Commentary on June 2022
Markets remained volatile in June. The month began with unexpectedly strong US inflation data, which rose to 8.6% in May, scotching hopes that April’s 8.3% rise had marked the peak. Markets reacted negatively, as investors discounted the likelihood that the US Fed would be forced to hike interest rates more aggressively, making an economic soft landing harder to achieve. Sure enough, the Fed responded with a 0.75% hike to 1.75%, stating that being tough now might bring inflation under control sooner and limit the need for more aggressive action in future. It went on to signal a further 0.5% to 0.75% at the next meeting, while reassuring markets that further super-sized moves are likely to be rare.
The inflationary trend was echoed globally, although the response from other central banks has been much more cautious. The Bank of England raised rates a further 0.25% to 1.25%, the fifth such move in a series of small hikes. In Europe, the ECB announced a 0.25% hike, a small but nonetheless significant shift away from its negative interest policy of recent years. Yield spreads between core and peripheral European countries rose sharply as investors started to differentiate between the credit worthiness of Eurozone countries, prompting an emergency meeting by the ECB. The risk of Eurozone fragmentation is back on the agenda after almost a decade since Mario Draghi promised to do ‘whatever it takes’ to ensure the euro’s survival. Elsewhere the Bank of Japan remained a notable exception, choosing to intervene to prevent bond yields from rising above 0.25%. The yen traded at a 24-year low as a result of this policy divergence.
As the month progressed however the narrative changed. Concern switched from inflation to growth after a series of weaker than expected data. Interest rate expectations for 2023 shifted dramatically to pricing in cuts, as the odds of a recession rose. The World Bank slashed its forecast for global economic growth in 2022 from 4.1% to 2.9%. Energy and other commodity prices tumbled accordingly and global equity markets recovered to close the month 1% higher, with a 3% rise in the US (driven by US dollar strength) offsetting small declines elsewhere. Bond markets also closed the month marginally higher. Sterling remained weak, as Boris Johnson was finally forced to resign following the latest in a series of scandals that raised questions about his integrity.
Central banks have been caught napping at the wheel over the past year and are now scrambling to get ‘ahead the curve’ to restore their credibility. Inflation is at 40-year highs across the major nations and the authorities are now faced with the unenviable task of tightening policy into slowing economies. The key question going forward is whether they will be able to bring inflation back under control without causing an economic hard landing in 2023.
After such a sharp sell-off it won’t take much to send asset prices higher again. Sentiment is now extremely oversold. The recent fall in commodity prices should also provide some respite going forward on the inflation front. While the risk of a recession has negative implications for corporate profits, a slowdown in growth will allow investors to look ahead to easier monetary policy in 2023, which should lead to a more positive investment environment.
The sell-off this year has been driven by valuations, as investors have been forced to re-price assets for a higher inflation and interest rate environment. Trends in 2021 have therefore been a mirror image of the preceding decade. Going into 2022 the valuation spread between growth and value had reached historic proportions, with the valuation of FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) commanding a hefty 100% premium over the US market. The good news is that a dramatic fall in the share prices of these stocks has unwound much of this excess, restoring overall US valuations to the middle of their range since 2000.
How are we currently positioned?
Growth stocks are starting to approach reasonable levels. It may be too early to return to this area for now, as central banks are unlikely to ease anytime soon, but we will look for an attractive entry point over the coming months. Our preference for the time being remains with value. The UK is the cheapest market, trading on a price/earnings multiple of 10X compared with 17X for the US. Japan and emerging markets also look good value, trading on 12X and 11X respectively. Exposure to Japan remains hedged to avoid any losses from Yen depreciation.
Portfolios remain underweight bonds, although exposure was increased slightly last month to reflect the return of more attractive yields. On balance we continue to prefer alternative areas where yields are linked to inflation, such as infrastructure, renewables and index-linked bonds. Gravis Digital Infrastructure is a new addition on low to medium risk portfolios that benefits from growing demand for data centres combined with an attractive inflation-linked yield.
Our core view remains that inflation is likely to remain above trend for a lengthy period. We have therefore taken advantage of recent price weakness to increase exposure to commodities on medium to higher risk portfolios, with new positions in Blackrock Natural Resources Growth and Income and Guinness Global Energy. Years of under-investment, exacerbated by product shortages, Russian sanctions and demand from the transition to net zero carbon targets are likely to keep commodity prices elevated for the foreseeable future.