- The Fed has finally turned up with a larger interest rate hike and commitment to continue to increase rates to tame inflation. While this is positive in the long run, the Fed is still very behind the curve and has been too complacent in tightening the abundant liquidity that has overflown into inflationary pressures. After a new record June inflation print of 9.1%, we expect the Fed to continue to move quickly to hike.
- We discussed the three R-words of rates, recession, and Russia last quarter. There seemed to be some respite initially at the end of last quarter and again in May as markets attempted a rebound. But Q2 ended up being another rough quarter with negative returns for both equities and fixed income again as concerns about recession took hold. In fact, a stronger USD and weaker outlook for emerging markets are also raising major global growth concerns ahead.
- The possibility of recession is real. While the possibility of a technical recession in H1 of 2022 in the US does exist, the bigger concerns are shifting to growth rates in 2023, with meaningful downgrades coming through. The real risk of instability in emerging markets is spreading especially due to the strong USD and the global shortages in energy and food.
- This downturn is testing the nerves and the strength of financial planning that investors had put into place prior to the downturn. Regular savers are being tempted to change their plans and pause their regular plans — going so far as to reverse course and sell. Yet the consistent message of markets through volatility has been this: stick to your plans. That discipline gives us the best chance of long-term success. Siding with evidence over emotions is still the right thing to do, especially in — not despite — these uncertain times.
The Fed finally shows up
The Fed’s more aggressive moves to increase rates by 75 basis points (bps) is a positive development, removing some uncertainty about the trajectory of interest rates and inflation ahead. It has been behind the curve and too complacent in tightening liquidity, leading to higher-for-longer inflation. After the record inflation print surpassing 9% in June, odds are building of a 100bps hike at the scheduled July 27 FOMC meeting. With inflation stubbornly rising, we have seen more than 30 other central banks around the world implementing record rate hikes of at least 100bps to catch up with runaway inflation. While it is still more likely that the hike will be 75bps like last month, the US Fed may be next to join this group.
The sudden sharp interest rate hikes are not positive for markets, and the perception that inflation is staying higher for longer is adding to the burden of consumers and market participants. As we have previously discussed, inflation is by definition a year-over-year comparison, and with higher base effects it will most likely — and eventually — come down for the remainder of the year. That said, while the pace of price increases may abate, the absolute price increase remains high, and this will remain as a tax on consumers. Higher prices for consumer staples and core spending such as housing and gas reduce the disposable income of consumers. Higher prices in turn affect economic demand and earnings. They also impact savings, which in turn impact markets.
A real risk of recession
The inversion of the yield curve between the 2-year and 10-year Treasuries is at the widest since 2007, and is widely seen as a leading indicator for a recession. First quarter growth in the US already turned negative at -1.6%, according to the third and final revision published at the end of June by the National Bureau of Economic Statistics. The contraction was driven by the technical roll-off of fiscal stimulus checks and inventory adjustments as well as slowing consumer spending and corporate profits. This comes after a torrid growth pace of 6.9% in Q4 2021.
Another negative quarter in the second quarter could mean a technical recession for the US economy — defined as two consecutive quarters of economic contraction. To be sure, the US has a separate panel that determines officially if the economy is in recession. As a result, economists still see only a 30% chance of an official recession this year. The concerns are that next year will see a more marked slowdown in growth if current conditions persist. With higher inflation, the concerns about stagflation and an earnings recession for equities markets have also risen meaningfully.
Furthermore, the focus has been on the US and major economies — rightly so as they remain the key drivers of global growth and financial markets. However, emerging markets (EM) and some developing nations have taken a major hit from the energy and food crises that have resulted from Russia’s invasion of Ukraine. The disruptions in the supply chain that we have seen cut across soft and hard commodities as well as the energy sectors. The USD is at the strongest it has been since the sharp moves in 2020 and prior to that, in 2007. The tighter USD liquidity is negatively affecting EM currencies as well.
From Sri Lanka, El Salvador, Ghana, Egypt, Tunisia to Pakistan, the list of emerging market and frontier markets seeing a major risk of default or that have already defaulted is expanding, and quickly. The fixed income markets have been roiled by China’s regulatory risk and the developed markets’ rapid interest rate hikes, and now are being hit by the turmoil in emerging markets. The IMF has just revised global growth projections downwards again for next year.
How low can we go?
The near two years of benign and rising markets following the rapid March 2020 crash brought on by the global outbreak of Covid-19 now seems so long ago. Yet, for perspective, the markets actually reached a historic peak at the end of last year and the beginning of this year, depending on which markets you look at.
That rally came to a screeching halt at the start of 2022, with investors thrust into a perfect storm. Who could have predicted the February 24 invasion of Ukraine by Russia, which sent markets teetering perilously over the edge? The euphoria of low interest rates and government stimulus cheques that supported both consumers and businesses has reversed rapidly. Public markets have been pummelled and growth stocks have taken the biggest hit.
The fact that the Fed was behind the curve in taming inflation did not help. The sharp shift in policy in recent times is now hurting sentiment. Inflation remains persistently high and China’s stringent Covid-related restrictions are hampering manufacturing in China, causing more concerns on rising prices. These shocks to the system are creating a negative spiral in both the equities and fixed income markets.
This has truly been an unprecedented market in the first half of 2022 — one of the worst starts to the year when both equities and fixed income markets delivered negative returns. In particular, the fixed income sector — long regarded as a safe-haven asset class — saw one of the worst falls in history and the worst performance in 30 years. It also looks like another rare outcome of the fixed income markets generating a second consecutive year of losses.
The markets are volatile because the outlook is murky and there are various permutations that have a broad range of outcomes. A good scenario could consist of i) an earlier end to the war; ii) China pivoting its zero-Covid policy towards opening up and stimulating its economy; iii) the market, having already priced in all the Fed rate hikes and with inflation starting to ease with the high base effect, starts moving higher. A doomsday scenario would be pretty much the reverse of that, featuring stagflation and worse, a domino effect of defaults in emerging markets with major developed economies simultaneously falling into deep recession in 2023.
Offering a prognosis on the direction of markets is often a pointless and thankless task. We will take stock of how the markets did in the first half and second quarter of 2022.
Global equities deepen decline in Q2
The global equity markets continued their downward trajectory in the second quarter of 2022. As the Fed amped up monetary tightening with a 75bps rate hike in June and other central banks followed suit, investors hunkered down to wait out another volatile period. The MSCI ACWI index — often a proxy for the aggregate global equity market — declined more than 13% in Q2, with the US underperforming the rest of the markets. Unemployment in the US remains low, but other economic indicators, such as manufacturing output and the number of home sales, have started to deteriorate. There is also evidence that consumer confidence (and spending) has decreased amid increased fears of a global recession.
The emerging markets and other developed economies ex US fared slightly better, with the MSCI EM Index retracting 11.5% and Europe performing marginally better.
The one bright spark in a sea of negative returns was China. China had a positive quarter as Covid-related lockdowns eased in some cities and factory activity returned.
Value stocks continued to outperform growth stocks although they too, were not spared from a sell-off. The MSCI ACWI Value Index declined by 9.2% in the second quarter while the MSCI ACWI Growth Index plunged by 18.1%, bringing the year-to-date return of global growth stocks to -25.7%. Large cap stocks also generally did better than small cap stocks as risk-off sentiments grew.
Within AWCI sectors, the energy sector, on the back of rising energy prices, proved to be the most resilient, declining by a mere 2.6%. The H1 2022 return for the energy sector was a hefty 18.7%; it outpaced the information technology sector — the worst performing sector year-to-date — by more than 46%. However, Q2 was challenging for all sectors, as even the energy stocks were not able to eke out a positive return.
Bloodbath in fixed income
The bloodbath in the global fixed income markets continued into the second quarter as bonds faced pressure from elevated inflation, tightening monetary policies, and rising interest rates. The Bloomberg Global Aggregate Index (USD Hedged) declined 4.3% as central banks around the world accelerated rate hikes in attempts to dampen soaring global inflation.
All the fixed income sub-asset classes declined in the second quarter. However, after a particularly difficult first quarter, the US Treasuries had a better second quarter and outperformed the rest of the asset classes. European bonds suffered as the ECB announced the termination of the asset purchase programme in Q3 and the raising of rates. The emerging market economies, hit by higher energy prices and other inflationary pressures, faced additional challenges from the strong US dollar.
In general, developed markets’ government bonds and investment grade bonds outpaced the riskier asset classes such as high-yield corporate debt and emerging-market debt. Credit spreads widened over growing recession fears as investors gravitated towards the safety of investment-grade debt.
Global inflation-linked bonds (ILBs), the best performing sub-asset class in Q1, dropped to the bottom in Q2, declining by about 14%. ILBs are designed to provide investors with some protection against inflation. However, even though ILBs benefit from the rise in inflation, they are also subject to the same duration risk as conventional bonds. The positive impact from inflation was more than negated by the impact of rising interest rates on the prices of these longer duration ILBs.
Commodities lose steam in Q2
The S&P GSCI Index (a proxy for the global commodities market) generated a small positive return of 0.4%. Even as the other components of the index — livestock, agriculture, industrial metals and precious metals — declined significantly, the index’s return was buoyed by the strong performance from energy. Energy makes up more than 60% of the index.
While commodities are still positive for the year, the disappointing performance in the second quarter after the spectacular first quarter serves as a reminder as to how volatile this asset class can be.
This downturn is testing the nerves and the strength of financial planning that investors had put into place prior to the downturn. Regular savers are being tempted to change their plans and pause their regular plans — going so far as to reverse course and sell. Yet the consistent message of markets through volatility has been this: stick to your plans. That discipline gives us the best chance of long-term success. Siding with evidence over emotions is still the right thing to do, especially in — not despite — these uncertain times.
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Read more:
Staying invested in the market downturn — with the right plan
Rational investment strategies to win in a tumultuous market
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