July offers some respite
After a rather dismal start to the year, risk assets enjoyed a stronger July, with developed market equities and bonds both enjoying stronger returns:
As we have discussed before, our aim of being diversified across style of investing (value vs growth) and size of company has been a material headwind this year. However, through the more “risk on” environment in July, medium sized companies also have outperformed larger ones:
A new bull market?
This near-term bounce in markets and apparent improvement in sentiment begs the question of whether the bear market is over, and we are in the foothills of a new bull phase, or is this just a bear market rally.
Whilst stronger markets in July are welcome, we view this with a degree of scepticism for now. The market appears to be betting on inflation numbers beginning to subside, the US economy avoiding a recession and the US Federal Reserve (Fed) being able to cut interest rates early next year.
Focussing on the US, various indicators are pointing toward a recession and, according to the European definition of two consecutive quarters of negative GDP growth, the US is already in one. However, the US definition is less formulaic and so the jury is still out as to whether the US will enter a recession or not.
For now, the market narrative is that inflation is peaking and that the stronger dollar and falling equity markets have already tightened financial conditions enough for inflation to continue to fall. This is supported by the fact that energy prices have fallen from their peak and there are some signs that food prices are also stabilising. Given deteriorating consumer confidence, lower manufacturing orders and a slowing housing market, this will all enable to the Fed to start cutting interest rates in 2023:
The chart shows market expectations for the path of interest rates in the light green line versus the Fed’s own expectations in brown.
For now, and the situation is highly fluid, we are erring on the side of the Fed and believe it is unlikely they will cut rates next year. Core inflation measures are still rising, and wages are rising at roughly 7% according to the Atlanta Fed wage tracker:
Therefore, we see a risk that inflation is stickier than the market expects as higher wages embolden consumers to spend and companies to pass through higher prices, resulting in yet higher inflation.
There is also an argument to suggest that the Fed will not want to repeat its past mistakes of the 1970s which resulted in runaway inflation and low growth. Some argue that the Fed has been too slow to raise rates in the face of inflation during this cycle and they will want to be seen to be aggressive. Fed Chairman Jerome Powell recently reiterated that combating inflation is the Fed’s number one priority, suggesting that they are willing to tolerate a mild recession to achieve their goals.
What about Europe?
Unfortunately, the situation in Europe looks much worse than in the US and it is probable that Europe is already in recession. The situation will be exacerbated if Russia further squeezes natural gas supplies in retaliation for European sanctions. The European natural gas price has already risen 933% since the start of the year:
Bearing all this in mind, we think (guess) that there might be further downside from equities and have a reasonably cautious view on the outlook. However, we do think that some areas of the bond market are particularly attractive at the moment, especially if we do see a developed market recession.
The table below shows the potential return from a 10-year government bond at various target base interest rates. If we focus on the UK government bond (Gilt) in the right-hand column, we can see that, in the event of a severe UK recession during which the Bank of England (BOE) cuts interest rates to zero, the potential return would be in the region of 21%, as denoted by the circle:
We think this is valuable portfolio protection and highlights the importance of proper portfolio diversification (yes, that old chestnut again!). Of course, the BOE has been raising rates but has also openly admitted that the risk of recession in the UK is high. Therefore, whilst bonds have fallen in line with equities in the first half of the year, we think that the risk of being out of bonds is higher than the risk of holding them, given the highly uncertain economic outlook.
As always, your financial adviser or investment manager is on hand to answer any questions you may have about your portfolio or current market conditions.
Until next time stay well.