'This too shall pass'
A tough first quarter has developed into the most painful first half-year for investors in over 50 years. Losses deepened, across almost all asset classes, leaving investors hardly anywhere to hide. Equities fell sharply and bonds, just as in Q1, gave no protection in diversified portfolios. Gold and many commodities fell, and even cash, while stable in nominal terms, saw purchasing power erode as inflation soared to the highest levels since the 1970s.
Markets have been forced to price in not only much higher and more persistent inflation than most investors expected, but also the prospect of a sharp slowdown in growth and a high risk of recession as central banks respond aggressively to curb inflation. Having acted decisively to support growth as the pandemic began, central banks have now reversed course, to prevent an inflation spike becoming an uncontrollable spiral. Higher costs for staples and luxuries are squeezing consumer demand; borrowing costs for firms and households are rising; and although wages are rising, they are rising by much less than prices, squeezing household budgets and clouding the demand outlook for firms. The impact of war in Ukraine on energy and agricultural supplies, and the repeated waves of Covid infection disrupting commerce and supply chains, add further complications to the picture.
Both US and global equities fell 16% in the second quarter, a fall of 20% year-to-date and around 14% over the trailing 12 months. Growth stocks fell 21% in Q2 and 29% YTD. Value stocks, which often perform better in an environment of rising yields, were almost flat in Q1, but still fell 11% in Q2. Emerging market and Asian stocks have fallen slightly less than global indices, helped by strong commodity producers in Q1 and by China emerging from lockdown in Q2. UK large-cap equities fell only 4% in Q2, after small gains in Q1 (boosted by energy companies), and Japanese stocks fell only 5% in Q2 but, in both cases, currency falls mask a more damaging decline: both Yen and Sterling fell significantly against the Dollar (15% and 11% YTD). Defensive sectors (Utilities, Consumer Staples and Healthcare) fell 6-10% year-to-date and even Energy stocks, after rallying hard in Q1 as oil prices surged, declined slightly in Q2. The only positive market is China in Q2 and energy in H1 across all sectors and regions for 2022.
While we might characterise 2022 as the worst start to the year in generations for equities, bonds have to go back even further to find a comparison. The carnage across the bond market in Q1 carried on in Q2. Ten-year US Treasuries lost over 9%. US TIPS fell in line with broader government bond indices, but longer duration UK IL Gilts fell over 20% in H1; Euro government bonds fell sharply by over 10%, with spreads for weaker borrowers like Italy widening notably. US High yield and investment grade corporate bonds fell around 14% across the half-year, hurt both by higher government bond yields and sharply higher credit spreads, as markets moved to price in a cycle of downgrades and defaults in a recessionary environment. Emerging market bonds also saw significant losses with the aggregate hard currency EMD index falling by over 15% in H1.
Recession fears undermined commodity prices too. Copper, a relatively reliable recession indicator, fell over 20% in the quarter, as traders priced in weakening demand. And while oil prices rose slightly for the quarter as a whole, they ended June well below peaks of $120 seen earlier in the month - fears over weaker demand offset supply concerns.
Having spiked over $2050/oz in March, gold steadily fell, to end June just above $1800/oz. While gold is seen as a potential hedge against inflation, a strong Dollar and the emergence of higher deposit rates on cash are clear headwinds. And the crypto crash continues to dwarf the equity correction: at below $20000, Bitcoin has halved since April.
Only the Dollar provided some relief: safe haven demand and higher deposit rates helped drive Dollar gains. The Pound fell 7% vs US Dollar in Q2 (and has fallen 11% YTD) - for Sterling-based investors, exposure to US Dollars (and to a lesser extent Euros) has been a rare profitable trade in 2022. The Yen fell sharply too (down 10% in Q2 and 15% YTD against the Dollar): Japan stands out as one economy where interest rate rises remain off the agenda.
The correlation of negative returns across bonds and equities, as well as commonly held alternatives like gold and commodities, has hit multi-asset portfolios hard. While holdings of cash may have provided some protection, investor focus will be on the success of less conventional defensive measures taken by some managers to protect portfolios: hedging strategies, truly uncorrelated alternatives and niches in areas like renewable energy or social infrastructure, which may have been able to protect against both inflation and growth concerns.
Much of what has driven the surge in inflation is outside central banks’ control: energy and food price rises, exacerbated by the war in Ukraine; and price spikes in services that saw rebounding demand as Covid restrictions eased. This makes central bankers’ path to a “soft landing” almost impossibly narrow. The Fed and others are clearly prepared to inflict pain on the economy in order to bring inflation back under control: interest rates have already started to rise but bond markets are pricing in significant further tightening to come - to over 3% next year in both the US and UK.
Official statistics don’t yet show a recession in the data, but it would be no great surprise if Q2 data (released over the next several months) ultimately show negative GDP growth: in other words, that a recession has started.
Labour markets still look strong, with low unemployment rates and wages growing strongly (although still below the rate of inflation). But of course, labour markets tend to lag changes in the broader economy. Forward-looking indicators are more worrying: surveys of consumer sentiment have nosedived to record lows in the US and UK, as households worry about higher costs, rising mortgage rates, wages rising below the rate of inflation, and also start to think about job security.
Surveys of firms are also weakening. Global manufacturing surveys show a sharp fall in business optimism, as firms are hit by higher borrowing costs and faltering demand in their end markets. Surveys of services industries reveal a similar softening, as consumers see higher costs for essentials like food and utilities leaving less to spend on leisure, travel and other services. China stands as an exception, with manufacturing output recovering and services demand resurgent as Covid lockdowns in major cities have come to an end in recent weeks. Globally, however, business surveys suggest the economy is growing very slowly, and may even be tipping over into negative territory, even if this won’t show up in official data for some time yet.
There is perhaps a silver-lining to the gloom in the growth outlook. Firms are already reporting that weaker demand is easing some of the pricing pressures they face, leading some commentators to suggest that inflation is close to peaking.
For markets now, the question shifts to what sort of slowdown - or recession - the global economy will experience. How deep, how long and how damaging? At what point will central banks feel confident that enough has been done to break the risk of an inflation spiral? Will investors have to wait for central bank action to overshoot - to cause a meaningful dislocation in assets, markets or the economy - before a shift in policy emerges?
Long-term investors know that market corrections are part and parcel of investing in equity markets; an element of the risk that accompanies the higher expected returns over time. Even quite significant corrections are common: the average correction within any given year over the last four decades is around 13% and while this year’s correction has gone deeper, investors know that the market environment will evolve with time: This too shall pass.
While risks and market volatilities remain as the economy slows and investors come to terms with central banks reacting aggressively to inflation, there are good reasons for investors to be wary of trying to time jumps out and back into the market.
First, equity valuations have fallen significantly; and in many areas look more reasonable against long-term comparisons. Second, investor sentiment is unusually pessimistic; extreme negatives can set up a turnaround in markets if the world doesn’t turn out to be quite as bad as expected. Third, market returns in the year or two after a major sell-off have tended to be higher than average; although of course, the past may not be a guide and we cannot know if this time will be different. Fourth, prospects for multi-asset investment look more interesting than they have done for years, with higher bond yields creating opportunities for investors to build resilient portfolios for the long-term.
N.b. All content is based on data at the time of writing on 8 July 2022.