Our latest investment commentary from Avellemy Chief Investment Officer, Graham Bentley

Graham Bentley

Gains in global markets

Despite the conflict in Ukraine, generally global markets saw gains during the month. Resource-rich Latin American markets advanced more than 14% during March, while the US (less impacted by sanctions against Russia) rose by over 5%, mainly driven by technology companies. Shares in UK firms also rose during the month, as might be expected given our 'headline' index of our largest 100 companies (FTSE 100) is biased towards oil and mining companies - major beneficiaries of the recent rise in commodity prices. China continued to see market falls as a resurgence of COVID cases saw draconian lockdown measures introduced in Shanghai, China's financial centre and largest city of over 26 million people. Bonds meanwhile, so-called 'safe-haven' assets, were again in negative territory, and more on this below.

The impact of surging prices

Over the first quarter of 2022, a key feature has been the impact of surging energy and commodity prices; Gold has risen almost 10%, Oil is up 33%, while European gas prices have soared over 50%. Most equity markets are below their levels at the end of 2021, but the markets of resource-rich countries have benefited: Latin American shares are up over 25% so far this year, and our own UK stock market has seen the FTSE 100 some 3% higher year-to-date. However, this masks a less obvious development - investors appear to be abandoning 'Growth' companies, typically those that reinvest profits rather than distributing them e.g. technology firms, and redirecting their focus to less exciting (depending on your viewpoint) companies that are mature and pay consistent growing dividends. For example, UK companies with low dividend yields are on average down over 7% this year, and smaller companies' shares are down more than 12%. Higher yielding UK companies on the other hand have seen average rises of more than 8%, i.e. a variance of 15 to 20%. As I've said in previous editions of this commentary, there is a lot more going on in the UK economy than might be deduced from monitoring the FTSE 100. There is a similar story in the US, where the Russell 2000 Value Index has outperformed its Growth equivalent by over 10% during Q1 2022.

G4 central banks slow to react to rising inflation

Looking forward, it remains important to recognise that there are two key narratives being recounted currently - the geo-political drama concerning relations with Russia (and a sub-plot including China) that are being played out as economic warfare, and the broader ramifications of rising inflation and central banks' responses. There is a consensus that the G4 central banks (US, UK, EU and Japan) were slow to react to control record levels of inflation that they had doggedly declared to be temporary. The trend of rising producer prices is now clearly established; the Bank of England has suggested inflation may reach 8%, compounding the difficulties consumers will encounter due to energy price rises that came into force 1st April. Nevertheless, they raised rates to 0.75%. In the US, the Federal Reserve (Fed) has for several months been prevaricating on tightening monetary conditions by raising interest rates and removing cash from the financial system, and finally ambled into action with the recent 0.25% hike. However, they may now have to raise rates by as much as a full 2% or more during the year to try to 'catch up'. In Europe, Germany and Spain are approaching 10% rates while Italian producer prices are rising at an annualised 40%. Turkey, an EU partner but not yet a member, is experiencing prices rising at an annual level of 60%! Despite this data, recent statements by Christine Lagarde, President of the European Central Bank, seem to lay the blame for more persistent inflation on the war in Ukraine, absently ignoring price rises before February 24th. With negative interest rates (unchanged since 2016) and a continued programme of pumping money into the system signalled to last through the remainder of 2022 year, if you'll excuse the mixed metaphors the EU might be said to be somewhat behind the curve, if not "asleep at the wheel".

Speaking of curves, we have referred to 'yield curves' in several our recent bulletins. As a reminder, the yield curve is simply a chart plotting the income yields on a government's bonds of various maturities, from one-month borrowing out to 30 years. Typically, the curve slopes upward - with higher interest for longer-term lending - because the longer the loan period, the greater the risk of investors not receiving an income payment or promised capital at maturity. Investors lending money to governments therefore usually demand higher interest payments for longer loan maturities, to compensate for these risks.

However, when short-term interest rates rise relatively quickly, investors can become very concerned about short-term economic prospects and potential central bank policy errors; the yield curve can thus become “inverted”, i.e. downward sloping. This is a relatively rare occurrence, signalling a preference for riskier longer-term bonds over short, and perhaps in preference to equities; it is hence a perceived indicator of a forthcoming recession. For example, if concerns of an impending recession increase, investors tend to buy longer term Treasury bonds assuming they offer a safe haven from falling equity markets, ultimately increasing their value when their prices rise as interest rates decline again to stimulate economic growth.

Yield on 30-year Treasuries falls

During March the yield on 30-year Treasuries fell below the 5-year, and as I write, strong statements on quantitative tightening by the US Federal Reserve's nominee vice-Chair have served to reverse the 10-year yield’s fall below the 2-year. This is important, as a persistent negative gap between the 2 and the 10 year yield has presaged every recession (typically by around 18 months, but as much as 3 years) in the last 50 years. I must stress that this relationship may not be causal, other than being a 'message' investors choose to interpret as pivotal. It should also be said that the background conditions of historically low yields and decades of low inflation might mean curves may now simply be more prone to inversion anyway. 

We maintain our philosophy of seeking incremental gains over the longer-term, while seeking out portfolio constituents with lower downside risk. Nevertheless, we are monitoring political and economic developments closely. For the global economy, what happens to supply channels and the prices of goods and services over the coming weeks and months is probably the most important thing to watch, and in turn how decisive (or not) politicians and central banks are in response.

Graham Bentley
Chief Investment Officer, Avellemy