Our view on the investment markets

Market Review

The second quarter was another difficult period for equity and fixed income assets, as the war in Ukraine and its impact on already elevated inflation levels caused central banks to escalate their monetary policy tightening and increased concerns over the outlook for economic growth and corporate profits.

The previous surge in demand, as economies benefitted from reopening following a period of Covid induced restrictions, had already seen a pick-up in inflation, as supply had struggled to keep up with demand. The Russian invasion of Ukraine has further exacerbated the level of inflation due to them both being important commodity producers.

Inflation is well above normal levels in many countries, with the latest UK consumer price inflation figure hitting a 40-year high of 9.1% for May. Whilst energy and food costs are a key part of this inflation, price increases have become more widespread and although wages have been rising consumers are still seeing a significant hit to real incomes and consumer confidence has fallen sharply.

Having initially thought that it was just a short-term issue that would quickly ease, central banks have belatedly recognised that they needed to reverse their very supportive monetary policies to rein in inflation, with many raising interest rates and withdrawing asset purchases. The UK saw two further rate rises in the second quarter to 1.25% and the US has moved more aggressively, including a hike of 0.75% at the Federal Reserve’s June meeting.

Markets have moved to price in further significant interest rate increases and that has led to weakness in both equity and bond markets, with the former also being impacted by concerns about the economic outlook and growing recession risks. China’s zero-Covid policy has also led to lock-downs in key cities which have slowed the world’s second largest economy.

Many equities have seen significant falls in 2022, but the impact on UK investors has been softened by the relative resilience of the UK market and the strength of the dollar which has helped international equity returns. Whilst smaller and medium sized UK companies saw double-digit losses in the second quarter, the overall UK market has benefitted from its exposure to commodity companies and fell by 5.0%, which took first half losses to 4.6%.

In local currency terms international equities fell by 13.7% in the second quarter, but currency moves improved this to a loss of 8.5% for a UK investor. This took first half sterling terms losses to 10.9% (-17.9% in local currencies), with 2022 seeing emerging and Asia Pacific ex-Japan markets holding up the best.

High inflation and rising interest rates have proved a difficult environment for fixed income investors and all bonds have seen increases in yields (and falling prices), with longer duration bonds especially weak. UK government bonds lost a further 7.4% in the second quarter, taking first half returns to an exceptional -14.1%. Other fixed income categories benefitted from being generally shorter duration assets than gilts but suffered from credit spreads widening (the additional yield over and above equivalent gilt yields), resulting in UK corporate bonds, high yield and emerging market debt seeing second quarter losses of 6.8%, 10.3% and 11.9% respectively. This resulted in first half returns of -12.6% for corporate bonds, -14.3% for high yield and -20.8% for emerging market debt. Index-linked gilts fell a further 17.5% in the quarter as higher near-term inflation expectations were heavily outweighed by investors pricing in higher long-term interest rates.  

After a relatively strong start to the year, the UK commercial property market has begun to be impacted by the slowing economy and rising interest rates. Further modest growth in the second quarter has taken estimated first half total returns to around 8%, led by the industrial and retail warehousing sectors.

Returns on cash deposits have improved following the Bank of England increasing the UK interest rate to 1.25%, but returns remain relatively low and well below current inflation levels. 

Market Outlook

Markets were prepared for a period of elevated inflation and an unwinding of very supportive central bank policies in 2022 as the global economy recovered from the Covid pandemic, but the war in Ukraine has worsened the outlook for both inflation and growth and created an extremely difficult environment for both central banks and investment markets to navigate.

The economic reopening that had been possible thanks to the success of vaccines in limiting the ongoing impacts of Covid had led to some supply challenges in keeping up with recovering demand. Alongside a relatively strong labour market this was leading to rising inflation pressures even before the impact of Russia’s invasion of Ukraine, which has had a significant impact on some key energy, food and metal commodity prices.

With inflation becoming more extensive and longer lasting than central banks had initially expected, they have begun to take action to try and rein it in before it becomes embedded in expectations. Central banks have made it clear that they are currently prioritising fighting inflation over the risks to growth, but it will be interesting to see whether they maintain their expected path of rate rises in the face of increasingly challenging growth data.

UK inflation could exceed 10% later this year when the next increase in the energy price cap kicks in, and alongside increased signs of industrial unrest there are some unwelcome reminders of the 1970’s. However, the Bank of England and most commentators are confident that we are not in for a period of extended double-digit inflation and levels should subside towards a more normal 2-3% as we move through 2023.

Although Covid is still very active around the world, the health and economic impacts have been greatly reduced since the success of the vaccine roll-outs. China has been a notable exception to this as they are still pursuing a zero-Covid policy and have had to restrict movement to contain outbreaks. This has reduced economic demand and caused some global supply chain issues, but hopefully conditions will soon return to normal.

Global economic growth was already set to slow as we moved through 2022, but the impact of inflation on consumer spending power and with rising interest rates set to further suppress demand, the outlook is challenging and recessions in key developed economies such as Europe and the UK is now a significant risk. However, with still strong labour markets and potential support from the remaining excess savings from the lock-down period and fiscal support from stimulus packages, the depth of any economic weakness is currently expected to be relatively shallow.

Whilst recessions can be painful for markets, the largest corrections tend to coincide with deeper and more sustained economic downturns or where valuations have become excessive or banks are vulnerable. With a deep recession looking unlikely and the relative financial strength of banks and overall corporate health suggests a significant crisis can be avoided.

Extremely low interest rates and central banks using their balance sheets to purchase assets have provided powerful support to markets since the financial crisis and again during the Covid pandemic. As expected, the subsequent tightening of monetary policy conditions has provided headwinds for many asset markets and investors will be monitoring for signs of progress on containing inflation to see how far interest rates will need to rise.

Central bank policies and many years of subdued inflation had seen bond yields driven down to exceptionally low levels and a long period of gains for fixed income investors. However, with such little income and stretched valuations, fixed income assets were vulnerable to even a modest reversal of conditions, and the recent period of inflation and tightening monetary policy has seen a substantial fall in bond prices. Government bond yields have now risen to their highest levels in recent years and whilst still vulnerable to central banks having to be more aggressive, their attractions have improved somewhat and the prospect for gains or further losses are now more balanced.

Other fixed income options such as investment grade corporate bonds, high yield and emerging market debt offer additional income to compensate for their greater risk. With risks coming from both elevated inflation and concerns about economic and corporate growth these yield spreads have widened significantly and led to poor returns, but like gilts, from these improved valuation levels their return prospects now look more balanced than previously.

Increasing interest rates and bond yields can also have a negative impact on equity valuations, especially more growth-oriented companies such as technology stocks. Valuations have also been hurt by the weakening outlook for economic growth and corporate earnings, and with many equities having fallen significantly in the first half of 2022 they have arguably already discounted a modest recession and downturn in profits.

Whilst there are elevated risks to the shorter-term economic and corporate outlook, the medium to longer-term outlook still offers the potential for growth and looking through the current difficulties equity valuations are beginning to offer opportunities for patient investors.

The sell-off in equities has been led by highly valued growth stocks who had previously seen a long period of outperformance. The most resilient sectors have been energy, mining and consumer staples which has been a key reason behind the outperformance of the UK market. Whilst the UK economy is relatively poorly placed currently in terms of the inflation and growth outlook, UK equities derive a significant proportion of their revenues and profits from outside the UK and the UK stock market is one of the cheapest in the world and offers one of the best dividend yields, so the recent period of relative outperformance has the potential to continue.

US equities had benefitted greatly from their above average exposure to growth and technology stocks, but this had left the US as the only region whose valuations were comfortably above their long-term averages. Valuations have since improved and whilst it is home to many excellent companies and justifiably forms a significant part of our global portfolios, more attractive opportunities are still seen in other equity markets where valuations are lower.

Europe has seen an above average impact from the war in Ukraine on its doorstep and is particularly vulnerable to a reduction in Russian energy supplies this winter. Emerging Markets contain a wide range of countries with different attributes. Recent Russian actions have been a reminder of the investment risks, but China, Taiwan and India are the dominant drivers of emerging markets and overall offer the potential for longer-term superior growth. Recent developments in China have worried investors in the largest emerging market, but despite somewhat elevated risks their overall growth prospects seem largely intact and valuations have become more attractive.

The UK commercial property market is currently undergoing an element of recalibration. Recent interest rate rises and the inflation spike have resulted in a slowdown in transactional volumes and some limited pricing adjustment have been seen.  The outlook for the remainder of this year is for growth to slow, with market forecasts indicating mid-single digit total returns for 2022, with industrial and residential sectors expected to remain at the forefront of the market.  

Following five interest rate increases and with further moves towards 2.5% expected over the next year, the returns on cash deposits have notably improved. However, rates will remain relatively low by historic standards and savers will continue to struggle to match the elevated levels of inflation being seen.

In conclusion, there remain a number of shorter-term issues for markets to navigate although asset valuations have now potentially priced in a lot of these risks. Slowing economic and corporate profit growth, high inflation, tightening monetary policy, an ongoing conflict in Europe and lingering Covid issues continue to produce a challenging investment environment. Whilst there is no obvious end to the war in sight, these difficult conditions will not last forever and markets will look for signs of a turning point in the flow of news such as a peak in inflation. Fixed income valuations are certainly less stretched than at the start of the year and equity valuations offer areas of value. Markets may remain volatile as we work through the current challenges, but suitably diversified portfolios containing equities, fixed income and property (where available) offer the potential to deliver reasonable medium to longer-term investment returns.

Paul Glover
Chief Investment Manager
July 2022