Before I start this month’s newsletter, I wanted to let you know that we are currently going through a high-level review of our 2022 portfolios, where there will be some changes. I’ll be back to you once this review has been completed.
So far this year we have experienced high inflation and rising interest rates causing bond and equity markets to sell off. The main US Equity index, the S&P 500, is down just over 20 % from its all-time high – the definition of a “bear” market – however, this describes what has happened and is not a guide to what will happen.
At present, we are weighing on whether inflation, particularly in food and energy, will remain elevated, thus impacting consumers ability to spend on other things. We are also looking on central banks continuing to aggressively tighten monetary policy in response to inflation (increasing interest rates) and if this may potentially lead to a recession.
The problem central banks now face is that they can slow demand but can do little about the constraints on supply further driving up inflation. Even though inflation is high now however, the US Fed, the Bank of England and the European Central Bank all expect it to fall back towards the 2 % target over the next two years.
Central banks will continue to raise interest rates further, but a resolution to the Russia-Ukraine war may have more impact on food and energy costs than interest rates.
As to the Russia-Ukraine war, a further escalation of this remains a key tail risk and a negotiated solution to the conflict looks increasingly unlikely. While Europe’s ban on importing Russian oil could force a rethink in Moscow, Putin might retaliate by restricting the gas supply to Europe and that would have grave economic consequences for region. Even with this aside, elevated gas prices would suggest that European households will face more expensive utility bills this coming winter.
The question now turns to recession and with global economies slowing rapidly, aggressive tightening by central banks could easily tip them into recession and this is quickly becoming a central case expectation for investment markets.
From an equity point, with rising costs and interest rates, we look to fund managers to invest in companies with low borrowings and the power to pass price rises on. Now of course these company’s shares do not outperform all the time, however their strong compound earnings do produce better returns in the long run. This slowdown in demand and rising costs have put pressure on corporate earnings and most major markets have already experienced double-digit declines in the last eight months, suggesting that this deterioration in earnings is already priced in to where stock markets currently sit.
A look at the various Purchasing Managers’ Index around the globe would support this contraction in economic activity where for the UK, the manufacturing PMI fell again in June, pointing to the slowest growth in factory activity since January 2021, though there was an increase in the service sector, so people are still going out and spending, however, elevated prices filtering through to pubs, restaurants and hotels will ultimately dictate how sustainable this is.
The PMIs for both services and manufacturing in the Eurozone fell in June as they did in the US, Japan and South Korea, although they remain above the 50 mark which, if you recall from previous newsletters, separates growth from contraction.
By contrast, China’s manufacturing PMI moved into growth territory in June, with its fastest pace of expansion in 13 months, with service activity being similarly buoyant, perhaps not too surprising bearing in mind the Chinese government’s zero tolerance towards Covid.
China is responsible for upwards of half of all global growth and their lockdowns have severely impacted the supply chain, creating wide global economic consequences. Despite China being where the outbreak of SARS originated in 2002, they have a lower level of infection induced immunity than other countries affected back then and with a lower vaccine take up, especially amongst the elderly, plus questions over the efficiency of their own vaccines, President Xi’s zero Covid policy would suggest that these lockdowns will continue to occur.
You may have heard that Russia defaulted on its external sovereign debt for the first time in a century, though this wasn’t down to the fact they didn’t have the money, it was the impact of the accumulation of Western sanctions that has shut down payment routes.
Inflation continues to rise, now standing at 9.1 % year-on-year in the UK, currently 8.1 % in the Eurozone, but expected to be 8.6 % for June and 8.6 % in US for May year-on-year, the June figure still to be released. Clearly there needs to be some major turnaround if inflation is going to drop back anywhere near the 2 % mark that central banks believe it will do in two years’ time!
One of the major concerns to inflation remaining high will be wage settlements, as many will be putting pressure on their employers to raise wages in line with the current rate of inflation and this becomes somewhat of a double-edged sword as, whilst it supports household incomes in the face of rising costs, the result could just embed inflation at the higher rate.
Data from Halifax suggests the UK housing market is continuing to cool, with annual price rises at 10.5 % year-on-year. As mentioned last month, this slowing in price rises is likely to continue as the pressure on the cost of living remains.
Most major central banks continue to increase interest rates and whilst the US Fed increased theirs by 0.75 % last month to 1.75 %, the Bank of England only managed 0.25 % leaving the bank base rate at 1.25 %. The response by the Fed was their single most aggressive move to interest rates since 1994, though by contrast some commentators believe the Bank of England’s Monetary Policy Committee (MPC) should have increased rates by 0.50 %, but that level of increase was only supported by three out of the nine MPC members.
At their recent meeting, the European Central Bank (ECB) announced that it intends to increase interest rates by 0.25 % when they meet this month (July), though with inflation still rising this may be amended. The ECB’s current interest rate is still in negative territory at – 0.50 %.
The cost of living crisis and weak consumer confidence has dominated newspaper headlines of late, however the story is not so one-sided as many households accumulated significant savings during the pandemic which have provided a buffer in recent months. Furthermore, the labour market is very strong here with more job vacancies than unemployed people, as it is in several other countries including the US and despite the inflationary pressures of higher earnings, workers are managing to achieve some pay increases, further reducing the squeeze on household incomes.
Looking forward for investment markets, as mentioned earlier, major markets have already experienced double-digit declines in recent months and a number of commentators are suggesting that this does not point to a significant further downside for risk assets.
In summary and as to whether this means we are towards the bottom of the current cycle, well that rather depends on several factors, including whether Moscow has a rethink on what could be a long and costly war and whether Putin retaliates to the embargo on Russian oil, central banks and how they deal with growth over inflation and what China does about its zero Covid policy.