'Higher for longer?'
Q3 in summary:
- Weak stocks and bonds again in Q3
- Stubborn inflation means interest rates will go higher for longer
- Recession seems inevitable - and has probably begun
- UK policy credibility questions - exacerbating Gilt and Sterling weakness
- Higher bond yields drive reappraisal of all asset valuations - but create opportunities to build robust balanced portfolios with fixed income playing a crucial role
- Equities face challenges, but the sentiment is very weak and markets are already pricing in a difficult growth environment
- Early signs of inflation pressures abating: a necessary step towards an eventual turning point?
Global stock markets fell again in the third quarter, to new lows for the year. After a sharp bear-market rally in July and early August, persistently elevated inflation readings and a hawkish Federal Reserve commentary rammed home the message that central banks would have to push interest rates higher for longer, causing renewed falls for both stocks and bonds.
International investors have much to ponder, with a weakening global economy, continued Covid disruption and a complex geopolitical picture, with widespread Ukrainian advances raising both the prospect of an eventual victory, but also the threat of escalation by a Russian state running out of options.
UK investors arguably face an even more complex picture: while the accession of a new King has few market or economic implications, the arrival of the UK’s fourth Conservative Prime Minister in six years heralds very clear policy changes. UK markets reacted very negatively to the new Chancellor’s mini-budget statement in late September, with the Pound and Gilt selling off sharply: investors were spooked by proposals of huge unfunded tax cuts adding fiscal fuel to an inflationary fire, at a time when the Bank of England is trying hard to douse the flames. Aspects of the proposals have already been abandoned, and both Gilts and Sterling rapidly bounced back on the policy U-turn, but concerns over the credibility of the new government persist.
As in the previous quarter, even very well diversified global portfolios were hit hard by the sell-off, with both stocks and bonds under pressure, and many alternative assets and strategies hit too. Global equities fell a further 6% bringing year-to-date returns to -25%. Emerging markets lagged significantly, dragged lower by a 22% fall in Chinese stocks in the quarter. UK and Japanese equities on the face of it fared better, in local currency terms, but sharp falls in the Pound and the Yen mask much weaker total returns from these markets for international investors thinking in Dollar terms. Of the major markets, only Indian and Brazilian equities saw gains in Q3. There was little to choose between Growth and Value styles in Q3; Global Growth marginally outperformed, losing 5% (vs -7% for Global Value), but Growth has still dramatically underperformed year-to-date, as valuations have retreated significantly, undermined by higher bond yields. Consumer Discretionary stocks were flat in Q3, having been one of the weakest sectors year-to-date, but all other global sectors saw losses. Rate-sensitive sectors, like Real Estate, and bond proxies, like Utilities, were among the worst performers; Materials lagged too, undermined by falling commodity prices.
Bonds fell across the board, with global bonds losing 4% in the quarter and now down around 13% YTD (for a global index hedged to Sterling). Government and corporate bonds, emerging markets and inflation-linked bonds have all suffered: there was nowhere for investors to hide. Gilts suffered more than most - as we explore later, the combination of high inflation, accelerating interest rate hikes and the new Chancellor’s proposed increases in borrowing to fund tax cuts spooked markets: Gilts returned minus 14% in Q3 and have lost over a quarter of their value year-to-date, with 10-year Gilt yields surging over 4%. Government bonds in the US and UK have approached levels not seen since 2009, in the wake of the Global Financial Crisis - the long grind lower of bond yields over a decade since the crisis has effectively been unwound in a heartbeat.
Gold fell 8% (in USD terms), and oil fell by over 20%, leading commodities as a whole lower. Once again, only the US Dollar gave potential relief to portfolios: the Dollar rose 7% against a trade-weighted basket of currencies and around 9% against Sterling over the quarter as a whole (at its worst, Sterling briefly touched record lows against the Dollar, below $1.04, around 15% lower than its level at the end of June). This extreme fall in the Pound meant that many overseas assets actually generated positive returns in Sterling terms - even if the underlying asset weakened, Dollar strength against the Pound outweighed those losses.
The first half of the year saw investors forced to start pricing in higher and more stubborn inflation than most had expected, as well as starting to price in weaker prospects for growth. After a few weeks’ respite in July as markets bounced from a very oversold position, these macroeconomic drivers have weighed on markets again. While inflation in the US may now have peaked, it remains at an uncomfortably high level, and inflation in Europe has continued to surprise to the upside - particularly in Germany - driven by energy costs. In the UK, the sharp fall in Sterling threatens to prolong inflation, by raising the cost of imports.
But inflation is far from the only problem. We have been concerned that central banks faced a narrow path towards an economic soft-landing: that path has become narrower still. The growth outlook has deteriorated further and it now looks increasingly likely that key global economies will fall into recession soon, if they have not already.
Central banks may have been late to change course, from unprecedented support of the economy in the first eighteen months of the pandemic, to increasingly aggressive interest rate rises in 2022, as they scramble to drive inflation out of the system. Interest rate rises are a blunt tool, perhaps ill-suited to combatting inflation driven initially by supply-chain disruption and then by surging commodity prices; but after a slow start, central banks are now hiking decisively. The Fed hiked 0.75% each in July and September, taking rates to 3.25%; the Bank of England hiked 0.5% each in August and September, taking base rates to 2.25% - currently a record 80% of global central banks are in rate hiking mode. And there is likely plenty to come: markets are now pricing in US Fed Funds reaching around 4.5% early next year and UK base rates as high as 5.75%. Investors’ view of the peak in interest rates has shot higher over the last quarter - three months ago, markets were pricing in interest rates just over 3% in 2023 in both the US and UK.
On top of the higher cost of living and margin pressures on firms arising from higher energy prices, higher interest rates mean a significant increase in debt costs across household and corporate borrowing, crushing aggregate demand. Central bank communications leave no doubt that they are prepared to cause meaningful pain - in terms of recession, unemployment, and lower stock prices - if that is the path to bringing inflation back under control. Unfortunately, this means central banks are now slamming on the brakes of an already slowing economy: the risk of stalling, or causing an accident somewhere in the system, is significant.
The slowdown is becoming increasingly evident. Key business surveys show that firms in the UK and Europe are becoming more pessimistic about their prospects, holding back investment and employment plans as they see their order books coming under pressure and their customers being squeezed. A key survey of global manufacturing firms has slipped into recessionary territory for the first time since June 2020; US firms saw some recovery in confidence, but the slowdown looks severe in Europe and Asia. Bellwethers of global trade, including exporters like Germany, Taiwan and South Korea, are seeing particular falls in manufacturing confidence and new orders. Shipping freight rates have collapsed, reflecting a decline in expected global trade volumes. Consumer confidence surveys in the UK and Europe are registering all-time lows; and while the US has shown a small bounce in confidence over the past month or so, it remains at unusually low levels. Advance indicators of housing markets in the US and UK are worrisome, with mortgage costs rising to their highest levels since 2009, housing transactions starting to fall and house prices now rolling over after two years of sharp gains.
In the US, most mortgages are fixed rates for very long terms: higher mortgage rates price out new buyers and make refinancing unattractive, but leaving existing borrowers relatively unaffected. In the UK, many more mortgages are floating rate or short-term fixed rate deals, meaning that the aggressive rise in rates will hit existing borrowers hard - right now for floating rate mortgages, or over the next 15 months for 2 million households, who will see their fixed rate mortgages mature before the end of 2024.
The combined squeeze from higher costs for essentials and much more expensive debt servicing has probably already put major economies into recession. US GDP data has shown two quarters of decline, and while recently published UK and Eurozone data for Q2 still shows modest expansion, other indicators suggest a recession is imminent, or indeed underway already.
Some observers have suggested that in order to fight down inflation, central banks will keep hiking rates until something breaks. What could that mean? Credit default insurance markets are already showing signs of stress in some significant financial institutions, which must be monitored closely. Credit spreads have moved sharply higher across all industries and segments, meaning that firms will be paying much more for their borrowings as existing bonds and loans mature; some will be pushed over the edge by higher debt costs. Corporate default rates remain very low currently, but a rise in bankruptcies seems inevitable in an environment of slower growth and much higher debt costs. But there are other potential stresses in the complex financial system that has evolved in the low-interest rate years since 2009.
Just before the quarter end, such stresses came to the forefront in the UK pensions market. Many large UK pension funds habitually use interest rate derivatives, alongside bond holdings, in an effort to more closely match their liabilities. As UK gilts sold off sharply, funds had to settle losses or post more margin on the derivative contracts with their counterparties. Often this would mean selling more liquid assets, specifically gilts, in order to raise the cash to settle losses on the derivatives; system-wide, fears grew of a loop of sellers driving gilt prices lower, and triggering yet more selling as derivatives losses grew: an accelerating spiral leading to a liquidity crunch. The Bank of England was forced to intervene, committing to provide that liquidity and break the vicious circle: accident averted, but not before some extraordinary volatility in long-dated gilt markets - normally sober assets locked up in pension plans trading like penny shares or meme stocks. For example, the 40-year inflation-linked Gilt maturing in 2065, which had already seen its price fall by 60% from January to mid-September, halved in a few days after the new Chancellor’s difficult mini-budget, before bouncing 50% in an afternoon after the Bank of England’s intervention.
It’s clear that higher interest rates mean higher mortgage costs and higher debt costs across the economy, potentially undermining house prices, curbing consumer spending and eating into corporate profitability. These economic challenges are clearly unhelpful for stock prices. But a world of higher rates - and especially of higher bond yields - has potentially even more significant implications for equities and other risky assets. The rise in yields so far this year means that today, investors can lock in returns of around 4% annualised by buying a ten-year Gilt or Treasury bond, and holding to maturity. For the first time in years, government bonds offer a meaningful total return from income, from an asset that can hold its value in an economic downturn: this is a profound shift for investors looking to build robust diversified portfolios today, compared to any time over the past decade or so.
All other riskier assets must be looked at in that context; there has to be a premium on offer to tempt investors into taking more risk. It may be evident now in inflation-linked government bonds, with US TIPS offering a positive real yield of 1.7% (real yields were negative as recently as five months ago) and even UK linkers offer a small positive real yield, having offered strongly negative real yields for years: a long-standing valuation anomaly that has finally been erased. High-quality corporate bonds are now yielding around 6%. Low-quality (“junk”) bonds, with yields of 9-10% perhaps are providing enough compensation for losses from firms going bust. Stock markets may look cheap now on many measures, cheaper than they have for a long time, but investors will be asking themselves if equities at current levels are sufficiently cheap and offer strong enough prospects to tempt them away from competing safer assets. Perhaps that’s hardest of all for investors to discern in companies most sensitive to an unpredictable slowdown in the economy (cyclicals), to companies most sensitive to higher bond yields (financials) and in early-stage growth companies, where profitability and pay-offs could be many years into the future.
We wrote last quarter that “this too shall pass”, as do all episodes of both good and bad times in markets. It has not yet passed. The extremely pessimistic investor sentiment at the end of June set up the conditions for a strong market bounce, but it’s now clear that was a bounce against a deeper downtrend. Arguably, conditions have been building again for a bounce, with some measures of investor sentiment again reaching extremes of pessimism, but we have not yet seen the peaks of intense volatility and investor capitulation that often characterise final bear market lows. Nonetheless, it’s worthwhile to consider what might be needed for markets to find a more sustainable turning point.
The list of challenges for equities seems a long one: we might cite higher interest rates, higher bond yields, war in Ukraine and disruption to commodity markets, high energy bills, erratic supply and demand patterns due to Covid 19, slowing economic growth, cracks in housing markets, pressure on business and consumer spending, and doubts over corporate profitability. But inflation runs as a common thread through every one of these: squeezing household spending power and corporate profit margins, but above all forcing central banks to act aggressively, with each new upside surprise on inflation making clearer the damage that policymakers will have to inflict to bring inflation back to target.
Here, maybe, we can find some comfort and some reassurance that this painful episode for investors will indeed pass, even if the pain is not yet over. Surveys of firms now consistently show that inflation pressures are gradually abating. Commodity prices are falling, with key food and metal prices retreating close to their lowest levels this year. Oil prices have been falling since June and now stand little changed from a year ago: this is crucial - if oil prices do not rise sharply from here, then the year-on-year inflation impact of oil will first dissipate and then become disinflationary as we go into early 2023. Shipping rates have fallen hugely: it costs far less to move goods around the world than it did a year ago. Slowing demand and a fall into recession has led to lower inflation and caused central banks to shift from the brake to the accelerator in cycle after cycle; this time should be no exception. And while a weak Pound prolongs the pain for the UK, through imported inflation, a strong Dollar helps ease inflationary pressures in the US, as imports cost less, and some surveys suggest flickers of confidence returning in firms. Will we see relief in inflation there first?
Meanwhile, asset valuations today - in bonds and equities - are at their cheapest levels for years. Valuation in itself is not enough to cause a turning point, but it provides some comfort for long-term investors looking through the cycle.
Investors know that markets are forward-looking, attempting to price in the best estimate of the future that can be made today. So bonds are pricing in further interest rate rises already; stock valuations have fallen significantly and now price in a slowdown, even a recession. These assets will likely price in an eventual softening of central bank policy and a turning point in the economy not when it happens, but well before it happens, as the conditions for stabilisation and ultimately recovery start to emerge from the gloom. Investors trying to time their way out of and back into markets, waiting for proof that the cycle has turned, risk being wrong-footed by volatility or being very late to the party.
N.b. All content is based on data at the time of writing on 7 October 2022.