Summary
There are encouraging signs that inflation in the US may have peaked but we are less confident that the same applies in the UK following the recent weakness of the pound. As before, though, both the timing and heights of the peaks are less important than the levels at which inflation settles in the medium term. It remains our view that inflation will prove stickier than central banks would like and wage price spirals could yet develop. Against this backdrop and as the US Federal Reserve has already made clear, we expect interest rates to continue to be raised aggressively until there is clear evidence that inflation is tamed. Higher mortgage and other borrowing costs will only exacerbate the cost-of-living squeeze and this will impact consumer spending and economic growth. Interest rates of 5% or more would be extremely painful in the UK economy.
The rout in bond markets in 2022 became a bloodbath in the third quarter as the upward trend in yields and downward trend in prices accelerated. In addition, prices of UK government gilts were sent into a tailspin in the final week of September after the new Chancellor of the Exchequer announced tax cuts which will almost certainly need to be funded by yet more borrowing. The re-pricing of bond markets after the distortion caused by years of quantitative easing has been brutal in both speed and scale, giving rise to losses that few could have imagined in an asset class that is meant to be a safe investment. Bond yields have risen to levels which are beginning to look attractive and competitive but downside risk will remain until there is clear evidence that inflation is falling and interest rates have peaked.
Global stock market indices fell further in the third quarter to extend their year-to-date losses in local currency terms to more than 20%. Both over the last quarter and also year-to-date, the UK stock market has been amongst the most resilient, thanks to its heavy weightings in energy and other multinational companies which benefit from a weak pound and also its low weighting (unlike the US) in highly valued growth stocks which have suffered most as bond yields have risen. Looking ahead, we expect investors to become increasingly focussed on the outlook for corporate profits. In portfolios which use actively managed funds, we continue to seek exposure to high quality companies with strong balance sheets and revenues that are likely to prove robust in any economic downturn.
Macro Highlights
Notwithstanding the mayhem unleashed by Kwasi Kwarteng’s swathe of tax cuts, financial headlines continued to be dominated by monthly readings of inflation from around the world which also set the tone in financial markets during the third quarter of the year. In the UK, the latest figure for Consumer Price Inflation (CPI) is 9.9% for the year to the end of August, a slight dip from July’s 40-year high of 10.1% but three times higher than where it was twelve months ago. According to the ‘old’ Retail Prices Index (RPI), the annual rate of inflation in the UK at the end of August stood at 12.3%, unchanged from July and up from 4.8% a year ago. The main difference between RPI and CPI is that the former includes mortgage interest payments and as this is most people’s biggest outgoing it is easily argued that RPI is a much truer measure of the cost of living. Moreover, annual increases in the prices of many services, such as train fares and mobile phone tariffs, are linked to RPI rather than CPI.
In the US, the annual rate of inflation at the end of August stood at 8.3%, down from 8.5% in July and 9.1% in June. Although this optically represents an encouraging trend, August’s number was higher than expected and prompted a sharp sell-off in US bond and stock markets. The decline in the US’s headline inflation rate can be mainly attributed to the price of oil, which has fallen steadily since the beginning of June. However, this was largely offset by price rises in other inflation components such as housing and food. The cost of groceries has surged by 13.5% over the year, the highest rate of increase since 1979. The eruption in inflation may have begun in energy markets but it is by no means certain that further falls in oil and gas prices will extinguish the flames. In the Eurozone, reliance on Russian gas and soaring food prices have caused inflation to rise to an estimated record high of 10.0% in September. Despite sharing a common currency, rates of inflation across the eurozone vary widely, from an estimated 6.2% in France, 10.9% in Germany and more than 20% in each of the three Baltic states.
In late August, Citibank forecast that the rate of CPI in the UK would reach 18% in early 2023. Just a week later Goldman Sachs trumped that with a figure of 22%. Mercifully, both predictions should now prove far too high in the wake of Prime Minister Truss’s decision last month to subsidise household energy bills by introducing a two-year energy price guarantee. Under the price guarantee, a typical household will see its annual energy bill capped at £2,500 a year from 1st October (and will also still receive the £400 grant announced at the end of July). As Ofgem had previously announced that the price cap would rise to £3,549 in October this obviously represents a very welcome discount. However, with the old price cap set at £1,971, consumers are still facing a 27% rise in the cost of energy when the £400 grant expires at the end of March and this will provide another upward bump to inflation. There has been much debate as to whether the raft of tax cuts announced by Chancellor Kwarteng at the end of September will stoke additional inflation by boosting demand. A much greater threat to inflation, however, stems from the weakness of the pound. As a result, the cost of everything that is priced in other currencies and needs to be imported has increased. We would therefore not be surprised to see the rate of CPI in the UK move back into double digits and this will only increase the risk of a wage price spiral developing.
Typically tasked with maintaining inflation at 2%, most central banks face an impossible dilemma. The clear conflict between fiscal policy (set by governments) and monetary policy (set by central banks) is not unique to the UK. As the US Federal Reserve battles to bring down US inflation by raising interest rates, President Biden is stoking the fire by forgiving student loans and through fresh government spending. The Federal Reserve is making it clear both through its actions and statements that this is not a battle it is willing to lose and we have seen predictions of the necessary peaks in interest rates continue to rise. In the UK, just three months ago the consensus was that interest rates in the UK would reach 2.75% in 2023. We are now seeing forecasts of 5% or even higher.
Unsurprisingly, the outlook for economic growth has received rather less attention than the path of inflation over the last few months. Consumer spending, which accounts for approximately 60% of the economy in the UK and almost 70% in the US, is clearly under pressure as wages fail to keep pace with inflation. However, unemployment rates remain very low, at least for now, and, except for the lowest earners, consumers have been able to draw down on savings accumulated during the pandemic. The biggest threat to economic growth is clearly interest rates and how high they will need to be raised to tame inflation. US 30-year mortgage rates have already doubled this year from 3% to more than 6% and this has stopped the US housing market in its tracks. The UK economy looks particularly vulnerable in this respect and interest rates at 5% or 6% would surely have a devastating effect on the economy. Across the channel, European economies face an additional headwind due to their former dependence on Russia for gas supplies, with the all-important Nord Stream 1 pipeline remaining closed. The consensus is still that economies will muddle through and that any recessions will prove both shallow and short-lived. The risks to this rosy outlook must be to the downside.
Bonds
After a dreadful first half of the year, the misery being inflicted on investors in bond markets in 2022 got even worse in the third quarter as the upward trend in yields accelerated. As a reminder, when the yield of a bond rises, its price falls (and vice versa). The reasons for the carnage in bond markets are threefold: inflation, interest rates and the consequences of years of quantitative easing (QE). First, inflation erodes the value in real terms of both interest payments and the return of capital when a bond matures, all of which are fixed. Thus, when inflation is rising, the yield of a bond needs to go up (and its price therefore fall) in order to compensate. Second, interest rates are the main tool that central banks use to control inflation as higher borrowing costs suppress demand. When interest rates rise, bond yields usually rise too. Finally, more than a decade of negligible interest rates and almost continuous bond buying by central banks after the economic damage wrought by 2008’s financial crisis and, much later, the COVID pandemic had driven bond yields down to levels which were simply absurd. Just two years ago, investors in 10-year gilts were receiving a return of just 0.1% p.a. to lend to the UK government for ten years. Investors in Germany were actually paying 0.8% p.a. for the privilege of lending to the German government for 10 years. QE created a mirage of value. In the ten years leading up to the financial crisis 10-year gilts yielded 5% on average and 10-year German bonds more than 4% even though inflation was much lower than it is now. On this basis, the painful re-pricing of bond markets is simply the distortion of QE being expunged.
The rise in yields and fall in prices, though, has been brutal in its speed, leading to losses that few would have thought possible in investments in government bonds, which are traditionally regarded as much safer than equities. It is common practice in the investment industry that the more cautious and risk averse an investor is, the greater his or her allocation to bonds should be. In 2022 this simply has not worked and cautious investors have suffered losses every bit as big as investors with more growth-oriented portfolios with much higher exposure to equities. At the beginning of the year, 10-year UK gilts yielded just under 1%. By the end of June yields had risen to 2.2% and indices representative of the returns of the gilt market were already down by 14%. Yields continued to climb in the third quarter as CPI soared above 10% and it became clear that central banks would need to raise interest rates by much more than previously thought. 10-year gilt yields breached 3% in early September and Chancellor Kwarteng’s announcement of debt-funded tax cuts on 23rd September sent gilt prices into a tailspin. Yields leapt by more than 1% to 4.5% in just five days, forcing the Bank of England to step in to steady the market and protect a number of pension funds which had become perilously exposed. At the end of the quarter, 10-year gilt yields stood at 4.1% and year-to-date losses for investors in the gilt market as a whole had ballooned to 25%. Fortunately, we have been very underweight (compared with strategic asset allocations) in exposure to gilts in the portfolios we manage.
Whilst the UK was an extreme, yields in other countries’ bond markets also rose significantly in the third quarter of the year, inflicting sizeable losses on investors. In the US, 10-year Treasury yields rose from just under 3% to 3.8% as Jerome Powell, Chairman of the US Federal Reserve, made it clear that interest rates will continue to be raised aggressively until inflation is brought under control. Interest rates in the US were twice increased by 0.75% in the last quarter and now stand at just over 3%. They are expected to be more than 4% by the end of 2022 and peak at about 4.5% in 2023. Faced with raging inflation, the European Central Bank has also finally ended its experiment with negative interest rates, increasing rates two times and by a total of 1.25% in the last quarter. German government bond yields have been rising in tandem with other bond markets and, having started the year yielding minus (0.18)%, yielded 2.1% at the end of the third quarter.
Bond markets are undergoing a dramatic re-pricing. There will come a point when the yields available will make bonds a worthy alternative to equities and cash, especially on a risk-adjusted basis. 10-year gilts yielding 4% are clearly much more enticing than when they provided a yield of just 1% at the beginning of the year. However, until such time as a downward trend in inflation is clearly established and there is certainty that interest rates have peaked, we see no rush to be brave and take the plunge.
Equities
Stock markets see-sawed violently during the third quarter but were down again over the three-month period as a whole, extending their losses since the beginning of the year. Astonishingly, six weeks into the quarter global equity market indices were up by almost 12%. The rally was prompted by better corporate profits than expected in the second quarter of 2022, the first dip in US inflation and weak economic data. The last led to optimism that the US central bank might moderate its assault on inflation, resulting in the peak in US interest rates being lower than previously thought. US Federal Reserve Chairman Powell’s speech to his fellow central bankers in Jackson Hole, however, completely extinguished those hopes, making it clear that the US central bank would continue to be aggressive in its fight against inflation. Bond markets then resumed their decline, causing global stock market indices to give back all and more of their gains and finish the quarter down by just over 4%. This took losses since the beginning of the year to more than 20%.
Whilst we certainly understand the anguish currently being suffered by investors, it should be remembered that equities are long-term investments. Volatility and episodic losses go hand in hand with the superior returns that equities have provided over time. Despite the painful losses this year, global equities have still provided a return of almost 10% p.a. including dividends over the last ten years and this is before the weakness of the pound has been taken into account. The figure for the UK’s stock market, a notable laggard, is 6% p.a. Over the same period, CPI inflation in the UK has averaged 2.5% p.a. and sterling cash deposits have provided a return of just 0.5% p.a. Stock markets fell by much more during 2000-2002’s dotcom bust and again in 2007-2009’s financial crisis but both periods appear as relatively minor setbacks in graphs recording multi-decade equity market returns. We still caution, however, that the exceptionally high real returns in global stock markets since the financial crisis were never going to be sustainable and that investors should steel themselves for lower returns in the years ahead.
There was once again considerable variation in the performance of different stock markets. Japan’s stock market continued to prove the most resilient in local currency terms, down by just 1% in the third quarter and 6% year-to-date. Japan is yet to experience the soaring inflation, interest rates and bond yields seen in most other developed nations and its legion of companies which export goods and services have benefited from the depreciation of the yen, which has been even weaker than sterling. The broad UK stock market fell by nearly 6% in the third quarter but is down by ‘only’ 8% year-to-date thanks to its heavy weightings in energy and other large multinational companies (which generate a high proportion of their revenues in currencies other than the pound) and dearth of highly valued growth stocks which have led the retreat in other stock markets such as the US. Within the UK’s stock market, however, many medium-sized and smaller companies continued to see their share prices decline because their fortunes are perceived to be more aligned to the health of the domestic economy. In local currency terms, the US stock market has been one of the biggest fallers but much of this has been offset by the strength of the dollar. In sterling terms, the performances of the UK and stock markets have been almost identical so far in 2022.
Worries about supply and cost of energy, as well as the rises in interest rates likely to be needed to curb the highest inflation in more than seventy years, caused European stock markets to remain under downward pressure. German stocks fell by another 5% in the third quarter, taking year-to-date losses to almost 24%. Although this is almost exactly the same as the US stock market, the euro has appreciated by only 4% against the pound so losses for sterling-based investors are still close to 20%. The big faller in the third quarter, though, was China (to which the portfolios we manage thankfully have very little exposure). New lockdowns in major cities as part of China’s zero-COVID policy and a deepening crisis in the property sector, which may account for as much as 30% of the country’s GDP, have caused forecasts of economic growth to be revised down to less than 3% in 2022 from more than 8% in 2021. Chinese stock market indices plunged by more than 20% in the third quarter and are down by about 30% year-to-date.
At the simplest level, there are just two components to a share price: a company’s profits and the multiplier or valuation that is applied to them. The weakness in share prices so far this year can be largely attributed to falling valuations which in turn can be attributed to rising bond yields. Valuations could decline further but it is hard to imagine that the biggest (upward and adverse) moves in bonds yields are still to come. The main driver of share prices in the months ahead should therefore switch to corporate profits. There is much talk that rises in interest rates will lead to recession. It is important to remember, though, that economic growth is measured in real (i.e., adjusted for inflation) terms. If economic growth falls by, say, 2% we might be in a recession but if inflation is at 6% then the size of the economy is still growing at 4% in cash terms. All things being equal, the top line revenues of companies should grow by at least 4% too. Of course, profits are more important than revenues and profit margins are under pressure on many fronts, including higher wages, higher energy prices and higher interest costs. In these circumstances, we expect investors to become ever more discerning and stock selection to be key. No company can insulate itself completely from rising costs. However, we expect the profits of companies with strong balance sheets and dominant market positions (which confer strong pricing power) to prove the most resilient in any economic downturn. In portfolios which use actively managed funds, we are therefore emphasising exposure to high quality companies which have these characteristics.
Currencies
There was no stopping the US dollar in the latest quarter as the US Federal Reserve made it clear that its fight against inflation was far from over, signalling that it was likely to continue with its much more aggressive policy of interest rate rises than other leading central banks. Over the three-month period, the dollar appreciated by 8% against the pound and by 6% against both the euro and the Japanese yen. Year-to-date to the end of September, the dollar has appreciated by 14% against the euro, by 18% against the pound and by an extraordinary 26% against the yen. These are colossal moves amongst G7 currencies and the strength of the dollar is only exacerbating inflation in other countries which import goods, such as oil, which are priced in the US currency.
Confidence in the pound collapsed at the end of September in the immediate aftermath of the new Chancellor’s announcement of unfunded tax cuts. On the eve of Mr Kwarteng’s speech, one pound was worth 1.13 US dollars. After traders digested the cost and implications of the tax cuts over the weekend, the pound plummeted to an all-time low of just 1.03 against the dollar. The pound has since recovered, particularly after the government backtracked on its proposal to abolish the 45% top rate of tax. Nevertheless, the damage in terms of credibility has been done. Undermined by a yawning current account deficit (the value of imports and other payments abroad far exceeds the value of exports and other payments coming in), high inflation and the need to fund recently announced spending and tax cuts in the bond markets, we would not be surprised to see the pound resume its decline.
However, decades of experience have taught us that changes in exchange rates are notoriously difficult to predict and are therefore often as much a source of risk as of return. Exposure to foreign currencies in the portfolios we manage is provided by investments in international equity markets and, opportunistically, in strategic and tactical bond funds.
Alternative Investments
Despite its reputation as a hedge against inflation, the price of gold continued to fall in the third quarter, down by 8% in dollar terms (the reference currency in which the precious metal is priced). Year-to-date the price has fallen by just over 9%. In sterling terms, however, the price of gold was flat in the last quarter and is up by almost exactly 10% year-to-date to the end of September. The strength of the dollar has been one of the headwinds to the performance of gold. Rising interest rates and bond yields have been another because both cash deposits and bonds now provide an income yield whereas gold does not. However, the main cause of the fall in the price of gold has been the trend and future expectations of ‘real’ interest rates, which is the difference between interest rates and inflation rates. Historically, gold has performed best when the trend is negative. However, it is now widely expected that interest rates will continue to rise. At the same time, forecasts of where inflation will be in several years’ time have remained anchored at benign levels. If you believe that inflation is becoming embedded and is unlikely to return to the 2% target set by most central banks anytime soon then gold at its current price is not without its attractions.
Given the ructions in mainstream financial markets over the last few months, it is perhaps unsurprising that little has been heard about bitcoin and other cryptocurrencies. This may also be because the price of bitcoin has been unusually stable over the last few months. Over the quarter, it appreciated by just 4% in dollar terms which is trivial when compared with the fall of 71% from its all-time peak in November last year. 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. However, the dust is still settling on the speculative frenzy into which bitcoin and thousands of imitators were drawn in the era of ultra-cheap money and it is by no means certain that the cryptocurrency markets will ever regain any credibility.
It remains Groundhog Day for daily dealing UK authorised property funds, with the FCA still to make and deliver any decision about resolving the obvious liquidity mismatch between the daily dealing offered to investors and the illiquidity of the assets in which property funds invest. A similar mismatch clearly exists in the daily pricing of property funds and the frequency of pricing of a property fund’s investments. We note that the IA UK Direct Property Sector index fell by 3.5% in the last quarter but is still up by 1.6% year-to-date, benefiting from investor demand for asset classes which provide actual or perceived protection against inflation. Rising bond yields and the growing risk of an economic downturn, and with it the possibility of corporate bankruptcies and rental voids, do not, however, constitute an obviously attractive backdrop for the commercial property sector as a whole. This, though, is just an academic observation as it continues to make sense for us to remain on the sidelines until the FCA has determined the future of UK authorised property funds.
