A tale of turbulence: Q2’2022 Global Markets Review

It’s Been Bad Out There

Once again, it’s been a quarter to test the mettle of investors. We knew that, after two years of the COVID-19 chaos, 2022 would be a bumpy ride, but there is no sugar coating it – this was the most turbulent first half global markets have ever seen.

To grasp just how torrid things have been, consider two things: MSCI’s 47-country world stocks index has suffered its biggest H1 drop since its creation while the S&P 500 has just had its 4^th worst H1 performance since its creation. At same time, 10-year U.S. Treasury bonds – the benchmark of global borrowing markets and traditional go-to asset in troubled times – have had their worst first half since 1788. Why? Russia’s invasion of Ukraine supercharged what was already fast-rising inflation, forcing the big central banks to jack up interest rates and politicians to warn of new world orders. The result? A $13 trillion wipe-out in world stocks, a 15.5% plunge of the Japanese yen, Italy’s worst rout since the euro zone crisis, and what is shaping up to be the strongest commodities rally since World War I. Add to that Russia being gouged out the global financial system, its sovereign credit rating downgrade (the biggest ever seen), widespread crypto and big-tech carnage, and worsening recession jitters.

In the United States, all eyes are on the mandated guardian of stable prices and full employment, the Federal Reserve, to see how it grapples with inflation. From our perch, the signs are not encouraging. The Fed is late at addressing the problem. Furthermore, it only recently started to shrink the mammoth balance sheet created by its money printing of the last 3.5 years. With the 75-basis-point hike in rates in June, does one get a sense of urgency on the part of central bankers? Compare the shuffling and ponderous approach of the Bank to the galloping inflation of the last year, and picture forms of bankers fiddling while money burns. Worryingly, the tools commonly used to control inflation have the unfortunate side effect of slowing economic growth, leading to a potential recession as monetary policy makers act aggressively to curb rising prices. 

Money and credit are the lifeblood of commerce. When scarce, growth is stunted. When abundant, growth follows but is often accompanied by misguided investment and, in some unfortunate instances, inflation. Sadly, the latter occurred over the last several years. The magnitude of distortions now in play is particularly problematic for central bankers and investors.

The challenge facing the Fed is immense. Scaling the size of the US stock market to the size of the economy in which it operates reveals an enormous break between the size of the equity market and the size of the economy. The S&P 500 Index market capitalization stood at nearly 160% of GDP at the end of Q1, and is now at roughly 130%. The average since September of 1989 is 84.5%. Similarly, scaling corporate profits to GDP reveals the potential for another reset. At nearly 12% of GDP, corporate profits are almost 20% higher than the long-term average of 10%. The corporate sector, despite enormous strides in capital and operating efficiency, has never durably operated above 11% of GDP.

Eurozone

The clouds around the eurozone continue to darken. The Russia/Ukraine war shows no sign of resolution, inflation pressures are increasing, the European Central Bank (ECB) has turned hawkish and peripheral risk is back in focus as Italian bond spreads widen.

The most significant risk is that Russia responds to the European Union’s embargo of Russian oil exports by cutting off gas supplies to Europe, something they have flirted with over the last few months. Europe’s heavy dependence on Russian gas means that retaliation and a large rise in gas prices would almost certainly send the region into recession.

The ECB has recently turned hawkish, signalling a 25-basis point rate rise is likely at its July meeting and that it is winding down its quantitative easing programs. Futures markets currently expect the ECB’s policy rate to rise from -0.5% currently to 2.0% by the end of 2023. Headline inflation in the Eurozone reached 8.1% in May 2022, in line with the U.S. and the UK. However, core inflation (which excludes food and energy prices) is more subdued at 3.8% compared to around 6% in the U.S. and UK. This should allow the ECB to tighten policy by less than the Fed or Bank of England (BoE).

The ECB’s other issue is the return of Italian debt risk with the spread between Italian and German government bonds widening sharply over the past two months. This threat prompted an emergency ECB board meeting to emphasise that the central bank would increase purchases of Italian bonds, if required, to counter fragmentation in the transmission of ECB policy across the eurozone. The ECB meeting sent Italian spreads lower by 40 bps, but the episode serves as a reminder of the fragility within the Eurozone when growth slows and solvency comes under question.

Provided energy prices remain subdued and a recession is avoided, European economies have the potential to maintain trend-like economic growth. This outlook should allow the MSCI EMU Index, which reflects the European Economic and Monetary Union, to recover. Europe’s exposure to financials and cyclically sensitive sectors such as industrials, materials and energy, and relatively small exposure to technology, should be an advantage as economic activity picks up and geopolitical risks subside.

Asia

The Japanese economy continues to face the challenge of higher energy and food prices, which have been exacerbated by the significant depreciation in the Japanese yen. This decline in the yen should improve the export-oriented parts of the economy through the second half of the year, although the positive impact on exports has been waning over time due to structural shifts in the Japanese economy.

Prime Minister Fumio Kishida recently announced his Grand Design economic plan, which will focus on raising wages and financing innovation in the economy. We will closely watch these announcements after the upper house election in July. Meanwhile, The Bank of Japan continues to stand out from other central banks (except for the People’s Bank of China) in maintaining very accommodative policy. We think the Bank of Japan will be slow to raise interest rates, given core inflation is still only around 1%. With this dynamic, and the potential for stubbornly high energy prices for longer, the yen is likely to struggle despite attractive valuation.

The recent lockdowns in China have seen economic activity slow significantly through the second quarter, but we are now seeing early signs of tentative reopening. The low level of vaccination among the elderly in China means the risk of further lockdowns will continue until either vaccination rates increase or COVID-19 treatment production reaches critical mass.

Our expectations for more monetary and fiscal easing have started to be met, with the People’s Bank of China cutting interest rates and the government announcing more infrastructure spending. We expect more fiscal stimulus, most likely in the form of consumption vouchers. Further easing measures should help the under-stress property market stabilise in the second half of the year.

Finally, and importantly for emerging market equities, is the outlook for Chinese regulation on technology companies. The government has announced intentions to reduce the uncertainty around regulation, which would be a net positive.

Fixed Income

When the stock market has periods of corrections, investors have typically looked to bonds as a source of relief from volatile stock price declines.  This year that has not been the case as US treasuries have lost more than 13% in H1, the most since the U.S. constitution was ratified in 1788, according to Deutsche Bank; Italy’s bonds have haemorrhaged 25% in preparation for the European Central Bank’s first rate hike in over a decade; and emerging-market debt is down nearly 20%.

“Government bonds are not expected to lose over 10% in six months,” JPMorgan Asset Management global strategist Hugh Gimber said. “This is unfamiliar territory for most investors. Central banks have seen markets come under pressure and haven’t reacted. That is what is different.”

The drama kicked in as soon it became clear that the world’s most influential central bank, the U.S. Federal Reserve, was serious about raising interest rates at its fastest pace since 1994 to combat inflation which has clearly not been a transitory one. Those 10-year Treasury yields that drive world borrowing costs leapt from less than 1.5% at the beginning of the year to 3.1%, knocking 20% off MSCI’s world stocks index in the first half of the year alone.

Commodities

The S&P GSCI Index which serves as a benchmark for investment in the commodity markets achieved a positive return in Q2 as higher energy prices offset sharp price falls in the other components of the index. Energy was the best performing component amid rising demand and supply constraints due to the ongoing conflict in Ukraine.

Industrial metals was the worst performing component, with sharp falls in the price of aluminium, nickel and zinc. Copper and lead prices were also significantly lower in the quarter with majority of that pull back coming in June – a reminder of how volatile commodities can be as the possibility of a recession looms larger. Within the agriculture component, prices for wheat, corn and cotton were all lower. In precious metals, the price of silver was significantly lower in the quarter, while the decline in the price of gold was less pronounced.

Looking Forward to H2

There has been nowhere to hide for investors this year, with global equities in a bear market and bond yields rising. Our long term investment decision-making process, however, cautions against becoming too pessimistic. Sentiment is currently at levels last reached during the depths of the COVID-19 market panic of March 2020.

Equity valuation is harder to benchmark, given uncertainties around mean reversion for price-to-earnings (PE) multiples and profit margins. Technology companies have maintained higher margins than traditional firms and now constitute a large proportion of the U.S. indices. The 1-year forward PE multiple for the S&P 500 is now around 16 times, down from 21 times at the beginning of the year. The median multiple since 1990 is 15.4 times. This makes it difficult to gauge if U.S. equities are currently at sufficient prices for an outright V-Shaped recovery, although value has clearly improved. The challenge comes from uncertainty around the cycle outlook. Aggressive central bank tightening and the threat of higher energy prices from the Russia/Ukraine war make a U.S. recession in 2023 possible.

The bullish argument is that U.S. core inflation seems to be peaking. This, combined with some softening in the labour market and stability in energy prices, could allow the Fed to become less hawkish in the second half of 2022. Lower inflation will boost real incomes and could trigger a renewed upswing in equity markets. Deeply oversold sentiment combined with peak market expectations for Fed hawkishness could be the catalyst for an equity market rebound. This is an appealing scenario but an unlikely one that may take some time to occur with central banks still aggressively raising interest rates.

 The U.S. dollar (USD) has made strong gains this year. It has benefited from Fed hawkishness and its safe-haven appeal during times of market volatility. The euro, yen and British sterling are now significantly under-valued on a longer-term basis. The argument for USD weakness in the second half of the year is similar to the rationale for becoming bullish on equities and bonds: inflation pressures subside, and the Fed becomes less hawkish. Dollar weakness should support the performance of non-U.S. markets, particularly emerging markets.

In our previous outlook, we emphasised the importance of economic and asset class fundamentals evidenced in hard data for our portfolio positioning. We continue to endorse this approach, but acknowledge that the current environment is a delicate balancing act that calls for focus on inflation protection while scaling back on cyclical exposures and firming up our defensive positions. The second half of this year has the potential to test resolve. Policy uncertainty that US mid-term elections bring; central banks that appear not to have the confidence of markets; and the vicissitudes of war, pandemic, and inflation combine to create a climate perfect for continued turmoil across markets and roil within them. While the economy battles inflation, de-globalization unfolds, war is waged, and political winds swirl, it seems clear most of the first half’s significant headwinds are still in place. This mix of measured optimism and elevated risks was the backdrop to informing our asset allocation and portfolio construction during the quarter and will continue to address how best to position our portfolio for the next six months and beyond. That’s the critical task in an environment where the noise has only grown louder, certain signals look less favourable and financial markets have doubled down on volatility.

Lastly, though we are long-term investors, we recognize that trading this volatility is devilishly difficult and requires agility to quick & seamlessly recalibrate our views as and when the fundamentals change. That’s why our portfolio construction themes re-emphasis on the need to search for value in diversified asset classes where we expect our clients to be adequately compensated for the risks taken. This is the essence of our overall approach to pursuing successful outcomes in turbulent times — and all the time.