The good news
Global equity markets enjoyed a powerful rebound in July after a miserable first half of the year. In fact, it was the best month the markets had recorded since late 2020. The S&P 500 gained 9.2%, and the UK's FTSE All-Share was up by 4.4%.
As far as bonds are concerned, the US High-Yield saw the best performance – it was up 6%. The UK Fixed Interest market, meanwhile, gained 2.8%. There was other good news with style returns: growth, value, commodities and global aggregate are all up.
And yet… July saw the release of a variety of data that provided incontrovertible proof that the global economy is in fact slowing. With very few exceptions, we remain in negative territory for global equity markets year-to-date.
Reaction to rising inflation
The world is now reacting to rising inflation: the European Central Bank, for example, has hiked interest rates for the first time in over a decade. And it has announced a new strategy – the Transmission Protection Instrument (or TPI). It is designed to prevent fragmentation as the ECB tightens monetary policy – it can purchase specific securities to counter unwarranted market dynamics. But the ECB has yet to set the criteria for activating the strategy. The collapse of Mario Draghi's government in Italy may prove a worthy test for it – the announcement of his resignation has triggered significant volatility in the Italian bond market.
Thursday saw the Bank of England raise interest rates to 1.75%. This was the sixth consecutive raise, marking the first half-point hike since the Bank of England was granted operational independence over monetary policy in 1997.
The Bank expects headline inflation to peak at 13.3% in October and to remain elevated throughout much of 2023 before eventually falling to its 2% target in 2025. The Monetary Policy Committee is now predicting that the UK economy will shrink in the last three months of this year, and keep shrinking until the end of 2023. It also noted that the labour market remains tight and that domestic cost and pricing pressures are elevated.
These are all factors that increase the likelihood of a longer period of externally generated price inflation, leading to a more persistent period of domestic pricing and wage pressures. The main reason for high inflation and low growth is soaring energy bills, driven by Russia's invasion of Ukraine. The Bank's Governor Andrew Bailey expressed his commitment to bringing inflation back down from its 40-year high (currently 9.4%) to its 2% target rate.
On the UK political front, current Conservative Party leadership contest favourite Liz Truss is reportedly considering a full review and overhaul of the Bank of England's independence and its mandate on inflation. Further UK interest rate hikes are now being reflected in market sentiment, making for a delicate set of circumstances.
A technical recession is not a recession
These two rate hikes (in Europe and the UK) have come on the back of the US Federal Reserve Bank's announcement of a further 0.75% increase at the end of July – Fed chair Jerome Powell’s reaction to the US inflation rate rising at its fastest since 1981. Interestingly, Powell indicated that he believes that there is a way for the Fed to tame inflation without creating a recession.
The US economy has, however, shrunk for the second consecutive quarter – meaning that it now meets the definition of a technical recession. And yet, there has yet to be an official declaration from the National Bureau of Economic Research to that effect.
Powell's statement buoyed sentiment on Wall Street – the main US indices rose and registered their biggest one-day percentage gain since April 2020. Unfortunately, these rate rises appear to have done very little to rein in rising food and petrol prices, or bring down rent costs. The Federal Reserve Bank committee will not meet again until September – at which point more economic data will be available and any further decisions about rate hikes can be announced.
Are we nearly there yet?
What everybody wants to know is whether or not we have finally seen the bottom of this bear market. Many technical analysts think we have – the S&P 500 Index hit a bottom on 16 June 2022 at 3,666.67. Some people may remember that this same index sank briefly to 666 on 6 March 2009 before going on to deliver a decade of strong double-digit annualised total returns.
There is no doubt that the threat of higher inflation combined with aggressive central bank tightening policies creates a very tricky economic backdrop for investors over the short term. Indeed, many fear a return to the inflationary era of the 1970s. Rising commodity prices make the parallels particularly striking, as do the military conflicts triggering a surge in oil prices.
In 1973, Egypt and Syria launched surprise attacks on Israel in what came to be known as the Yom Kippur War. The US supported Israel, Saudi Arabia and other exporters during the conflict, resulting in oil bans and a fragmented world. The price of crude oil tripled… and the inflation genie was well and truly out of the bottle. Stock markets around the world were volatile throughout the 1970s – the S&P 500 fell by almost 40% during the bear market that lasted for most of 1973 and 1974. The UK fared even worse: the FTSE All-Share lost more than 70%.
It’s not quite the 1970s
While inflation is once again rampant in 2022, we are not expecting to see a complete rerun of the 1970s. Admittedly, however, there is a risk of stagflation (a combination of high inflation and slowing growth). If stagflation does rear its head, then commodities, gold, real estate investment trusts and US quality equities should all do well.
The late Paul Volcker was a senior Federal Reserve official from 1975 until 1987 and was renowned for the aggressive stance that he adopted on inflation during his tenure as chairman. His strategy involved delivering shock therapy to the US economy during a period which saw interest rates hit 20% and unemployment soar to nearly 11% in 1981.
The price that the US economy had to pay was a steep recession. Consumers stopped buying houses and cars, and millions of workers lost their jobs. But Paul Volker triumphed, crushing inflation out of the economy.
His victory ushered in an era which saw the leaders of both US parties largely deferring to the Central Bank. Technocrats are now free to navigate the course of monetary policy with little in the way of political interference. If inflation proves stubborn, policymakers are likely to expect Jerome Powell (who knew and admired Paul Volker) to implement Volker-style measures.
It is therefore likely that things will play out as they did in the eighties, rather than the way they did in the seventies. If this proves to be the case, then a good strategy in a recessionary cycle is to hold companies with strong balance sheets, steady business models and pricing power – despite the economic backdrop. Such businesses tend to be found in sectors such as utilities, consumer staples, energy, healthcare and industrials… as well as (surprisingly) communications services and information technology.
The worst businesses to hold when inflation is rising along with interest rates are highly-leveraged, cyclical, speculative companies: these run the risk of insolvency.
Whatever you own in your portfolios in such times (with the exception of cash) is vulnerable to the Kingda Ka effect. Always remember that your time horizon should govern your appetite for risk: short-term money should replicate cash plus, longer-term investing should embrace the opportunity.
Earlier I said that the S&P 500 Index bottomed out at 666 in March 2009. Even with the dramatic fall seen in 2022, it closed at 4155 at the time of writing.
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