It has been an extraordinary quarter. Inflation remains stubbornly high and central banks are increasing their target interest rates at the rate of knots in the hope that they can get inflation under control. Global economies are slowing down and starting to retract with recession ever more likely, or in the case of the US already here. Apart from labour statistics other macro-economic data points towards anaemic global growth at best, re-enforcing our view that central banks will prioritise controlling inflation above all else.
Governments are keeping the fiscal taps on full flow to alleviate a potential slowing down in the economy, increasing the overall debt burden even further, at a time when the cost of this debt is rising. This increased borrowing has been used to cushion the blow of inflation to the consumer with spending for the short term rather than long term investment, which is inflationary itself. Therefore, fiscal and monetary policy are working in direct opposition to each other, and it is causing increased volatility in markets, with little signs either are working to control inflation and grow the economy.
Is the era of cheap money over?
The rate rises we have seen from central banks have been the largest and fastest in history, and all starting from rates at historical lows. They have been universal across developed economies, apart from Japan. On top of all this rate hiking we have also seen central banks start programmes of quantitative tightening, reducing their balance sheets and selling off government and corporate debt they have built up over 15 years to fight the great financial crisis and more recently the pandemic. The era of cheap easy money would appear to be over and it will have long lasting effects on the economy, with reduced global growth for the foreseeable future.
It is too early to tell if central banks’ actions will have the desired effect on inflation. It remains at very high levels across the globe, although there are signs the rate of increase may have at least plateaued. There is more evidence that these increasing rates are influencing global growth. US Q2 GDP recorded a -0.6% annualised growth rate, which was the second quarter in a row of negative growth meaning the US is in a technical recession. In the UK Q2 GDP was 0.1%, but the market expects that Q3 GDP growth will be negative. Europe is growing still with GDP at 0.8%, driven by good growth in Italy and Spain. However, Germany’s growth was just 0.1% and France’s 0.5%.
Confidence in the UK economy has been ebbing
Special mention must be given to the current chaos that is the UK government. Over the last three months the country has had four chancellors, three prime ministers and rafts of ministerial resignations and sackings. It has had an unfunded fiscal statement and the most chaotic budget process in living memory when a budget was not even due. Markets hate instability and they have reacted in the only way they know, selling sterling assets, as confidence in the UK floods away.
Interest rate expectations have risen faster than other western economies on the back of this, having a real effect on borrowing rates, especially mortgages. The currency has dropped in value with little prospect of a recovery, making imports significantly more expensive and thereby feeding into inflation. All this insecurity has meant that business cannot or will not make decisions to invest in the long term, either postponing plans or shelving them altogether for the foreseeable future. The consequence will be a longer, harder recession in the UK than would otherwise have been, with monetary conditions tighter and inflation lingering for longer. The only saving grace for most investors’ portfolios is that they are global in nature, but those with sterling assets have been hung out to dry.
UK bond market: knock on impact on other asset classes
Gilts last quarter fell over 13.5% and year to date they have fallen nearly 25%. While earlier falls in the year were caused by the rising rate environment, the ferocious downward movement in sterling bond prices in the past quarter has been a direct consequence of the government’s mini-budget, U-turns, deck changing and the markets’ lack of confidence in their financial stewardship.
Meanwhile the riskiness of bonds has soared whilst they have lost their ability to protect clients’ assets. This has had a knock-on effect in other asset classes, in particular commercial property, and real assets. UK Listed commercial property fell nearly 20% over the quarter. These have fallen in price because bond yields have risen, and investors have sold alternative assets to take advantage of higher interest rates. There has been a massive yield substitution effect – again protection has been lacking. These movements have had a disproportionate effect on low-risk portfolios, with lower risk portfolios suffering larger losses than higher risk portfolios. This has been a truly ‘black swan’ event. What may have taken years in terms of rising rates has taken place in a matter of months.
Global equities had a relatively quiet quarter with most markets falling slightly, but with no significant increase in risk. The S&P 500 fell 4.9% in dollars but was up 3.5% in sterling terms as sterling weakened by over 8% against the dollar over the quarter. The UK market fell 3.5%, European markets 2% while Japan was up slightly (+0.5%) in sterling terms.
Global equities gained 2.0% in sterling terms over the quarter. Growth stocks (+3.0%) outperformed value stocks (+0.9%), and the best performing sectors were consumer discretionary (+9.0%) and energy (+7.2%). The equity market is clearly waiting to see what effect rate rises will have on the economy and in particular earnings over the next few months, but they have appeared to have priced in a global recession already, and while volatility remains at elevated levels, this seems to be the best behaving market now.
Overall, our long-term outlook remains unchanged:
- Equilibrium rates will remain lower than they were pre GFC but higher than the previous decade. Real rates will remain negative for a prolonged period of time.
- Inflation is set to become more volatile over the next decade
- We must adjust to permanently lower risk premia. We get paid less for taking on the same risk.
- Monetary policy is now ineffective as a tool to combat future recessions.
- Fiscal policy will have to take up the slack with ever expanding government balance sheets.
- Fiscal policy will remain loose for much longer to combat the effects of the Covid-19 pandemic and sluggish demand.
- Global demand and growth will remain weak while inflation and geo-political risk remain high
- Outlook for fixed income is poor as central banks look to combat inflation with rate rises in the short-term.
- Equities still provide resilience but only those companies with pricing power, strong balance sheets, good cash flows, strong brands and barriers to entry will provide long term value.
Bevan Blair is the Chief Investment Officer of One Four Nine Portfolio Management