Commentary on August 2022
Markets have remained volatile, with sentiment swinging from doom and gloom to unbridled optimism and back again. The month began with further strong gains, as investors found plenty to celebrate after US inflation decelerated in July by more than expected, reflecting lower energy prices and a stronger US dollar. The CPI rose 8.5% on an annual basis; down from the 9.1% increase recorded in June, raising hopes that the US Fed can ease off the pace of rate hikes enough to avoid an economic hard landing. At the same time profit expectations rebounded from pessimistic forecasts in July following a better that expected second quarter results season. This was highlighted in a trading update from Walmart, where recent trends are ahead of expectations following an earlier profit warning.
The US rallied to recover more than half of its losses since the start of 2022, a milestone that is often seen that a new bull market is underway. Technology shares led the rally, with the Nasdaq recovering 20% from its June low. However the second half of the month saw a sharp reversal of gains as central banks stepped up their anti-inflation rhetoric, signalling that markets have been premature in pricing in rate cuts in 2023. The US Fed moved quickly to dispel any notion of an early ‘pivot’ on interest rate policy, making it clear that it would like to see inflation under control for some time before changing policy even if it will ‘bring some pain to households and businesses’. Global equities closed the month broadly flat in sterling terms, as weakness in the pound mitigated losses overseas, and with gains in Asia and emerging markets offsetting falls in Europe and the UK. Trends in the major bond markets followed a similar pattern.
There are growing signs of a deceleration in global growth as higher interest rates are starting to bite. Rising energy prices, increased mortgage costs, excess retail inventories and a slowing housing market all point to a consumer slowdown ahead. Despite these headwinds, the US economy is proving surprisingly resilient and opinion remains divided on the likelihood of a recession. Slower growth has yet to feed through to employment numbers, where the latest figures show total payrolls at a record high, with companies adding twice as many workers as forecast. Labour market statistics are generally a lagging indicator but nonetheless the current data is impressively strong. Other economies are looking less robust. British consumer price inflation is back in double figures for the first time in 30 years, rising 10.1% year-on-year in July, up from 9.4% in June. The Bank of England raised rates a further 0.5% and issued an extremely downbeat statement, expecting consumer prices to rise to a peak of 13% in Q4 and remain at elevated levels throughout 2023 before falling back to the 2% target in two years time. The economy is expected to enter into a recession by the end of 2022 that could last throughout the following year.
Authorities in China are already in easing mode. The central bank unexpected cut key interest rates for the second time this year in an attempt to revive credit demand and support its flagging economy following repeated Covid lockdowns. This was accompanied by a huge US$146bn fiscal stimulus package focussing on infrastructure spending. Elsewhere, equities in Asia and emerging markets have generally remained relatively resilient. Many of these economies have a long history fighting inflation and were much quicker to raise rates early on and are therefore arguably much closer to an end in the current tightening cycle.
Policymakers are in a difficult position. On the one hand inflation is unacceptably high and with major economies operating at or near full employment following the post-Covid recovery, the risk of it becoming entrenched is rising. However there are emerging signs that inflationary pressures are receding, economies are now slowing and recessionary warning signals are flashing red. A global recession is not yet a foregone conclusion but the odds are increasing.
Under normal circumstances rising inflation does not coincide with recessionary conditions for very long. History suggests that once inflation has peaked equities can rally but that a sustainably recovery is more likely to coincided with a peak in interest rates. Most economists would agree that this is likely to occur soon but the shape and extent of any subsequent decline remains unclear. It may therefore be premature to say that equities are out of the woods until the Fed itself to calls for a victory.
Against this background markets are likely to remain volatile over the coming months until there are concrete signs that inflation is abating and the extent of any slowdown in growth and earnings becomes clear. Arguably a mild recession has already been discounted with lower prices and the underperformance of more cyclical sectors. Many shares have fallen significantly and while growth stocks remain historically expensive, other areas of the market offer strong value. Once the outlook clears a good opportunity to reinvest cash should emerge.
How are we currently positioned?
Diversification for different outcomes is essential in the current environment, with risks finely balanced between high inflation and weaker growth. It is important therefore to structure portfolios to reflect either outcome (or both).
The recent sharp recovery took markets back into overbought territory. We used this strength to cut cyclical exposure in anticipation of slowing growth through the sale of Artemis UK Select in favour of cash. Overall equity exposure is focussed on relatively defensive areas such income funds that own companies with strong cash flow and resilient balance sheets. There is much to be said for the steady accumulation of dividends during periods of uncertainty.
We have also sought where possible to mitigate the impact of inflation. In practice this means owning index-linked bonds (TIPS) and other inflation-linked areas such as infrastructure and renewables along with real assets such as gold bullion and precious metal and commodity stocks. The backdrop to the rise in commodity prices has been a major period of under-investment over the past decade, particularly in oil and gas, where new investment has focussed on renewable energy. An increase in post pandemic demand has been met with capacity constraints, suggesting that prices may remain elevated for a considerable period, as supply will be slow to adjust.