Investment commentary - Third Quarter 2022
Equity markets experienced a volatile ride over the third quarter of 2022. Most markets began the quarter on a positive note with some making notable gains. The situation was soon to reverse however, and over the latter half of the quarter markets generally trended downwards, resulting in the majority of major indices ending the period in negative territory. The US S&P 500 for example got off to a particularly good start and by mid August had notched up gains of over 13%, at which point it began to trend lower and continued to decline for the remainder of the period, ending the quarter with a loss of 5.3%. Similarly, the UK’s FTSE 100 index had gained in excess of 5% by mid August, before it also turned negative and ended the quarter 3.8% lower. European markets also followed a similar trajectory with the pan European STOXX 600 index declining 4.8% over the period.
There were strong headwinds for commodity markets in the third quarter, with a rising dollar and weaker demand sending prices lower. Oil declined over 23% with Brent crude ending the quarter around $87 a barrel. Gold, despite its safe haven qualities, lost 8.2% whilst the overall broad based Bloomberg Commodity index declined 4.8%.
Some of the most dramatic events of the recent quarter were seen in the currency and bond markets, especially in the UK. Over the 3 month period the pound lost over 8% against the dollar, leaving it down by over 17% year to date. Sterling also eased around 2% against both the euro and the Japanese yen. It is worth noting however, that the steep decline against the dollar is not just sterling weakness but also partly attributable to dollar strength. This can be seen when looking at the dollar index, which tracks the dollar against a basket of currencies, as the index gained 6.5% over the quarter leaving it around 17% higher for the year so far.
Inflation remains at elevated levels across much of the world, and far in excess of central bank’s target levels. In the US for example, headline inflation for August came in at 8.3%, although this was down from the peak of 9.1% recorded in June, it remains far in excess of the central bank’s target rate of 2%. In the Eurozone August inflation reached 9.1% against a similar target level. In the UK the inflation number came in at 9.9%, just below the peak of 10.1% reached in June, but again far in excess of the bank’s target rate. Whilst there may be some early indication that inflation levels are easing or at least may have peaked, it is far too early to say with any degree of certainty that this is the case, and moreover inflation still remains at levels likely to impede economic growth and squeeze household budgets.
Having taken what could be described as a relaxed view of the inflation threat throughout much of last year, more recently policy makers have acknowledged that inflation is far from transitory and have become increasingly aggressive in their attempts to curb further upward price pressures. The degree to which they have taken a more hawkish stance and raised interest rates goes a long way in explaining some of the recent moves in the currency markets, as interest rate differentials are a significant influence on exchange rates. The US Federal Reserve has been the most aggressive in this respect. Although it did not commence raising interest rates until March this year when it added 0.25% to its target rate, it has since increased interest rates on a further four occasions, with the last three being in increments of 0.75%. The UK on the other hand began its rate tightening cycle sooner, with the first rate rise of the cycle back in December 2021 and has since increased rates on a further five occasions, however the increments have been smaller with the last two being 0.5%. Although by historic standards this would have been considered a sizeable move, in the current climate it has left the pound in a weaker position, hence the additional pressure that the Bank of England (BoE) now faces to take more aggressive action at its next policy meeting, if not before. The situation was compounded further by the recent mini budget in which the newly appointed chancellor introduced the biggest package of tax cuts in over 50 years. With a lack of detail on how these cuts would be funded markets reacted badly, sending bond yields higher and sterling to fresh lows. In the days that followed the chancellor reversed his decision to abolish the 45p tax rate, and on September 28th the BoE intervened and announced it will purchase up to £65bn in long dated government bonds and roll back its plan to begin running down its balance sheet and selling bonds until the end of October. Markets reacted positively to the news, at the time of writing the pound has regained some of its lost ground and bonds yields have settled back down. How long this effect will last remains to be seen, and markets are likely to remain volatile until further clarification on how the budget cuts will be funded is forthcoming.
Economic growth expectations have clearly declined since the start of the year. In their September update the Organisation for Economic Cooperation and Development (OECD) left their estimate for real global growth in 2022 unchanged from their June projection of 3.0%, but this is still lower than their 3.7% forecast at the start of the year. For 2023 they revised down their estimate to 2.2% from the 2.8% they were forecasting in June. For the UK, they have adjusted their estimate down slightly to 3.4% growth in 2022 and maintained their forecast of zero growth in 2023. It is difficult to draw any solid conclusion from these estimates however, as we are living through a very dynamic era with numerous unpredictable influences at play. Looking at the recently released growth numbers from the Office for National Statistics (ONS) and despite a preliminary estimate of economic growth declining in the 2nd quarter, revised figures showed the UK actually expanded 0.2% quarter on quarter and has not slipped into recession as many economists predicted.
The more forward looking indicators are in the main pointing to a slowing economy. The Purchasing Managers Indices (PMI) for the UK have been trending lower over the last few months with the final reading for the September Composite PMI coming in at 49.1 (below 50 signals contraction). A similar picture can be seen across much of Europe with the September Eurozone Composite PMI at 48.1. In the US PMI survey data has also trended lower over recent months, however the most recent September reading showed a pickup to 49.5 from a low of 44.6 in August.
We noted in our last review that despite what has generally been a negative economic backdrop, we were not seeing any signs of corporate earnings estimates being revised down. The picture has not changed much in this respect, we note some slight downward revision to aggregate earnings for US companies but surprisingly not for the UK as yet. This leaves UK equities looking particularly cheap when compared to their international peers. Again however, it is difficult to draw any solid conclusions from this as estimates can quickly be revised.
What does this mean for investors?
We are currently experiencing higher levels of volatility in markets as central banks battle to rein in inflation which is running far in excess of target levels and beginning to cause economic hardship. Central banks increasing interest rates to curb inflation is nothing new and perfectly normal in a well functioning economy. What has rattled investors this time however, is the pace and severity of the rate increases and uncertainty as to just how far they are prepared to go.
As noted above, for the UK the picture is further complicated by the recent moves from the newly appointed chancellor. Effectively on the one hand the government has just added stimulus to the economy by reducing taxation and providing a fuel price cap and other support packages, whilst on the other hand the BoE is desperately trying to curb consumer demand and bring down inflation.
A weaker pound is not ideal, but it is worth noting that the impact on portfolios will depend greatly on the underlying investments. Where we are invested in UK companies, those with significant import costs in their production run will clearly suffer from higher costs, on the other hand, those companies which receive a large proportion of their revenue stream from overseas sales will benefit.
It is also worth remembering that our portfolios invest globally in a diversified range of equities, bonds and alternative assets, all of which behave differently. For investment in overseas funds and companies which are typically not currency hedged, a fall in sterling will translate into a gain for these holdings when they are valued back in sterling. Obviously, this works in reverse when the pound gains against these currencies.
Investments in corporate and government bonds have looked less attractive in recent times, as the prospect of rising interest rates has sent yields higher and prices lower, rendering them a drag on portfolios. At current levels however, they are once again beginning to look more attractive and as and when interest rates peak, will be a valuable inclusion in a broader portfolio.
In summary, inflation and higher interest rates will impact underlying portfolio holdings in different ways. Attempting to make radical changes to portfolios to capture short term movements requires a level of timing and foresight that is not consistently achievable and exposes portfolios to greater risk by being too overweight or underweight an asset class or region at exactly the wrong time. Therefore, our preferred course of action is to maintain a well diversified portfolio with a sensible medium to long term view and not attempt to react to short term noise.
Neil Jefferies, Head of Adroit Financial Planning