After a strong rebound in July, markets pulled back again in August as central banks reinforced their commitment to bring inflation under control. The prospect of further interest rates in the US unsettled developed equity and bond markets. Slowing global growth combined with heightened levels of uncertainty surrounding the outlook for the global economy caused developed equity markets to fall, notably the US and Europe, while Japan proved relatively stronger. Emerging market equities broadly outperformed as better economic momentum in many markets including India offset the difficulties in China.
Within bond markets, rising yields resulted in negative returns from all fixed income sectors in August, however, emerging market bonds and European high yield bonds outperformed.
In the US, there have been signs that inflation may have peaked as CPI declined to 8.5% year on year in July, from 9.1% year on year in June. However, this remains well above the Federal Reserve Bank’s target rate of 2.0% and in combination with strong wage growth, markets are now expecting an interest rate increase of 0.75% in September, the current interest rate being 2.50%. This has contributed to the strength of the US dollar but weighed on equity and bond market returns. Tighter monetary conditions are being reflected in the real estate sector where house sales have declined, however on a more positive note, retail sales and industrial production remained resilient.
Much of the uncertainty around the global economic outlook relates to Europe, where a recession seems increasingly likely this winter as the energy crisis continues to intensify with no resolution to the war in Ukraine. Gas prices reached a record high in August due to the reduction in gas supplies from Russia which has since escalated with the indefinite suspension of gas supplies through the Nord Stream 1 pipeline.
The European economy proved relatively resilient in the first half of the year due to the fiscal measures deployed since the start of the war in Ukraine. Countries such as Spain, Italy and France have benefited from the rebound in the services sector after COVID, however the German economy, which is the most dependent on Russian gas imports, has been significantly weaker and producer prices have increased sharply. The outlook appears challenging given the logistic disruptions caused by droughts and heatwaves in both Germany and China.
The UK equity market lost ground in August, UK gilts underperformed developed market peers and sterling weakened against the US dollar. The Bank of England raised interest rates by 0.5% to 1.75% at the beginning of August and warned of further interest rate hikes to contain inflation, which is currently at its highest level in 40 years and is expected to rise to 13% within the next few months. Despite the expectation of recession from the fourth quarter, monetary policy tightening will continue until longer term inflation expectations are more in line with the 2% target rate. Based on the Monetary Policy Committee’s baseline projections, UK interest rates are forecast to peak at 3.0% in quarter 3 2023, thereafter rates will be reduced to 2.5% in 2024 and 2.2% in 2025. This is of course a forecast and market expectations are for the peak in rates to be nearer to 4% in 2023 fuelled by persistent increases in forecast inflation and soaring energy prices.
The newly appointed UK Prime Minister, Liz Truss, replaced Boris Johnson on 5 September. She is now confronted with various challenges including elevated inflation, a looming recession, labour unrest and possible energy shortages this winter. Her plans to deal with the current cost of living crisis and stimulate UK growth will be announced at the end of September and are likely to include tax cuts, an energy relief package, funding of renewable energy projects and the prospect of increased borrowing.
Chinese equities came under pressure in August. The local economy continued to struggle due to weakness in the housing market and the services sector lost momentum including retail sales. The significance of climate change on economic conditions has also been evident, with extreme heat and severe drought disrupting energy and water supplies and leading to reduced power being supplied to factories and homes as well as plant shutdowns. From a monetary policy perspective, support provided in recent months to encourage credit growth and infrastructure investment spending saw growth in social financing and fixed investment below expectations. Further support was provided in August including an additional interest rate cut.
The global outlook has deteriorated and some major economies are expected to fall into recession, including the UK and Europe. While further economic and market volatility is likely in the coming months, much of the bad news including higher interest rates and recession appears to be largely priced in to markets. Persistent inflation suggests further aggressive monetary policy tightening is necessary and this has been the message from central banks. While investors are starting to come to terms with ‘higher-for-longer’ interest rates, the impact of this scenario on growth may force central banks to reverse course in 2024 or sooner.
|2022 Year to Date|
|FTSE World ex-UK||-4.12%|
|FTSE Actuaries UK Conventional Gilts All Stocks||-18.55%|
|FTSE Actuaries UK Index-Linked All Stocks||-23.94%|
Total returns in GBP to 31/08/2022
|Bank of England Base Rate||1.75%|
|Inflation (Retail Price Index/Consumer Price Index)*||12.30%/10.10%|
* July 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.