and a low of 0.5% in August 2020). For investors in the broad US Treasury bond market this translated into a loss of more than 3% over the quarter and just under 9% since the beginning of the year. It looks odd that bond yields have climbed by more in the US than in the UK but investors in the US bond market have lost less than investors in UK gilts. This is entirely due to the so-called ‘duration’ of the UK gilt market (which is essentially the average time to maturity or repayment of outstanding bonds) being considerably longer than other sovereign bond markets. As a result, returns from UK gilts are much more sensitive to changes in yields and interest rates, gains being magnified when yields are falling but losses being amplified when yields are going up. It was clearly in the best interests of the UK government to lock-in long-term borrowing at an attractive cost but at the same time it was effectively passing on the interest rate risk to investors.
Bonds issued by companies are generally regarded as riskier than bonds issued by governments and investors demand additional interest to compensate for this (the incremental yield being known as the ‘credit spread’). Despite receiving that extra interest, investors in corporate bonds still suffered even bigger losses than investors in equivalent-maturity government bonds over the last three months. Growing fears of an economic downturn and the impact this would have on companies caused investors to require higher credit spreads and prices of corporate bonds have therefore fallen by more than government bonds. In an index-linked bond, both payments of interest and the final repayment of capital are linked to inflation. With inflation soaring, you might have thought that index-linked bonds would have been a great investment. They haven’t, indeed quite the opposite. Indices representing the returns of the index-linked gilt market plunged by almost 18% in the second quarter. The reasons are twofold. First, the index-linked gilt market is even longer-dated (in maturity) than the conventional gilt market, making it even more sensitive to movements in interest rates and bond yields. Second, the inflation component depends not on the current inflation rate but on the expected rate of inflation over the lifetime of the bond. Those expectations are currently predicting the longer-term outlook for inflation remains benign. Accordingly, and staggeringly, the price of the Index-Linked 2068 Gilt has fallen by 57% since its peak in November 2021. In a nutshell, there have been very few places for investors in bond markets to shelter in 2022.
Bond markets seem likely to continue to be subject to a tug-of-war between inflation and slowing economic growth. Given that inflation in the UK is running at more than 9% and heading higher, a 10-year gilt offering a yield of 2.2% does not appear very appetising. With the US Federal Reserve taking a much tougher stance on inflation than the Bank of England, US Treasury bonds yielding more than 3% look relatively more attractive. However, and in contrast to August 2020 when yields were 0.1% and 0.5% respectively, there is now at least some scope for bond yields to fall, and prices therefore to rise, if economies fall into recession. Government bonds are clearly not, though, primed to provide as much protection as they did at the beginning of both the dotcom bust in 2000 and the start of the financial crisis in 2007, when 10-year gilts yielded more than 5%.
Equities
The correction in stock markets deepened in the second quarter of 2022. Having lost just over 4% in the first three months of the year, global stock markets indices slumped by 14% in the second quarter, taking the year-to-date decline to almost 18%. Although this has provided a very rude and unwelcome awakening for many investors, it is important to put the recent performance of stock markets into perspective. Despite their painful falls this year, global equity indices are still up by just under 11% p.a. (including dividends) in local currency terms over the last ten years. Over the same period, the UK’s inflation rate has averaged 2.3%, so global equity indices have delivered a real return of almost 9% p.a. Frankly, real returns of such magnitude were never going to be sustainable and a large part of them can be attributed to more than a decade of artificially low interest rates and bond yields engineered by central banks. With the return of inflation and, with it, higher interest rates and bond yields, those times are now over and investors should steel themselves for much lower real returns in the years ahead.
Given that the key elements of the macro backdrop (rising inflation, rising interest rates, rising bond yields, strong US dollar and the war in Ukraine) were broadly the same as in the first three months of the year, it is not surprising that regional variations in stock market performance were similar in the second quarter of the year to the first. Amongst developed markets, the UK and Japan were the most resilient in local currency terms and the US and European markets the weakest. Down by ‘just’ 5% in the second quarter and also year-to-date, the UK stock market as a whole continued to benefit from its heavy weightings in multinational companies which generate a high proportion of their revenues outside the UK (which are boosted by weakness in sterling), ‘old’ economy companies such as mining and oil stocks (the oil price remained above US$100 per barrel for almost all of the quarter) and its dearth of technology firms. Once again, though, there was substantial divergence between indices representing the performance of the UK’s largest companies and of the much weaker performance of medium-sized and smaller UK companies, whose fortunes tend to be more aligned to the domestic economy. It was therefore another tough quarter for active fund managers who understandably tend to be drawn to the more exciting growth prospects of medium-sized and smaller companies in the UK. The Japanese stock market was boosted, at least in local currency terms, by the weakness of the yen and relatively low levels of fickle foreign ownership.
The composition of the main US stock market index could hardly be more different to the UK, all five of its biggest constituents being technology companies (Apple, Microsoft, Alphabet/Google, Amazon and Tesla). Growth stocks such as these have seen their valuations, and hence share prices, tumble as bond yields have soared. Exactly the same factors which made the US the best performing stock market in previous years are making it the worst so far in 2022. The benchmark US stock market index fell by 16% in the second quarter and is down by more than 20% year-to-date. Unbelievably, interest rates are still negative in the eurozone despite inflation running at 8.6%. Despite this and also that bond yields in much of the eurozone remain significantly below bond yields in the UK and US, European stock markets were weak due to the mounting risk of recession as a consequence of the region’s dependence on Russian energy supplies and other trade with the pariah state. The only major stock market to buck the trend and deliver a small gain in the last quarter was China. This can probably be attributed mainly to the easing of COVID lockdowns. Nevertheless, the Chinese stock market is still down by 10% year to date and more than 40% below its February 2021 peak, which was just before the Chinese authorities embarked on a series of ruthless clampdowns on some of the country’s most successful companies.
We cannot promise that share prices will not fall further in the months ahead. So far, the sell-off has centred on growth stocks which have seen their valuations plunge as bond yields have soared. Although bond yields may rise further, the outlook for stock markets now probably depends more on the depth of the impending economic slowdown and its impact on corporate profits. It should come as no surprise, then, that in portfolios which use actively managed funds we are emphasising exposure to high quality companies with strong balance sheets and earnings that are likely to be resilient in a downturn, often due to dominant market positions.
However, we are also confident that equity markets will recover. Equities are by nature volatile and anyone who invests in them should be doing so for the long term. Already this century global stock market indices (including dividends) have experienced peak-to-trough declines of 48% (the 2000-2002 dotcom bust) and 54% (the 2007-2009 financial crisis). Despite this, someone who invested at the worst possible time on the eve of the dotcom bust at the end of August 2000 has still received a very respectable return of 5.3% p.a. Someone who invested on the eve of the financial crisis at the end of September 2007 has received a return of 6.3% p.a. Both figures are at least 3% p.a. ahead of UK inflation over the respective time periods and even more substantially ahead of cash deposits.
Currencies
From financial headlines you might have thought that the standout feature in currency markets over the last three months was the weakness of the pound. It wasn’t. In fact, it was the strength of the US dollar. The dollar appreciated by almost 8% against sterling but it also strengthened by 6% against the euro and by nearly 12% against the Japanese. yen. The pound, therefore, fell by less than 2% against the euro and it appreciated by about 4% against the yen.
It is easy to explain the dominant driver in foreign exchange markets: actual and expected changes in interest rates. As noted earlier in this report, the US Federal Reserve is raising interest rates aggressively to tackle inflation. In contrast, the Bank of England is taking a much more softly-softly approach. We expect the difference between US and UK interest rates to widen further in the months ahead. The European Central Bank is expected to raise its own interest rate for the first time at the end of July and to finish its experiment with negative interest rates in September. The Japanese yen has been weak because inflation in Japan stands at just 2.5% and 10-year Japanese Government Bond yields remain close to zero.
Changes in exchange rates are notoriously difficult to predict. However, it seems likely that exposure to foreign currencies in the portfolios we manage (which is provided by investments in international equity markets and, opportunistically, in strategic and tactical bond funds) will continue to be of incremental benefit to returns.
Alternative Investments
Given its reputation as a hedge against inflation, gold has been a surprisingly poor investment so far this year. In US dollar terms (the reference currency for the precious metal), the price of gold fell by 7% in the second quarter and is down by 1% year-to-date. In sterling terms, however, gold was up by 1% in the second quarter and has delivered a return of 10% so far in 2022. A key driver of the price of gold is the trend in ‘real’ interest rates, which is the difference between interest rates and inflation rates. Historically, gold has performed best when that difference is negative (i.e. inflation rates are higher than interest rates) and widening. This has been the case so far in 2022 and, indeed, real interest rates are currently more negative than they were even in the inflation-ravaged 1970s. However, the prices of financial assets, including gold, reflect expectations in the future instead of the present or past. The disappointing performance of gold this year is therefore a prediction that the aggressive interest rate policy now being pursued by the US Federal Reserve to combat inflation will be successful.
The last three months have witnessed a bloodbath in cryptocurrency markets. The price of bitcoin, the first and best-known cryptocurrency, slumped by almost 60% and has now fallen by 72% from its all-time peak just eight months ago. The values of many other cryptocurrencies have fallen by even more. The concept of a store of monetary value of which there is finite supply and which cannot be printed and debased by central banks remains attractive. This was the basis of describing bitcoin as digital gold. Fuelled by the very money-printing it was intended to protect against, however, the cryptocurrency market descended into a speculative frenzy with more than 10,000 different cryptocurrencies being launched. As a result, comparisons with the 17th century Dutch tulip mania instead of gold currently seem more appropriate. Despite the precipitous declines in their prices, it remains our stance that bitcoin and other cryptocurrencies are wholly unsuitable to be considered for use in the portfolios we manage.
With the sector still benefiting from a post-COVID bounce as workers return to offices and town centres and investors flocking to asset classes which provide actual or perceived protection against inflation, it is no surprise that the commercial property sector is one of the very few to have delivered a gain for investors in the first half of 2022. Of course, what happens to property values if there is a recession remains to be seen. From an entirely practical standpoint, however, there has still been no decision from the FCA about resolving the liquidity mismatch in the sector (the daily liquidity currently offered to investors in property funds vs. the liquidity of the funds’ underlying investments), which in the past has temporarily forced property funds to suspend redemptions. Consistent with the continuing uncertainty, we note that the managers of one of the biggest and most highly respected funds in the sector have recently decided to liquidate their fund and return all capital to investors. Against this backdrop, it makes sense for us to remain on the side-lines.
