04 July 2022 | William Buckhurst
Thoughts on 2022: The Halfway Point
After many years of strong stock market returns, the first half of 2022 has unfortunately been the worst start to the year for global equities since the early 1970s.
Global equities fell by 21%, back to late 2020 levels. The six-month period was dominated by a swift and sudden reversal of the outperformance of growth stocks, many of which had been the top performers over the last decade and a half, to the extent that their falls have a disproportionately large effect on the performance of global benchmark indices.
The NASDAQ index fell by 29% in local currency terms over the first six months of the year; yet the UK market, which has a higher proportion in Oil & Gas and Mining and less in Technology, only fell by around 5% as higher commodity prices powered sectors that were until recently being shunned by ESG investors.
Many of the so-called “meme” stocks – particularly the Covid winners such as Zoom and Peloton – now trade at a fraction of their peak values in 2021. Yet, although the valuation unwind has been severe, from an operational point of view the more mature internet behemoths have – on the whole – continued to perform well. As an example, Microsoft, the world’s largest software and cloud computing provider, continued to exceed market expectations in terms of earnings and revenue generation; however, the shares fell by around 25% and the valuation de-rated from mid-30’s to mid-20’s. Markets have been fairly unforgiving in that sense.
The catalyst for this sharp re-pricing of growth was, of course, the higher and more persistent inflation data unforeseen by many investors and certainly all central bankers, which in turn triggered a rise in bond yields. Put simply, as the government bond yield (“risk-free rate”) rises, investors lower the price at which they are prepared to pay up for a dollar of future earnings – this can have an unduly negative effect on companies with high ratings where the expected profits used to justify that rating are still some years ahead. In stock market terms, this has been one of the main consequences of higher inflation.
It is now clear that soaring demand and a lack of supply, thanks to bottlenecks caused by the pandemic, have led to more persistent price rises across a broad swathe of goods and services. This has been exasperated by the war in Ukraine which has heightened food insecurity and triggered a surge in fuel and energy prices. The annual inflation rate hit 8.6% in the US and 9.1% here in the UK, at or around 40-year highs and, as things stand today, show little sign of abating. Western governments face a once in a generation cost of living crisis, for which they appear to have few solutions. The central bankers’ response has been to slow or stop asset purchase schemes and hike interest rates faster than many had expected.
Higher rates are designed to dampen activity and so the market narrative through the year has turned fairly quickly from “growthflation” (growth and inflation), to “stagflation” (lower or zero growth with inflation), to, more recently, the prospect of outright recession. Chairman of the Federal Reserve, Jay Powell, first acknowledged recession as a material risk in mid-June. He argued the US was sufficiently resilient to withstand tougher monetary policy without sliding into a downturn but acknowledged that outside factors, such as the war in Ukraine and China’s Covid-19 policy, could further complicate the outlook:
“[Recession] is not our intended outcome at all, but it’s certainly a possibility.”
We simply do not know yet whether we face the possibility of a technical recession (two quarters of negative growth) – a scenario which the market, arguably, has already priced in. Or do we face a deeper more damaging recession?
Economic data over the last few months has actually not been that bad. Unemployment remains very low (albeit skewed by the fall in the participation rate) and business surveys on areas such as new orders, inventory levels and supplier deliveries have fallen but remain in positive territory in many parts of the world – the US manufacturing PMI at the end of June fell but still came in at 53 points (anything above 50 points to expansion), while Services PMIs still hover above 50. Admittedly, consumer confidence surveys have been a lot weaker but – due in part to the fickle nature of human emotion – can be volatile, often bouncing as quickly as they fall. Nevertheless, with annual inflation data pushing 10% in many parts of the world we face an unprecedented cost of living crisis and consumers are unlikely to come to the rescue of the economy any time soon.
What is perhaps surprising, though, is that company earnings at the aggregate level continued to improve over the six months and analysts’ expectations have not really fallen yet. As we approach July, we start to enter another quarterly earnings season point again and everyone expects earnings expectations to start coming down once companies have reported. But a lot of these lower earnings expectations may already be in the price.
Bond markets, unsurprisingly, have been weak: in the UK government bond indices fell by 16%. It has felt at times over the last six months that central banks, now indisputably shown to have been behind the curve last year, spent much of this year trying to “out-hawk” each other, culminating in the Federal Reserve announcing a 0.75% single hike in one afternoon in mid-June – the first time this has happened since 1994. But the fear of falling economic growth in response to higher borrowing rates has gone some way to helping yields to moderate once again: the 10-year US Treasury yield, having risen from 1.5% at the start of the year to 3.5% by mid-June has now fallen below 3% again.
Meanwhile the ECB, once more finding itself confronted by a spike in bond yields in some of the weaker and more fragile European member states (remember the “PIGS” during the early part of the last decade?), convened a swift but characteristically muddled meeting to tackle the so-called fragmentation of periphery bond yields. This was enough to put a cap on soaring yields and bring some stability to bond markets elsewhere in the world. Nonetheless, it was a torrid six-month period for global fixed income investors. For sterling investors, domestic bonds fell almost as much as global equities leading to a serious revaluation of the tradition 60/40 approach.
China, for so long the powerhouse of global growth, has also been slowing (albeit still exhibiting economic growth far higher than in the West). The first few months of 2022 saw little relief from the Chinese government’s crackdown on internet giants and indebted real estate companies as well as a continuation of its harsh zero-Covid policy. But the question remains will China emerge from its Covid-driven slowdown with fresh stimulus, or will it accept slower growth? China may divide the bulls and bears more sharply than any other issue at present. Some are convinced that the authorities will soon have no alternative but to release credit flows once again, and spark another upsurge. Others, pointing to China’s overhang of debt, suggest that this slowdown is for keeps. If the latter is correct, that implies some kind of lid on inflation, rates and, alas, economic growth. Yet we ended the six-month period with a loosening of lockdowns and data showing factory activity starting to expand again. Chinese equities enjoyed their best month in June in years. While Chinese equities were weak over the six months, the bulls point to monetary policy that – in stark contrast to the West – is accommodative and in a comfortable range with the potential for further loosening.
Inflation was notably absent In Japan. The Nikkei has fared much better than US or European benchmarks this year, limiting losses to about 10%, thanks in part to the impact of a weaker Yen boosting the profits of exporters. Whilst most countries and their Central Banks are worrying about inflation and interest rises, Governor Kuroda at the Bank of Japan has made it clear that, unlike other central banks, they are very unlikely to put interest rates up anytime soon and will not start withdrawing support either. The negligible rate of interest available from the Yen, relative to other major currencies, has triggered a wave of short-selling resulting in the Japanese currency finishing the period around a 24-year low versus the US dollar. This offers a significant opportunity for foreign investors targeting a market that was already cheap and has many companies awash with cash on their balance sheets. Activist shareholders remain alert to the opportunity.
It’s been a very difficult six months. Both equities and bonds have corrected, while gold has made little progress and index-linked gilts have failed to protect, which means that investors have had almost no place to hide. Even well diversified portfolios have taken a hit, albeit only giving back some of the returns of the previous decade. When the rate hikes stop and investors can once again price risk with some certainty, cheaper assets across equity and bond markets will represent a good opportunity set for those seeking attractive long-term returns. Markets have a funny way of falling in anticipation of a recession while beginning their recovery when the recession becomes a reality. The US market is much cheaper now, at around 16x, than it was at the start of the year (22x). So, broadly speaking, the last six months has been a healthy re-set, albeit dramatic in some of the more expensively valued areas such as technology. A portfolio balanced across different equity styles and asset classes continues to make sense while exposure to the US dollar provides some protection.
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