The ‘September effect’ was again in full force this year, with all major financial assets generating below-average returns last month.
Rising rates and the subsequent tightening of financial conditions began to translate into slowing economic activity worldwide, with Global PMIs signalling a further deterioration in manufacturing activity. Equities were sold-off amid economic concerns. The MSCI World Index declined 8.3% over the month. Unsurprisingly, the most interest rate-sensitive parts of the market fell the most, with the US Nasdaq index losing more than 10%. European stocks also continued to decline with downward pressure from the war in Ukraine and overall negative investor sentiment. The local market was a relative outperformer, with the ASX 200 finishing the month down 6%.
Global and US fixed income markets tracked lower in August, as central banks delivered outsized rate hikes and signalled more on the way. Meanwhile, global risk-off sentiment and the Fed’s hawkish stance continued to support the US dollar, which continued to appreciate over the month. While the US dollar could continue rallying over the near term, it is now expensive and oversold, which suggests it is likely to weaken over a cyclical investment horizon.
The stronger US dollar and slowing global demand outlook weighed on the performance of commodities. The price of Crude Oil fell 9% and dipped below the level last seen before Russia invaded Ukraine. Similarly, industrial metals weakened on concerns about Chinese demand, while gold fell amid rising real interest rates.
What’s next for global markets?
So far, 2022 is shaping up to be a year where headwinds are stronger than tailwinds. The world is still recovering from the impacts of the pandemic, and many supply chains are affected as China broadly pursues a zero-Covid policy.
Global central banks turned hawkish, with rates going to levels not seen since the Global Financial Crises (“GFC”). Unsurprisingly, these forces have led to sharp selloffs in both fixed income and equity markets.
While pressure on financial markets is likely to remain over the short to medium term, long-term investors must now assess how these factors impact the future investment environment and the extent to which expectations are, or aren’t, priced in.
There is no doubt that inflation proved not to be transitory, but it is still expected to move towards its long-term equilibrium range. It is likely we would have seen this happen faster. However, strong labour markets, increasing labour costs, ongoing Covid – related disruptions, and the war in Ukraine made some inflation components stickier than initially expected. Yet there are some reasons to believe that inflation will start fading, with a softer global economy leading to weaker employment and slowing consumer spending. Such conditions would mitigate any remaining inflation and lead to a potential reduction in base interest rates.
The post-GFC era of ultra-accommodative policy has ended as central banks have sharply pivoted to tightening. We expect yield curves to remain relatively flat compared to history, but this is still higher than observed in most of the past decade. Even though expected cash returns still imply slightly negative rates on a real (after inflation) basis, the departure from negative rates should help economic functioning and provide a return to normalcy for various market participants, including savers and financial institutions. Longer term, this is likely to positively impact the economy. However, it’s important to note that uncertainty around central bank responses is high as policymakers adapt to the new backdrop of balancing growth and inflation amid ongoing geopolitical shifts.
Inflation and monetary policy aside, there are other factors impacting the long-term shape of global economies. This includes demographic headwinds as well as higher government debt levels following the pandemic stimulus spree. Simultaneously, the world is also transitioning from pandemic to endemic, from globalisation to regionalisation and finally from traditional energy sources to renewables. In general, the more exposed a country is to slow transitions, debt and demographic headwinds, the greater the economic pressure.
We are mindful that some current risks may take longer to play out. However, we believe that many factors are pointing out to return to the slow-growth, low-inflation, low-interest rate environment that has supported both the bond and stock markets for many years.
Emerging Markets – cheap but Chinese path still uncertain
We have previously discussed our positioning in Emerging Markets (“EM”), having reduced allocation earlier in the year. While valuations are now looking much more attractive, uncertainty over the Chinese economy remains a risk to monitor.
Historically, the relative performance of non-China EM versus the broad EM market has been closely linked with industrial commodity prices, but the relationship has not held up since the Covid outbreak. According to BCA Research, this is because the rebound in commodity prices after the onset of the pandemic was not driven by Chinese demand as it used to be. Instead, it was largely the result of the pandemic-induced constraints on the supply side.
Currently, China’s modest economic stimulus and imported inflation from high energy prices do not bode well for the region’s profitability. Furthermore, in contrast to many developed markets, China faces a deflationary problem. The government may eventually need to reflate its economy with more stimulative policies. But any stimulus package is likely to be moderate so that the “conventional beneficiaries” – other EM countries, the euro area, and the industrial commodity complex – may not receive the usual boost from China’s reflationary efforts. Since the timing and scale of the Chinese stimulus are uncertain, investors should remain on the sidelines until the policy path becomes clearer.
Without a doubt, there are a multitude of factors impacting the financial markets over the short term. The change of monetary and fiscal policies globally coupled with additional macro and geopolitical issues suggest the potential for more volatility. Over the next year, we expect the economic environment to be characterised by fading fiscal stimulus, declining consumption, higher mortgage rates, slow profit growth constraining CAPEX and a high dollar and overseas weakness hurting exports. When the public becomes more fearful of recession than inflation, the Fed will likely begin its slow return to more accommodative policy settings. This should provide a positive backdrop for both stocks and bonds. However, any surge in volatility between now and then could lead to an even greater investor focus on defensive positioning and valuations. This could favour long-duration bonds, value stocks and income-generating alternatives over more growth-oriented investments.
Across our portfolios, we continue to apply cautious portfolio positioning with a neutral weight to global equities. While equities are now more fairly valued, with multiples aligned to long-term averages, some further weakness on the back of higher rates, lower earnings and ongoing recessionary fears are plausible. In this environment, our core-satellite approach that combines an index-based core for overall market beta exposure with selective, highly skilled managers for alpha generation should deliver relative value.
Fixed interest asset classes have seen both government bonds and credit yields increase in response to tightening monetary policy, as well as increasing chances of recession. At these levels, public fixed income is starting to look relatively more attractive and introducing some duration back into portfolios seems reasonable. Corporate credit should remain a resilient source of income in the near term, as corporates remain well capitalised and default rates are below long-term averages. Furthermore, higher interest rates are likely to cap the upside for equity valuations and the opportunity cost of holding cash and fixed income versus risk assets to be much lower than in the past decade.
Private debt allocation remains attractive, given that most loans are now tied to floating rates, providing an attractive spread over the reference rate. The tailwinds in the space remain strong, and we continue to hold good quality managers in our portfolios to provide yield and diversification benefits and reduce the overall volatility of returns.
Core real assets such as real estate, infrastructure, timberland and transportation should continue to provide investors with both inflation protection and income. We also remain positive on various alternative investments and private market opportunities for downside protection and diversification of return streams in portfolios. Although we acknowledge that some private markets investments are yet to see a revaluation of the underlying assets, in line with the public peers. Being selective and investing with high-grade managers remains a priority.
We continue to recommend that clients remain invested yet maintain some cash outside the portfolio, giving them dry powder when a better entry point into risk assets presents itself. In times of market volatility, it is important to have a robust investment framework and focus on long-term investment objectives. If you would like to discuss the positioning of your portfolios, we encourage you to reach out to your Lipman Burgon & Partners Adviser.
We encourage you to contact us should you wish to discuss this further or if you have any questions about how these trends are impacting your portfolio.