Transitioning to more normal levels of interest rates is a genuine vote of confidence in the world economy, but getting there was never going to be easy.
World markets remain in the grip of rising interest rates and Vladimir Putin’s war. Yes, equities remain extremely oversold and value is clearly appearing in many areas, but the spark that triggers a lasting rally has so far proved elusive.
After a 25% decline in nine months, the S&P 500 index has now suffered its third-worst performance at this point in a year since 1931. So how should investors respond?
What we are seeing across markets is more logical than it looks –a straightforward repricing of assets that reflects a much more rapid normalisation of interest rates than was conceived of nine months ago. It is worth remembering that at the December 2021 Federal Reserve meeting, US interest rates were 0.1%, with a forecast for end 2022 of 0.9%. At last month’s meeting the same projection for the end of 2022 had soared to 4.4% Valuations unsurprisingly, are de-rating in response. This has been painful for almost every asset in the short term but is probably to be welcomed in the medium term: it is a vote of confidence in a world that no longer needs super-loose money to prosper and grow.
Did 2022 mark the death of diversification?
There were further challenges for investors in 2022. In addition to price falls, portfolio diversification singularly failed to deliver. Unlike the 2020 Covid-led sell-off, where a steep decline in equities was offset by soaring bond prices, this year has seen a synchronised correction in almost every asset class. Indeed, the end of the third quarter saw parallel bear markets (a fall of greater than 20%) in three entirely different assets; the S&P 500 (-25%), the yen/US dollar rate (-20%) and the copper price (-23%). Apart from 1994, I cannot remember a global market downturn with so few places to hide.
As well as high correlations, investors have also had to contend with the loss of the ‘central bank put.’ This is loosely defined as the tendency of central banks to step in with aggressive monetary support, in the face of every economic crisis. Such a policy was possible in recent years because global inflation remained stubbornly low, meaning there was little economic cost to zero or negative rates. The side effect of this strategy was, of course, to inflate assets – often dramatically. In the months following the outbreak of Covid in 2020, for example, the world economy contracted sharply, triggering massive central bank intervention. Global equity indices rapidly fell, by more than 30% in a month, but then rallied to actually exceed pre-Covid highs just four months later, despite a still-raging pandemic. It was perhaps the sharpest v-shaped recovery in stock market history.
Today, the picture could hardly be more different. Monetary stimulus now has a very real cost in terms of exacerbating inflation, while central bankers tacitly welcome asset price falls, as a tool to dampen demand and so control prices. Yes, in a complete breakdown of market operations, monetary authorities will still intervene (as the Bank of England did in the gilt market last month) but the barrier to action has certainly been lifted.
Raising rates 'til something breaks…
As Warren Buffet famously said of rising interest rates “only when the tide goes out do you find who has been swimming without clothes.”
This time the naked swimmer was not in the emerging world or in some arcane leveraged financial product, but right here in the heart of Westminster. Our new chancellor’s arguably naïve and cavalier budget was the trigger for a dramatic sell-off in the gilt market and sterling. A toxic mix of politics, inflation and interest rates resulted in extraordinary volatility, as investors (both foreign and domestic) took fright. In one day the 30-year UK index-linked bond yield moved more than it normally does in a year.
What technically ‘broke’, was liquidity, in a far corner of the giant UK pensions market; margin calls on complex derivatives led to forced sales of gilts and then further sales. For investment old-timers, it was a victory for the ‘bond market vigilantes’, a term coined in the early Clinton administration when bond investors pushed up yields to curtail fiscal profligacy. Last week the UK gilt market vigilantes claimed two scalps in just a few days – the reversal of the 45% income tax cut and the early publication of the chancellor’s fiscal framework. Over the weeks to come it wouldn’t be a surprise if the bond markets rein in more of this government’s tax-cutting agenda, as they force fiscal orthodoxy on a fragile UK economy.
Indeed, fiscal prudence (or as Margaret Thatcher would have called it, ‘good housekeeping’), imposed by bond markets, will likely become a global theme over the coming months. After a miserable 2022 for fixed income, this offers the hope of better returns ahead, and certainly supports our recent allocations to high-quality UK corporate credit.
Managing the Russia risk
Added to the difficulties of tighter money and poor diversification has, of course, been the continuing war in Ukraine, where there sadly seems scant prospect of even the most limited ceasefire. Indeed, Putin’s annexation of captured Ukrainian regions marks the ‘most serious escalation since the start of the war’ according to Nato Secretary-General Jens Stoltenberg. By effectively declaring that any attack on the annexed regions would be treated as an assault on Russia itself, Moscow appears to see itself in an almost existential war with the West. Yes, Ukrainian strategic successes have been extraordinary but they seem only to drive the Kremlin to further escalation.
This suggests that while a recovery in equity markets from oversold levels is probable, the move will likely be capped by winter energy risks in Europe and threats of military escalation (that may yet target NATO). US dollar strength may moderate and European asset returns may start to improve, but for a convincing next leg up in European value and a long-term pivot away from the US dollar, we will need at least the outline of a roadmap to peace.
For even the most patient of investors, this year has been tough; valuations have contracted, balanced portfolios have experienced simultaneous declines across all assets while the war in Ukraine still hangs over any long-term rally in Europe. Cash held in US dollars has been king, while almost every other asset is in, or close to being in, a bear market.
However, I see three good reasons for a little, cautious optimism. First, leading global companies are financially robust, with banks in particular boasting near-record reserves (in sharp contrast to 2008). Corporate earnings have been surprisingly resilient (note that inflation helps company revenues) and dividend flows are still prodigious (our equity income funds are clear beneficiaries). Sentiment toward equities is also extraordinarily negative, so a little good news goes a long way. In short, much of the bad news is probably now priced in.
Second, the global decarbonisation agenda has been made all the more imperative by Russia’s actions. Europe will lead one of the greatest post-war investment booms the world has ever seen, with the twin goals of climate and energy security driving long-term earnings across every major industry. This will benefit our climate theme and many of the global industrial holdings we hold that will play a key part in this massive re-plumbing of the world economy.
Third, there are few crises that do not throw up opportunities, and this is true of the UK’s recent budget crisis. We see increasing value in UK investment grade corporate bonds, particularly from issuers in less cyclical or global industries. Yes, we expect a UK recession, but we think it will be mild (especially with energy prices capped, employment strong and savings robust). The sterling corporate bond index now yields about 6.5%, the highest since 2009, presenting a particularly tempting backdrop for the managers of our responsible corporate bond fund.
In summary, we are all on a journey back to financial normality. It is one where we can hopefully say goodbye to the unnatural world of zero or negative interest rates, and to the wall of central bank bond buying, which has so distorted global asset prices. It’s been a painful start to date but it was probably always going to be. As I hope we have shown above, the next leg should be more rewarding - opportunities for the patient investor are already emerging.
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