Market Review and Outlook

The first six months of 2022 have all been about the macro backdrop (war, inflation, and central  bank policy on interest rates). There has been a regime shift in the economic environment we experienced for most of the last decade to where we are now – notably on the inflationary backdrop and the corresponding effect on central bank policy. This has had a significant impact on all asset classes this year, described in more detail

Global equities have seen some of their sharpest falls since the pandemic-induced sell-off of 2020, falling 20% in the first six months of the year, in US dollar terms.

There has, however, been differentiation in performance across geographies. The US market led the falls, down some 20%, whilst the often unloved UK market weathered the storm well, broadly flat for the year. Reasons for this are:

• Valuations were not as rich in the UK coming into this year, so were less sensitive to an increase in interest rates/central bank (monetary) tightening.
• US dollar strength – the pound has weakened some 8% against the dollar, helping boost UK-listed companies with overseas earnings, as well as sterling-denominated overseas assets in portfolios.
• Commodity exposure in the FTSE 100 has been a positive contributor.

The equity growth style has come under extreme pressure, led by unprofitable technology, falling 28% this year, as central banks have looked to combat rising inflation by increasing interest rates, which tends to have a particularly negative effect on growth stocks.

The energy sector is the only major industry which has seen positive movements this year. The sector has increased almost 30%, as oil and gas prices have remained elevated following the Russian invasion of Ukraine.

Fixed income, which often provides some protection when equity markets run into trouble, has also had a poor start to the year, with the global bond market falling 10% year to date.

Bond yields, which began the year at record lows, have been pushed higher as inflation has caused central banks to reverse their quantitative easing programmes and increase interest rates (the price of bonds falls when their yields rise).

Default rates remain relatively low amongst investment grade and high-yield debt, however the uncertain outlook for the global economy may increase default rates, which has led to spreads (the difference in yield on US Treasury bonds, relative to corporate bonds) to widen – negatively affecting the price of corporate bonds.

Commodities had a strong start to the year, which has fuelled inflation. In June, however, there was a significant retracement, as fears turned to recession and a demand shock for commodities.

The oil price has risen by over 40% year to date, as the war in Ukraine has caused many countries to boycott the purchasing of oil from Russia – one of the world’s largest oil producers. However, even before the war there were upside pressures on oil.

OPEC, a group of countries which control most of the supply of global oil, has not bowed to pressures from the US to rapidly increase oil production, while years of underinvestment has left countries like the UK and the US struggling to cover the shortfall.

Gold prices have remained stubbornly flat for the year in the face of higher inflation and macroeconomic uncertainty, largely due to rising bond yields offsetting the inflation and geopolitical tailwinds.

The US dollar has had one of its strongest starts to the year for some time – driven by investor desire for safe haven assets (in the face of geopolitical tensions and increased recession risk), but more so due to the growing policy divergence between the US and other developed nations’ policy on rates, with the Federal Reserve being more willing (finally) and (importantly) able to raise rates aggressively to fight inflation.

The Japanese yen has dropped to levels not seen since the early days of the Asian financial crisis, as the Bank of Japan continues its accommodative monetary policy, in stark contrast to most other central banks.

The pound and the euro remained relatively volatile over the period, as both have had their fair share of political and geopolitical risks to contend with. Both have fallen by around 10% against the US dollar.

Cryptocurrencies have failed to live up to their ‘digital gold’ tag with Bitcoin falling almost 50% this year.

This fall has been mirrored by the broader crypto market which has fallen as much as 60%. This fall in cryptocurrencies has been further exacerbated by the rolling back of central banks’ loose monetary policy, which had helped to propel speculative assets, such as cryptocurrencies, to stratospheric levels.

Cryptocurrency exchanges have also come under pressure with Coinbase joining other major exchanges in aggressively cutting their workforce, as trading activity has cooled.

Hedge fund returns have remained relatively volatile across this six-month period and returns have differentiated significantly across investment approaches.

Hedge funds whose strategy focuses on the equity market have had one of their worst starts to a year, while macro strategies which aim to capitalise on movements in interest rates and currencies have performed considerably better.

As has been seen in public markets, there has also been a pullback in listed private equity markets. Discounts (share prices relative to net asset value) have widened to levels almost comparable to other notable market shocks, such as the pandemic.

Deals within private equity have also decreased – admittedly from a high level – as managers take a more conservative approach and financing costs increase.

Key will be the valuation updates at the mid-year point to gauge whether the severity of the sell-off in listed PE has been justified by lower net asset valuations. Early indications suggest the selling may be overdone.

Our current cautious stance is reflected in our discretionary portfolio positioning. However, rather than reduce equity allocations further (after such a big fall), we have moved our risk exposure further into defensive equity styles of quality and low volatility.

We have also reduced our exposure to smaller companies, which typically fare poorly in periods of economic slowdown or recession. Furthermore, we have increased our exposure to Japanese equities, at the expense of European stocks. A net benefit here is gaining more Japanese yen exposure, which is looking very cheap and historically a good haven exposure to hold. Should we get a bounce in equity markets over the summer, but no real change in the economic backdrop, it is possible that we would lighten our risk allocations below neutral – we will consider that when the time comes.

We are maintaining our overweight exposure to real assets – commodities, infrastructure, property and gold – as we do expect inflation to be persistently higher over the medium term, albeit come off its high in the short term. These assets have historically acted as good inflation hedges over the medium term.

For portfolios that hold a portion of defensive assets, we have slowly been increasing our fixed income allocations back to neutral weighting, as yields have risen. Despite being at our maximum underweight at the beginning of the year, US Treasuries (government bonds) hitting 3.5% and yield spreads widening on credit was a catalyst for a move back to neutral.

Clearly, the short-term picture is unsettling for investors. And whilst we have a cautious tone to this note, it is often during the difficult periods, when the backdrop feels very uncertain and uncomfortable, that superior long-term returns emerge – rather than during times when all appears calm.

Finally, on inflation – we can look back to a few inflationary periods in the past 50 years, none more pronounced than the 1970s – holding a diversified blend of equities, bonds and real assets served investors well in providing inflation-beating returns over the long term. But it certainly wasn’t smooth sailing year-on-year.