Developed market equities experienced their worst first half of the year in over 50 years, particularly the US, with inflation soaring across the globe. Although all equity markets are in negative territory for the year to date, the UK FTSE 100 Index has been more resilient given its greater exposure to more defensive companies trading on lower valuations and its heavy weighting to energy stocks which rallied, however it lost momentum in June as concerns over the global economy increased significantly. For the month of June, the Chinese equity market delivered its strongest returns in three years as the country lifted its lockdown restrictions, coupled with an improved outlook for China’s economy.
Global government bonds have failed to provide protection this year as a result of higher interest rates and elevated inflation. US Treasury bonds, are considerably more attractive now with 10 year bonds yielding just below 3%, almost double the level of one year ago. The risk of high inflation becoming embedded in the economy and further interest rates hikes mean that yields may have further to rise.
As central banks continue to combat heightened levels of inflation, the impact of higher prices and higher borrowing costs on consumers has increased recession fears. Consumer confidence has fallen to record lows across most developed markets, namely the US, UK and Europe.
The US Federal Reserve has indicated its determination to get inflation under control. US interest rates were increased to 1.75% from 1.00%, the largest rise since 1994 and the Federal Reserve’s projection indicate that rates could increase to 3.80% by next year. The concerns around rising interest rates, persistently high inflation and its impact on the economy has resulted in a sharp fall in US equities and bonds this year.
Higher US interest rates have already started to weigh on US economic activity particularly in the property sector. House prices are significantly higher than at the start of 2020 and 30-year fixed mortgage rates have risen. As such, housing has become less affordable and the number of home sales has declined. It appears unlikely that there will be a repeat of the 2008 housing-led financial crisis as a greater proportion of Americans are on long-term fixed rate mortgages and banks are better capitalised now compared to 2007.
UK inflation continues to rise rapidly and is now the highest among the G7 group of countries. The pound has weakened against the US dollar this year, compounding the rising cost of commodities like oil, metals and imported food. While unemployment is low in the UK, consumers are currently faced with the impact of negative real wage growth, rising mortgage costs, as well as higher food and energy prices. It is uncertain at this stage if the assistance from the Chancellor to households in dealing with higher prices will make a material difference to stretched household budgets. During June, the Bank of England raised interest rates for a fifth time to 1.25% from 1.00% in an attempt to combat inflation however this added to the already heavy burdens on businesses and households.
The reduction in gas supplies from Russia presents a major risk to the European economy, prices have been driven up significantly and there are fears of shortages and rationing by the winter. Concerns over the indebtedness of governments such as Italy have led to an increase in the cost of borrowing compared to core countries like Germany. Historically this divergence has triggered a debt crises which the European Central Bank is attempting to avoid in order to keep the Eurozone together. Markets are expecting interest rates to rise to 3.0% in the UK and 1.6% in Europe by next year.
In China, although the strict lockdowns enforced have disrupted economic activity, including adding to supply chain issues which have been contributing to inflation, the impact of the Omicron variant was mild in terms of the number of patients who developed severe complications. This raises hopes that China may be able to move beyond the harsh restrictions imposed and return to something closer to normal levels of economic activity.
Despite recession fears increasing, equity and bond markets have already priced in a considerable amount of bad news. Most equity market valuations are starting to appear more attractive relative to historical levels, as such, growth in company profits may occur this year and next, albeit by much less than current expectations due to elevated inflation. Markets are however likely to be sensitive to corporate earnings and disappointments against expectations are likely to be treated harshly. A significant risk to markets is if the still relatively expensive US growth stocks continue to see further declines, on earnings reports. Companies with pricing power are likely to remain more resilient however.
|2022 Year to Date|
|FTSE World ex-UK||-11.33%|
|FTSE Actuaries UK Conventional Gilts All Stocks||14.06%|
|FTSE Actuaries UK Index-Linked All Stocks||-22.07%|
Total returns in GBP to 30/06/2022
|Bank of England Base Rate||1.25%|
|Inflation (Retail Price Index/Consumer Price Index)*||11.70%/9.10%|
* May 2022
Source of data: FE Analytics, www.bankofengland.co.uk, www.ons.gov.uk The content contained in this article represents the opinions of MacIntosh & James Partners Ltd. The commentary in no way constitutes a solicitation of investment advice and should not be relied upon in making investment decisions. Past performance is not a reliable indicator of future results. The value of your investments can fall as well as rise and are not guaranteed.