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Investment Commentary Q3 2022

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In Brief

  • Q3 2022 was a quarter of two halves, with increases over the first half and falls over the second half, which erased earlier gains.
  • Optimism that the US Federal Reserve might moderate its rate hiking cycle fuelled the early gains, but that optimism later faded in the face of persistently high inflation and continued central bank hawkishness around the need to respond to control it.
  • UK assets were fragile over the quarter, with sterling falling heavily against the dollar, UK domestic equities struggling, and UK bonds experiencing a torrid period after the UK ‘mini-budget’ of 23 September.

Quarter Overview

July saw yet another round of higher inflation prints across significant economies. This prompted further central bank rate rises by the US (another 0.75%), and a first increase from the ECB (0.5%), taking the euro area out of a hostile rate environment for the first time since 2014. Concerns about higher rates causing a fall in global growth continued to build, with provisional data suggesting that the US might already be in a recession. Interestingly, markets had been ahead of this news and so rose, given the expectation that any economic weakness would allow central banks to be less aggressive in hiking rates than priced in. This meant longer-dated bond yields fell, and their prices rose, giving positive returns for fixed-income investors. Equity markets also bounced, led by Growth equities, whose valuations tend to be more closely linked to lower interest rates.

August saw further central bank rate rises. Although the US didn’t have a policy meeting, a speech by US Federal Reserve Chairman Powell in late August reinforced messaging around the Fed’s determination to continue to raise rates to reduce inflation. Inflation did show signs of slowing in the US, although it continued to tick up elsewhere as further Nord Stream gas pipeline disruptions by Russia pushed gas prices towards all-time highs in Europe. A trip by U.S. House Speaker Nancy Pelosi to Taiwan raised geopolitical friction between the US and China, but these worries were eclipsed mainly by inflation, rates and gas price worries by the end of the month. These higher interest rate expectations resulted in bond prices falling and negative equity returns on fears of a possible recession.

September saw the sad passing of Queen Elizabeth II at the age of 96, with the UK nation (and the wider world) mourning her in the lead-up to her state funeral. Later in the month, the Federal Reserve in the US, the Bank of England and the European Central Bank hiked rates in response to stubbornly high inflation. US inflation, in particular, fell less than hoped, bringing about expectations of more and faster rate rises in the US. In the UK, the effects of Chancellor Kwarteng’s mini-budget were anything but mini as a multitude of unfunded tax cuts spooked markets. The announcements caused significant gyrations in the pound and UK bond market falls which also extended into global markets. This forced the Bank of England into urgently intervening as a buyer in gilt markets to protect the UK pension industry, a victim of rapid falls in UK bond prices. Markets struggled to digest the month’s economic news, with bond & equity prices falling globally.

Overall, the third quarter saw poor performance across most asset classes due to aggressive central bank hiking. However, falls in the pound did support the performance of overseas equities when converted into sterling. This was particularly true of those asset classes denominated in strengthening dollars, such as US equities and some commodities.

Volatility, as measured by the VIX index, rose over the quarter. Developed market equities (as measured by the MSCI World Index, including dividends) rose 2.1% in sterling terms over Q3, benefitting from a weaker pound. The FTSE 100 fell -2.7% over the quarter, including dividends, and emerging market equities (MSCI EM Index) fell 3.8%. Global bond yields rose steadily over the quarter, leading to higher quality bonds (as measured by the Bloomberg Global Aggregate Index) falling by 3.8% (bond yields and prices move in opposite directions). Lower quality ‘high yield’ bonds also fell, down 1.9%, as investors worried about the strength of the global economy. After strong gains earlier in the year, oil fell 23.4% over Q3, whilst gold fell 8.1%.

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, high-priced securities (often described as ‘growth’) bounced back somewhat over the quarter, up 3.3%, as did smaller companies, up 3.1%. Cheaper ‘value’ companies (which generally includes oil and gas and other commodity companies) relatively underperformed over the quarter, rising just 0.9%.

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

In terms of currencies, the pound had a weak quarter overall. It fell 8.3% against the US dollar, 2.0% against the euro and 2.2% against the yen.

Portfolio Performance Overview

The PortfolioMetrix Core portfolios fell less than the FTSE All Share over the quarter. Lower-risk portfolios sold off slightly more than higher-risk portfolios, given their lower dollar exposure (higher-risk portfolios hold more equities than lower-risk portfolios, and many of these companies are either priced in US dollars or earn dollars as part of their operations). Asset allocation was mixed with small relative underweight to outperforming US equities, being unhelpful, but lack of exposure to dramatically underperforming UK bonds supportive in lower risk portfolios. Active fund performance was broadly neutral over the quarter. UK funds underperformed, giving overweights to poorly performing UK small and mid-sized companies, but strong, active returns in other asset classes offset this.

Sustainable World portfolios performed more or less in line with Core portfolios overall, having bounced harder earlier in the quarter before later retracting their outperformance. We do believe sustainable funds continue to enjoy significant long-term structural drivers as the world shifts to focus more on environmental and social issues – for more on this, please see our blog on the topic: Portfoliometrix – Long-term-case-for-sustainable-investing.

Looking Forward

Moving into the last quarter of 2022, only one question is still driving markets: “When will inflation definitively begin to fall?”

CPI

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

This is so important because it links directly to when central banks will be able to ease up on their aggressive tightening. Having been raising rates throughout Q3, markets are currently pricing in significant further moves, for example, to just under 6% in the UK next year (the Bank of England’s UK base rate is currently 2.25%).

Source: J.P. Morgan Asset Management Guide to the Markets UK Q4 2022

Central bank rates are so important for markets because they are reflected in the current prices of all investments in some way. They show up directly in lower bond prices (higher expectations for future central bank rates cause bonds to fall) and indirectly in equity prices (lower bond prices increase the relative attractiveness of bonds to investors who sell equities to buy those bonds, causing equity prices to fall). If inflation starts falling, central banks may be able to raise rates less than expected. This would cause bond prices to rise and, possibly with a lag, equities to perform better, too.

Whilst nobody knows for sure, economists predict that the US is already past its peak inflation level. They predict peak inflation should be reached in the UK and the Eurozone in Q4 (at just over 10% CPI for the UK) before falling back in all three regions to close to central bank targets of 2% by the end of 2023.

Forecasts for CPI

Source: J.P. Morgan Asset Management Guide to the Markets UK Q4 2022

Now, economists and markets have, over the last year, been hopelessly behind the curve in anticipating actual inflation. Hence, it’s pretty likely that inflation won’t decrease as quickly as expected. However, there are good reasons to believe we are past or near the peak. Many post-COVID bottlenecks in shipping rates, lorry drivers or new car production (as a substitute for used cars whose prices spiked as economies re-opened) have been cleared. Energy prices remain elevated, particularly in Europe, but would need to keep increasing from here to contribute to higher inflation, which is more difficult from these already elevated levels.

Source: J.P. Morgan Asset Management Guide to the Markets EU Q4 2022

And should energy prices fall from here, they would start contributing negatively to inflation. From an energy store perspective, Europe is now actually in quite a good place, with its gas inventories nearly 90% full. At these inventory levels, it would then take a freezing winter (as well as limited wind to power the continents’ wind farms) to strain supplies.

EU natural gas inventories

Source: J.P. Morgan Asset Management Guide to the Markets UK Q4 2022

The other likely driver of lower inflation is a slowing global economy. Growth expectations have already fallen significantly, and it’s likely that the US, UK, and Eurozone will all experience technical recessions. These need not be particularly deep recessions, though—not all recessions are as serious as those sparked by the global financial crisis. A shallow recession wouldn’t necessarily cause deeper asset price falls than we’ve already seen.

Growth forecast major economies

That said, the speed of rate rises by central banks risks exposing vulnerabilities within the financial system that the era of lower interest rates had previously hidden. We’ve already seen one example of this in the UK, where falling bond prices coupled with derivative positions in the pension industry saw dramatic swings in the ordinarily placid government bond market before the Bank of England stepped in to stabilise prices. Expect volatility ahead as markets await signs that inflation is indeed falling and whether there are any other market fracture points out there.

The Fall in one Long-Dated UK Government Bond (2051 Maturity) post the ‘mini’-budget

Mini-budget affect on Government Bond

Whilst economic uncertainty is high, the indisputable silver lining is that most asset prices are now pricing in a lot of bad news and are now good value. Equities are cheap in most areas outside the US, and even in the US, they are slightly below long-term average valuations.

Global forward P2E ratios

Source: J.P. Morgan Asset Management Guide to the Markets Q4 2022

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 rate rises—which means they can perform well as central banks continue to tighten monetary policy just as long as they don’t hike more than already expected).

Fixed income yields

Source: J.P. Morgan Asset Management Guide to the Markets Q4 2022

Given the relatively more attractive valuations, we are optimistic for the long-term returns of portfolios, although we do continue to favour diversification to manage what is likely to be a bumpy ride over the near-term.

Data: Monetary Policy* (Rates & Extraordinary Measures)

The third quarter of 2022 saw continued dramatic tightening by several developed and emerging market central banks. The US Federal Reserve raised rates by 1.5% and accelerated quantitative tightening (letting some of the bonds they bought during COVID mature without reinvesting the proceeds), whilst the Bank of England tightened rates by 1%. There were, however, a few notable exceptions. China loosened rates slightly to support its economy, battered by issues in its property market and the impacts of its zero-COVID policy. The Russian central bank, which had dramatically raised rates in Q1 to defend its currency post-western sanctions, also continued cutting rates in Q3.

Global monetary rates

Data: Global Economies

GDP figures released in the third quarter were for Q2 2022 and were mixed, with China, in particular, experiencing a below-expected fall on its COVID lockdowns. The US saw its second quarterly GDP fall in a row, the technical definition of a recession for many countries, although given the strength of its labour market is not yet likely to be declared in recession officially. Inflation generally increased during Q3, although it’s possible that it peaked in the US during the quarter. Unemployment generally fell as economies continued their recovery from COVID.

Key figures global economies

DATA: ASSET CLASSES

Asset class performance Q3 2022
Asset class performance table Q3 2022

Note: The above 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. 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

Key

  • The FTSE 100 is an index of the 100 largest companies by market capitalisation listed on the London Stock Exchange. Crucially, while these companies are priced in sterling, the majority of their revenues come from outside the UK, making the FTSE 100 more of a global rather than domestic UK index.
  • The MSCI World Index gauges 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. It is not to be confused with the MSCI All Country World Index, which includes both developed 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) measures 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: Currency fluctuations can be eliminated 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 much less volatile/risky.
  • High yield: High-yield debt is rated below investment grade and is riskier. Its higher yield compensates for this additional risk.
  • Monetary Policy: The decisions central banks make to influence the money supply in an economy, primarily the setting of base rates, but also through specific extraordinary measures such as quantitative easing.
  • Quantitative easing: Quantitative easing refers to expansionary efforts by central banks to help increase the money supply 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 money supply 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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