Commentary on July 2022

Market Overview

Global equity markets rallied sharply in June, led by the US where stocks gained 9%. Other major markets recorded gains of 4-5%, while bond markets also rose across the board led by the inflation-linked sector.

The month began on a negative note as US inflation data revealed a further 9.1% surge in the CPI for June, the biggest annual jump since 1981. This fuelled concern that the US Fed would be forced to raise rates more than expected to stamp out inflation, causing a recession in 2023 in the process. The Fed subsequently raised rates by 0.75% for the second month running but this time the accompanying statement was more dovish. Fed Chair Powell described it as an “unusually large” increase, saying that “as the stance of monetary policy tightens further, it will become appropriate to slow the pace of increases”. He refuted the idea that a recession was imminent, citing strength in the labour market with unemployment still at a very low 3.6%. However he also admitted that the need to curb inflation might ultimately lead to a recession, stating, “the path to a soft landing has narrowed” but that failing to restore price stability would be a “bigger mistake”.

Equities staged a sharp turnaround from mid month following the Fed’s less hawkish statement, helped also by better than expected earnings from leading mega cap technology stocks. Alphabet, Microsoft and Texas Instruments posted double-digit revenue growth and expressed optimism about current trading, soothing fears that a strong dollar and weakening economy would hurt growth. On an intra-day basis the tech sector surged 20% and the overall US market recovered 13% from its low. Bond markets also rallied as yields dropped back from recent highs on hopes that the headline rate of inflation may be peaking. The ISM manufacturing survey showed an unexpectedly sharp fall in prices paid as supply chain pressures eased and commodity prices closed below recent highs.

The UK economy continues to face multiple challenges. The surge in living costs are squeezing consumers at a time when credit costs are also rising, while labour unrest and a political vacuum are creating further uncertainty. GDP grew by 0.5% in May, following a decline of 0.2% in April, while headline inflation has yet to peak. Sterling remains close to lows against the Dollar, reflecting concern over the potential for a lengthy period of stagflation. The market is trading at a discount, reflecting these concerns.

The ECB raised rates for the first time in more than a decade by 0.5% to zero, marking the end of negative rates. It also announced a new policy to prevent spreads between bond yields of individual countries widening and deal with the risk of Eurozone fragmentation. The transmission protection instrument (TPI) was immediately dubbed ‘To Protect Italy” and underwhelmed investors with its lack of detail. The situation was not helped by political turmoil in Italy (again). The resignation of Prime Minister Mario Draghi following a confidence vote leaves an autumn election on the cards.

Our Views

2022 remains one of the most unique periods in financial markets. The combination of higher inflation and aggressive monetary tightening has created an environment where there are few safe havens. Bonds have fallen in tandem with equities, as investors have had to deal with the unusual combination of rising rates and falling growth simultaneously. However extended periods of stocks and bonds falling together are rare.

Markets have rallied on hopes that inflation has been defeated and the Fed will start cutting rates in early 2023. The debate is now firmly on the likely extent of a growth slowdown and whether it will result in a soft landing or recession. Recent data points to a slowdown but is not yet weak enough to signal a recession. The earnings season so far paints a similar picture.

The bad news is that Fed is unlikely to relent anytime soon. While inflation will cool, it’s not expected to fall to target levels in the foreseeable future. Bond markets are currently anticipating a peak in interest rates of 3.5% by early 2023 but there are downside risks to this forecast should inflation prove more embedded in the global economy. A key factor will be the future direction of energy prices.

Overall there are reasons for optimism but we remain cautious for now. A relief rally was overdue, as sentiment had fallen to levels not see since the peak of the COVID crisis. A sustainable recovery may require more concrete evidence that inflation is on a downward path.

How are we currently positioned?

Trading activity of late has been higher than usual, as we have taken advantage of the increase in market volatility. Two new positions were added last month following market weakness. However following the subsequent sharp rally we are inclined to raise cash on any further strength in anticipation of a better buying opportunity for equities later this year.

A new position has also been added in the iShares Physical Gold ETC. The gold price has fallen back to test its long-term uptrend line following a strong move up earlier this year, providing an attractive entry point. It should provide valuable diversification in the current environment given the risk of stagflation and on-going geopolitical tensions.