Central banks caught napping now face the hardest of balancing acts
Markets remained volatile in June. The month began with unexpectedly strong US inflation data, which rose to 8.6% in May, scotching hopes that April's 8.3% reading had marked the peak. As the month progressed, however, the narrative changed. Concern switched from inflation to growth after a series of weaker than expected data, and interest rate expectations for 2023 shifted dramatically to pricing in cuts as the odds of a recession rose.
The Fed responds with its biggest hike in decades
Markets reacted negatively to the May inflation print, as investors discounted the likelihood that the US Fed would be forced to hike interest rates more aggressively, making an economic soft landing harder to achieve. Sure enough, the Fed responded with a 0.75% hike to 1.75%, stating that being tough now might bring inflation under control sooner and limit the need for more aggressive action in the future. It went on to signal a further 0.5% to 0.75% at the next meeting, while reassuring markets that further super-sized moves are likely to be rare.
The inflationary trend was echoed globally, although the response from other central banks has been much more cautious. The Bank of England raised rates a further 0.25% to 1.25%, the fifth such move in a series of small hikes. In Europe, the ECB announced a 0.25% hike, a small but nonetheless significant shift away from its negative interest rate policy of recent years. Yield spreads between core and peripheral European countries rose sharply as investors started to differentiate between the credit worthiness of Eurozone countries, prompting an emergency meeting by the ECB. The risk of Eurozone fragmentation returned to the agenda after almost a decade since Mario Draghi promised to do "whatever it takes" to ensure the euro's survival.
Elsewhere, the Bank of Japan remained a notable exception, choosing to intervene to prevent bond yields from rising above 0.25%. The yen traded at a 24-year low as a result of this policy divergence.
Growth concerns replace inflation as the primary worry
As the month progressed, concern switched from inflation to growth after a series of weaker than expected data. Interest rate expectations for 2023 shifted dramatically to pricing in cuts, as the odds of a recession rose. The World Bank slashed its forecast for global economic growth in 2022 from 4.1% to 2.9%. Energy and other commodity prices tumbled accordingly.
Global equity markets recovered to close the month 1% higher, with a 3% rise in the US, driven by US dollar strength, offsetting small declines elsewhere. Bond markets also closed the month marginally higher. Sterling remained weak, as Boris Johnson was finally forced to resign following the latest in a series of scandals that raised questions about his integrity.
A note from the desk
I am pleased to share our monthly update on market events. The overview seeks to summarise market movements together with our views and the rationale for the positioning of investments going forward. As always, should any aspect of this commentary prompt a question, we would welcome the conversation.
Martyn Charlwood · Managing Director
After such a sharp sell-off, it may not take much to turn the tide
Central banks have been caught napping at the wheel over the past year and are now scrambling to get ahead of the curve to restore their credibility. Inflation is at 40-year highs across the major nations, and the authorities are now faced with the unenviable task of tightening policy into slowing economies. The key question going forward is whether they will be able to bring inflation back under control without causing an economic hard landing in 2023.
After such a sharp sell-off, it will not take much to send asset prices higher again. Sentiment is now extremely oversold. The recent fall in commodity prices should also provide some respite on the inflation front. While the risk of a recession has negative implications for corporate profits, a slowdown in growth will allow investors to look ahead to easier monetary policy in 2023, which should lead to a more positive investment environment.
The sell-off this year has been driven by valuations, as investors have been forced to re-price assets for a higher inflation and interest rate environment. Trends in 2022 have therefore been a mirror image of the preceding decade. Going into 2022, the valuation spread between growth and value had reached historic proportions, with the valuation of FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) commanding a hefty 100% premium over the US market. The good news is that a dramatic fall in the share prices of these stocks has unwound much of this excess, restoring overall US valuations to the middle of their range since 2000.
Sentiment is now extremely oversold, and the recent fall in commodity prices should provide some respite on the inflation front.
Growth stocks are starting to approach reasonable levels. It may be too early to return to this area for now, as central banks are unlikely to ease anytime soon, but we will look for an attractive entry point over the coming months. Our preference for the time being remains with value. The UK is the cheapest market, trading on a price-to-earnings multiple of 10x compared with 17x for the US. Japan and emerging markets also look good value, trading on 12x and 11x respectively. Our exposure to Japan remains hedged to avoid any losses from yen depreciation.
Our core view remains that inflation is likely to remain above trend for a lengthy period. Portfolios are positioned accordingly, with an emphasis on value regions, inflation-linked alternatives and commodities.
Value regions over expensive growth
On a global basis our standard portfolios remain overweight the UK, Japan and emerging markets, where valuations look much more appealing. The UK is the cheapest market at 10x earnings, compared with 17x for the US. Exposure to Japan remains hedged to avoid losses from yen depreciation.
Selective bond exposure at improved yields
Portfolios remain underweight bonds, although exposure was increased slightly to reflect the return of more attractive yields. On balance we continue to prefer alternative areas where yields are linked to inflation, such as infrastructure, renewables and index-linked bonds.
Infrastructure and inflation-linked income
Gravis Digital Infrastructure is a new addition on low to medium risk portfolios, benefiting from growing demand for data centres combined with an attractive inflation-linked yield. These alternative holdings complement traditional bonds and equities and help hedge against persistently high inflation.
Increased commodity exposure
We have taken advantage of recent price weakness to increase exposure to commodities on medium to higher risk portfolios, with new positions in BlackRock Natural Resources Growth and Income and Guinness Global Energy. Years of under-investment, exacerbated by product shortages, Russian sanctions and demand from the transition to net zero carbon targets, are likely to keep commodity prices elevated for the foreseeable future.
Important information
This article is a marketing communication intended for general information only. It does not constitute personal advice, a recommendation, or an offer to buy or sell any investment. If you are unsure whether an investment is suitable for your circumstances, please seek personal advice.
Past performance is not a guide to future performance. The value of investments and any income from them can fall as well as rise. Capital values are at risk and not guaranteed. Forecasts and views expressed in this commentary represent our assessment at the time of writing and are subject to change.
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