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Investment Commentary Q2 2022

Investment commentary

In Brief

  • Q2 2022 saw falls in most asset classes, with the main exception being commodities and Chinese domestic equities.
  • 2022 investment returns so far have been negative.
  • Russia’s invasion of Ukraine rumbled on, but it was inflation, and central bank tightening to try to tame it, that dominated markets and led to bond and equity falls
  • Towards the end of the quarter markets began to price in a greater chance of a global recession, which provided some support for higher quality fixed income bonds but led to further equity falls

Quarter Overview

April saw a number of familiar themes extend risk-off sentiment in financial markets. The war in Ukraine sadly continued, China’s COVID outbreak dampened economic activity in the country and pretty much everywhere else inflation continued to surge, driven in large part by higher energy costs. This inflation began to be felt acutely in the UK too as the latest round of energy price rises made their way into bills, adding to concerns around consumers’ financial positions and hence their likelihood of continuing to spend to drive the economy.

 

May saw a lot of central bank activity which drove stock markets and sentiment. Both the US and UK carried out forecasted rate hikes to help tame inflation, alongside specific fiscal aid in the UK for households to deal with energy price rises. However, markets began to get concerned about central banks raising rates too quickly, possibly choking-off economic growth that was already softening.

 

June saw further central bank rate hikes to combat rising inflation with investors getting more and more concerned that these rate hikes could cause recession. US rate increases of 0.75%, surprised some market participants, and clearly indicated their desire to hike swiftly to control inflation. The UK only raised their base rate by 0.25%, despite inflation expected to exceed 11% later this year.

 

Overall, the second quarter saw generally poor investment returns across most asset classes with the main exception of commodities and Chinese domestic shares. Unusually, bonds and equities fell together as central banks aggressively increased interest rates to try to control inflation. Commodities continued to benefit from global shortages resulting from sanctions on commodity exporting Russia after their invasion of Ukraine. However, they did fall in June as markets began to worry about the possibility of a global recession. Chinese equities benefitted towards the end of the quarter as the country began to emerge from its strict lockdowns.  Volatility, as measured by the VIX index, rose almost 40% over the quarter. Developed market equities (as measured by the MSCI World Index including dividends) fell 9.1% in sterling terms over Q2. The commodity heavy FTSE 100 returned a relatively better -3.7% over the quarter including dividends and emerging market equities (MSCI EM Index) fell 4%. Global bond yields rose steadily over the quarter leading to higher quality bonds (as measured by the Bloomberg Global Aggregate Index) falling 4.5%. Lower quality ‘high yield’ bonds also fell, down just over 11% as investors worried about the strength of the global economy. Oil was up 6.4% over Q2 whilst gold fell 6.7%.

Selected Asset Class Returns 2022

Data source: Financial Express

Indices used (including interest & dividends): Defensive Investment Grade Bonds – GBP hedged Bloomberg Global Aggregate Index; Riskier Bonds (High Yield) – GBP hedged Bloomberg Global High Yield Index, Developed World Equities – MSCI World Index in GBP; Emerging Market Equities – MSCI Emerging Markets Index in GBP; FTSE 100 (UK Large Capitalisation Equities)

Diving into stylistic performance within indices, cheaper ‘value’ companies (which generally includes oil & gas and other commodity companies) relatively outperformed over the quarter, down just over 4%. Smaller companies fell slightly more than world equities, down just over 10% whilst ‘high price’ securities (often described as ‘growth’/’momentum’/’quality’ companies) underperformed over the quarter, down 14.6%.

Selected Style Returns 2022 2

Data source: Financial Express

Indices used (including interest & dividends): Developed World Equities – MSCI World Index in GBP; Growth Equities – MSCI The World Growth Index; Value Equities – MSCI World Value Index; Small Company Equities – MSCI World Small Cap Index

The pound had a weak quarter overall. It fell 7.3% against the US dollar and 2.2% against the euro but was up 3.4% against a poorly performing yen.

Portfolio Performance Overview

The PortfolioMetrix Core portfolios fell over the quarter, but by less than global equities. Asset allocation was helpful, due to an underweight to poorly performing US equities and overweights to better performing Japanese equities and emerging markets (and particularly Chinese A shares). Active fund performance was broadly neutral over the quarter. UK funds underperformed given overweights to poorly performing UK small and mid-sized companies, but this was offset by strong active returns in other asset classes.

 

Sustainable World portfolios again had a weaker quarter, with their tilt towards underperforming quality/growth companies detracting as did their lack of exposure to strongly performing commodities. They do continue to enjoy significant long-term structural drivers as the world shifts to focus more on environmental and social issues though.

Looking Forward

Moving in to the third quarter of 2022, the prevailing worry on global investor’s minds remains inflation and whether central bank’ tightening will tip the world economy into recession.

CPI

Source: Deloitte COVID-19 Economics Monitor, 29 June 2022

Western economies haven’t had to deal with serious inflation for decades and we are just now beginning to see how corrosive inflation can be in terms of damaging living standards (particularly for those less well-off who are struggling with food and fuel costs) as well as societal disorder (witness for example the increasing number of strikes we’re seeing here in the UK).

 

High inflation is also directly impacting consumer confidence, a key determinant of consumer’s willingness to spend. Combine this with increased borrowing costs for both individuals and businesses as a result of central banks raising interest rates and you can clearly see why economic growth has been slowing and markets are worried about a recession.

UK Consumer confidence

Source: Deloitte COVID-19 Economics Monitor, 29 June 2022

GPD growth forecast 2022

Source: J.P. Morgan Asset Management Guide to the Markets Q3 2022

That said, a global recession still isn’t inevitable given how strongly the global economy started out the year. Nor does a recession, if one does occur, have to be particularly deep. The key question for the rest of the year remains that of inflation though. Inflation will peak at some point, but the sooner it does and the quicker it falls, the sooner central banks can slow their rate of monetary tightening and the lower the risk of a deeper recession.

CPI forecast 2022

Source: J.P. Morgan Asset Management Guide to the Markets Q3 2022

Europe, unfortunately, has an additional source of weakness it needs to deal with. It is still very reliant on Russia for energy and the point of maximum danger will be this winter when energy requirements are at their maximum due to the need to heat homes. Europe needs to have built up sufficient gas reserves to make it through the cold months – a process that is likely to be difficult and very, very expensive. This will be another significant drag on growth for the continent.

EU natural gas inventories

Source: J.P. Morgan Asset Management Guide to the Markets Q3 2022

European and US gas prices

Source: J.P. Morgan Asset Management Guide to the Markets Q3 2022

So, the second half of the year is likely to be bumpy for the world economy, but the silver lining is that markets have already fallen a lot this year, pricing in a great deal of uncertainty. Equity valuations have now fallen to below average valuation multiples.

Global forward P2E ratios

Source: J.P. Morgan Asset Management Guide to the Markets Q3 2022

And bonds, after their falls this year, now have far more generous yields than they began 2022 with, implying much greater return potential going forward (remember, bonds are already pricing in aggressive future interest rate rises – they can perform well as central banks continue to tighten monetary policy just as long as central banks don’t get even more aggressive).

Fixed interest yield comparisons

Source: Schroders

Given the relatively more attractive valuations, we are cautiously optimistic for the rest of the year, although we continue to favour diversification to manage the obvious uncertainties ahead.

Data: Monetary Policy* (Rates & Extraordinary Measures)

The second quarter of 2022 saw dramatic tightening by a number of developed and emerging market central banks. The US Federal Reserve raised rates by 1.25% and began quantitative tightening (selling some of the bonds they bought during COVID), whilst the Bank of England tightened rates by 0.5% and began to reverse its quantitative easing. Almost the sole exception was the Russian central bank, which had dramatically raised rates in Q1 to defend its currency post western sanctions and began to relax policy in Q2.

Global interest rates Q2 2022

Data: Global Economies

GDP figures released in the second quarter were for Q1 2022 and were mixed. Inflation generally increased strongly during the second quarter, in many cases to levels not seen for decades. Unemployment, however, generally fell as economies continued their recovery from COVID.

Global GPD growth Q2 2022

DATA: ASSET CLASSES

Asset class performance 2021 - 22
Asset class performance 2021 - 22 - table

Note: The above returns are total returns, including dividends and interest payments. Asset classes with the “HDG” label are currency hedged to pounds sterling, which means that foreign currency movements are removed whilst those with the “£” label indicate that we are reporting returns to British holders which includes the effects of the foreign currency moves non-UK listed securities are exposed to.

Data source: Financial Express

Indices used: Bank of England SONIA, GBP hedged version of FTSE World Government Bond Index, GBP hedged version of FTSE WorldBIG Corporate Index, GBP hedged Bloomberg Global High Yield Index, GBP hedged version of FTSE Global Emerging Markets US Dollar Government Bond Index, MSCI North American Index, MSCI Europe ex-UK Index, FTSE All Share Index, MSCI Japan Index, MSCI Pacific ex-Japan Index, MSCI EM Index, FTSE Global Core Infrastructure 50/50 Index,  FTSE EPRA NAREIT Global Index and Bloomberg Commodity Index

DATA: INDICES, COMMODITIES, CURRENCIES

Indices performance Q2 2022

Key

  • FTSE 100 is an index of the 100 largest companies by market capitalisation listed on the London Stock Exchange. Crucially, whilst these companies are priced in sterling, the majority of their revenues comes from outside the UK making the FTSE 100 more a global, rather than domestic UK, index.
  • MSCI World Index is used to gauge global developed market equity performance. This is heavily influenced by US equity performance which, as the world’s biggest equity market, makes up more than half of the index. Not to be confused with the MSCI All Country World Index, which includes both developed equities and emerging market equities.
  • MSCI Emerging Market Index measures emerging market equity performance.
  • Bloomberg Global Aggregate Index represents global investment grade bond markets, mostly made up of government bonds.
  • Chicago Board Options Exchange Volatility Index (VIX) is a measure of implied volatility in the S&P 500 Index (how volatile market participants expect big US equities to be/how risky they view them to be). It is also known as the “fear index” – with higher numbers crudely representing “more fear” in markets and lower numbers crudely representing “more greed”.
  • Brent Crude oil prices are a key indicator of movements in the global oil market, the world’s most important commodity as it is such an important input into economic activity (in providing energy and as a raw material in production of materials such as plastics).

Data Source: PortfolioMetrix, Bloomberg

 

*Glossary of Financial Terms

  • Hedging back to sterling: The risk of currency fluctuations can be removed by “hedging” the foreign currency back to the pound. In this way, a UK investor holding a US government bond or bond fund would not experience changes to the pound to US dollar exchange rate and their holding would be a lot less volatile/risky.
  • High yield: High yield debt is rated below investment grade and is riskier. It has a higher yield to compensate for this additional risk.
  • Monetary Policy: The decisions central banks make to influence the supply of money in an economy, primarily the setting of base rates in the economy, but also through certain extraordinary measures such as quantitative easing.
  • Quantitative easing: Quantitative easing refers to expansionary efforts by central banks to help increase the supply of money in the economy (and help indirectly lift the economy). It involves the central bank purchasing financial assets, mainly government bonds.
  • Quantitative tightening: A mechanism for decreasing the supply of money in the economy to cool excess growth (above a stable level). It involves the central bank allowing purchased bonds to mature or in more extreme cases selling previously purchased financial assets.
  • Quarterly vs annualised growth rates: Some national statistical agencies prefer to quote country growth levels in a quarter as an actual quarterly rate (the estimate of growth over three months, x, sometimes referred to as “on quarter” growth) whilst others prefer to quote the growth over the quarter on an annualised basis (i.e. assume the growth over three months continued for a year, approximately 4x). Unless specified otherwise we quote only annualised rates using actual calculations rather than the simplified approximation of annual rate = 4 x quarterly rate.

This document is only for professional financial advisers, their clients, and their prospective clients. The information given here is for information purposes only and is not intended to constitute financial, legal, tax, investment, or other professional advice. It should not be relied upon as such and PortfolioMetrix cannot accept any liability for loss for doing so. Any forecasts, expected future returns or expected future volatilities are not guaranteed and should not be relied upon. The value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment. Past performance is not a reliable indicator of future performance. Portfolio holdings and asset allocation can change at any time without notice. PortfolioMetrix Asset Management Ltd is authorised and regulated by the Financial Conduct Authority. Full calculation methodology available on request.

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