Investment Update – Summer 2022
Behind the curve
The world economy has recovered strongly since the pandemic hit in 2020, but 2022 has proved to be a challenging year for the majority of assets.
The labour market has been tight, with the US unemployment rate at a near multi-decade low and wage growth a multi-decade high. These conditions have been compounded by supply chain disruptions leading to the economy experiencing inflationary expansion.
In our view, central banks should have had one foot firmly on the interest rate brake and governments been less loose with fiscal policy, but populist politics tends to be less accepting of prudent economics.
As we entered 2022, central banks were behind the curve just as price rises were exacerbated by the Russia/Ukraine conflict pressuring the cost of energy, food and transportation. Now playing catch-up, with some large and prompt increases to interest rates, around 24 countries have already raised rates once this year. The US has led the way, with some of the larger moves increasing rates by 0.75% in both June and July. Further global rises are on the cards for 2023, although likely to be at a slower pace.
Nowhere to run, nowhere to hide
In this environment, typically ‘defensive’ assets (bonds) have fallen year to date to reflect higher market yields, but so to have equities, especially ‘pricier’ rate sensitive shares (e.g. tech/growth stocks).
In the first half, it is only really property and commodities that have held up, with energy and utility companies being the brightest spots amongst equity sectors, helping the UK to fare better than others. On the other hand, being home to many of the major tech firms, the US market retreated more with some of that weakness offset only by a stronger dollar for UK investors.
US stocks officially entered a bear market (defined as a 20% decline) as investor sentiment and consumer confidence fell, a slowing economy and mild recession at the forefront of investors’ minds. Q2 has been particularly tough as financial markets do not like rising interest rates. Higher mortgage/borrowing costs and more attractive cash returns simply don’t incentivise investment, but the UK has been a structural sufferer on this front since leaving the EU.
With two negative quarters of GDP already this year, you would be forgiven for thinking the US is already in recession, but with the Mid-term elections fast approaching, the White House would be quick to remind you that that doesn’t ‘technically’ mean the economy is in recession! If that convinces you, one still cannot deny the late cycle dynamics of price pressure, global monetary tightening and tight labour markets. In short, these factors all stress company profits and we don’t think this has been fully felt by firms as disposable consumer income is likely to feel a greater squeeze into 2023 and Covid-induced savings are spent.
A ‘recessionary’ bear market is typically accompanied by declining company profits, but in the first half of the year profits have been rising, just at slower rates. What we are hearing from company CEOs is more forward guidance of the challenges ahead and that corporate profit margins have already peaked.
China and the Eurozone
If the US is not in recession, then the Eurozone appears to be teetering close to the edge, continuing to suffer the fate of reliance on reduced Russian gas supplies. Political instability with a snap election in Italy, the Eurozone’s third largest economy, at a time when the European Central Bank is bringing the region out of negative interest rates, is adding to near-term trepidation.
China, the world’s second largest economy has been slowing for some time and Hong Kong slipped into recession in Q2. The economic toll of following a zero Covid strategy resulting in rolling lockdowns is certainly being felt. A weakening housing sector in China also remains a dark patch with shares dropping further, especially through July.
Not all doom and gloom
Despite all the doom and gloom this year, the major assets of bonds and equities turned positive in July and August to bring some summer respite for investors. Trends also turned again, the largest gainers being those that fell the most year to date, with tech stocks rallying.
Although noting the weakness in Chinese markets, economically there are some green shoots. China is further through into its slowdown phase and some data has surprised. Exports significantly beat expectations, credit growth is improving and importantly, while still suffering with rising input prices, Chinese consumer price rises are more stable. This is allowing monetary policy to loosen, in direct contrast with policy in the West. At attractive valuations and prices lower than the worst seen during the pandemic, in our view, the outlook for Chinese stocks is improving if they can battle through recent property market weakness and balance their political tensions with the US.
The recent positive performance has been driven mainly by expectations that interest rate rises would not be as fast or high due to slowing economic activity and limited corporate earning weakness. Markets are never linear and are now far from their highs. A rally in a ‘bear’ market is normal just as corrections are in rising ‘bull’ markets. Whether this is just a bear market rally remains to be seen – the economy is very late stage and has understandably lost momentum. Policy makers remain in tightening mode, the impact of which has not been fully felt by consumers, neither has the full winter cost of higher energy prices which are bound to weaken demand without further government support.
Stickier than anticipated inflation could yet cause further problems and populist politics of lower taxes and handouts add to price pressure. Either way, we typically discount much of the benefit you might think a new leader may or may not bring whether in No 10 or elsewhere. There are greater forces at play.
Against this backdrop, we feel investor optimism for profit growth is still too high. Expectations that this would be in double digits in 2022 at a time when conditions are challenging, significantly exceed the low single digit long-term earnings growth rates seen since 1950.
The details, views and opinions expressed above are KMD’s, can change at any time and are not intended to be advice or a solicitation to make an investment. Professional advice should be sought before acting on any information contained in this document. The value of investments can fall as well as rise and your capital is not guaranteed. Past performance is not a reliable indicator of future performance.