The first half of the year delivered a number of shocks to the financial markets and the global economy. War in Europe, a significant rise in global inflation rates and a roundabout turn in the language used by the central banks about monetary policy tightening… not to mention the continuing effects of Covid.
The results are no secret: rising energy and food costs, combined with supply chain bottlenecks, which have hit consumer confidence hard and reduced household spending. This unparalleled purchasing power squeeze, catalysed by surging inflation, has rapidly reduced people’s saving rates and even depleted any savings that they may have managed to accumulate during the pandemic.
Over the first six months of this year, investor sentiment and positioning – along with market internals – led us into extremely bearish territory. Indeed, it was the worst start of the year for global stock markets in over 50 years. Between January and June, some £10 trillion were wiped off the value of global stock markets. Meanwhile, benchmarks across the world tumbled.
Global economic activity has slowed sharply, leading many of the larger financial institutions to revise their gross domestic product forecasts downwards. And yet… many still believe that the global economy will avoid true recession this year. It goes without saying, however, that the outcome is likely to be very different for a number of individual domestic economies.
Although rising inflation is something of a problem for the central banks (caught, as they are, between a rock and a hard place), questions remain over the path ahead for them. Should they raise interest rates aggressively over the coming months, almost certainly triggering a recession? Or should they allow inflation to peak once supply chain bottlenecks are less of an issue, leaving inflation to eventually die of natural causes?
Central banks around the world have been raising interest rates and implementing a range of other measures in a bid to curb inflation, but policymakers have been moving in different ways.
Latin America and Eastern Europe began raising rates last year in a bid to get ahead of the curve. Consequently, these regions will likely see their current tightening cycles peak later this year before starting to ease next year.
The US and other developed markets have only recently started to implement rate tightening policies. They are now facing a trade-off between high inflation and slowing growth.
While the European Central Bank has been pondering its position on quantitative easing (purchasing bonds to keep credit flowing), it may need to concede and raise interest rates now that inflation across the EU now stands at well above 8%.
In Asia, the central banks are normalising policy... but not necessarily in sync with one another. The Reserve Bank of India surprised the market with a hike in early May. In Japan, meanwhile, some economists are advocating keeping rates at current levels, but while the Bank of Japan is maintaining an ultra-low-interest rate policy, they are keeping a close eye on the yen’s recent sharp decline and monitoring the consequences on their economy.
Unquestionably, the downside risks are still outweighing the upside potential. Inflation remains stubbornly high, central bank policy is mixed, supply bottlenecks remain, Covid cases are on the rise in Europe and the outcome of the Russia-Ukraine conflict remains uncertain – all factors which are depressing economic backdrop and impacting investor sentiment.
Added to that heady mix of uncertainty is Boris Johnson’s resignation as Conservative Party leader and the turmoil in which the government now finds itself. Many commentators view this as the right decision in the wake of so many high-profile resignations.
Speaking from Downing Street, he thanked the millions who voted Conservative at the last election before lamenting that “[…]no one in politics is remotely indispensable”. We are now bracing ourselves for the third Conservative Party leadership contest in six years. On the back of these developments, however, our blue-chip index, the FTSE 100, gained ground while sterling strengthened a tad against the US dollar.
Even in the midst of these difficult and extraordinary times, there are some bright spots on which we should focus. Asia, for example (with the exclusion of China), is likely to deliver far superior GDP growth rates than the developed world. Furthermore, Japanese equities continue to be a notable outlier: valuations are low, return on equity is approaching a 40-year high, and corporate earnings have been boosted by the Japanese yen’s current weakness.
Other asset classes of interest include commodities – despite the extremely nasty correction they suffered in June. Supply shocks and the war in Ukraine will likely trigger further price rises in energy-related commodities: some large institutional houses are predicting crude oil prices to rise to between US$130 and US$140 a barrel over the next couple of quarters.
Otherwise, there are sectors such as global real estate which offer investors a true alternative to the traditional asset classes of equities and bonds. Equally, this option gives investors the opportunity to have some exposure to more resilient market areas, such as self-storage, student housing and servicing the requirements of an ageing population. And in times such as these when inflation and interest rates are rising, businesses with pricing power can be an effective hedge, and global real estate can also provide this.
In the wake of such a pullback in global equity valuations, the biggest risk now seems to be disappointing corporate earnings. We will be watching those very carefully, but if central banks do succeed in reining in the current surge in inflation by damping down demand, then they might be able to consider cutting interest rates in 2023.
We believe this will create a much better outlook and backdrop for global equity and bond markets. It has been a difficult year for global investors… as well as for us as financial planners and wealth managers. But at times such as these, it is worth listening to American billionaire investor and businessman Charlie Munger: “It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that”.
As long-term investors, we are very much about deferred gratification.
