Q2 2022 In Review
It has been another difficult quarter for markets after what had already been a tough start to the year. This is now the worst first half of the year for developed market equities in over 50 years. To make matters worse, government bonds have also been hit so far this year, failing to provide the protection that investors usually look to them for, by moving to price in significant further increases in interest rates on top of what has already been announced. Markets now expect interest rates to rise to 3.4%, 3% and 1.6% in the US, UK and Europe, respectively, by next year. That increase in expectations for the path of interest rates has also contributed to a decline in equity valuations, along with concerns about the growth outlook. Recession fears have risen, due to the squeeze on consumers from higher prices and higher borrowing costs as central banks seek to fight inflation.
Despite recession fears building, consensus analysts still forecast, perhaps surprisingly, positive growth in company profits for both this year and next. So, the key risks from here, are if company earnings disappoint relative to expectations, or if the still relatively expensive US growth stocks continue to see further declines in their valuations.
In China the number of COVID-19 daily infection numbers has declined sharply. This allowed the reopening of Shanghai on June 1. As lockdowns in various cities are relaxed, the government is turning up the macroeconomic stimulus. There is the need to protect small and medium enterprises, a key source of employment. Tax cuts, loan facilities and deferral of social security payments should provide some support. In addition, public spending on infrastructure, including on transportation and renewable energy, should offer an additional boost to the economy. The 2022 economic growth target of 5.5% may be hard to achieve. Nonetheless, May Purchasing Managers’ Index (PMI) data shows that the trough of the economic downturn may be behind. A robust recovery in 2H 2022 should still set an upbeat tone as we approach the 20th Party Congress in November.
On top of fiscal and monetary stimulus, the authorities would also need to boost consumer and business confidence. This could be achieved by adopting a more pragmatic approach on future lockdowns while maintaining the zero-COVID-19 strategy. Enhanced protection from higher vaccination rates and progress in treating COVID-19 could also allow the Chinese authorities to be less stringent in containing the pandemic.
Remaining in Asia, in Hong Kong, as at time of writing this update, a new CEO has been appoited on the 1st of July, with Chinese president Xi Jinping attending the ceremony. The new CEO, as his predecessors, will aim his focus on the city’s housing issues, and adapting COVID-related restrictions, with the possibility of greater mobility with the mainland and for international travel. Over the past weekend the city recorded its highest daily flow of passengers through its airport since the beginning of the pandemic, paired with a new increase in infections within communities. Despite possible efforts to reintegrate the city as Asia’s financial hub, autorities marked the 100th ban of inbound international flights, due to breaches of carriers.
In the U.S. the Federal Reserve is rightfully concerned about inflation, and reducing price pressure is its top priority. There is good news and bad news.
A piece of good news is that year-over-year (y/y) inflation has most likely peaked. It fell to 8.3% in April from 8.5% in March. This was largely expected considering the high base set in 2021. However, the bad news is that month-over-month (m/m) momentum in price increases is still strong, at 0.6% in April, and significantly above the 10-year average of 0.2%.
In terms of the drivers of inflation, the good news is that the impact from higher oil and food prices should fade in the coming months. However, the bad news is that there are other areas where inflation could be more stubborn to come down. Housing costs, especially rent, are usually sticky. The job market in the U.S. is also hot, with strong labour in the services sector.
Employers need to raise wages to attract new hires or to retain existing workers. These businesses may need to pass these higher costs to customers, which could fuel inflation.
While the Fed can’t do much about food and energy prices, higher interest rates can help to cool the housing market and overall demand in the economy. Global investors are widely expecting the Fed to raise interest rates by half a percentage in its June and July meetings, then move to a more modest 25 basis points for the rest of the year and early 2023. Even as the Fed is now laser-focused on controlling inflation, it will aim to avoid pushing the economy into a recession. Provided the central bank does not turn much more aggressive relative to this expectation, we should see calmer markets in 2H 2022.
One area where wit is yet to see a clear peak is food and energy prices. Having hit above USD 125 per barrel in the early days of the Russia-Ukraine conflict and returned to USD 100, Brent crude has been rising steadily again through May in response to tightening European sanctions against Russian oil exports. OPEC’s pledge to increase output has yet to show a clear impact on calming the market. The economic recovery from Asia could push demand up further and keep the price pressure high.
Food prices have also seen a strong rise in recent months. Food prices are usually closely linked to energy prices because of transportation and fertilizer costs that go into food production and distribution. The Russia-Ukraine conflict also had an impact on the supply of grains and vegetable oils, which have seen the steepest rise in prices compared with a year ago. The price index compiled by the United Nations Food and Agricultural Organization has seen a modest drop in May versus March and April, but it is still 23% higher than a year ago. Meanwhile, some countries, such as Indonesia and India, have limited selected agricultural exports to protect domestic supply, and this could disrupt global supply and exacerbate price volatility.
Asset classes & strategy implications
As witnessed throughout the first quarter of the year, our defensive and selective investment criteria have partly helped us fend off the negative market moves. Diversification is also much to thank for, as a key component of portfolio construction, that enabled us to limit exposure to more sensitive assets. We have been maintaining a constant allocation and selection throughout the downturn with certain rebalancing and reinvestments leading to a noticeable performance difference compared to our benchmarks. Such positive deviation does not nonetheless mean we can let our guard down and we are closely monitoring our exposures in case we see either a pick-up or whether the bottom is yet to come.
The fixed-income asset class has come under considerable pressure over the last six months. As investment theory dictates and as historically has always been, it would be the go-to investment for protection should equity markets go in distress. The combination of economic circumstances we are facing now, nonetheless has much limited the extent to which the asset class can provide downside protection. Our diligence over the past several years to retain only short to mid duration investments has made a noticeable positive impact within our investment strategies. Besides several maturities in these couple of months, we are currently predominantly retaining exposure to bonds with maturities up to 2026 only. As central banks are on the path of raising interest rates to reign in inflation, from a risk/reward point of view, we continue to opt out of considering longer-dated maturities, as being the more sensitive to such monetary policies. Additional, factoring in inflation, real yields continue to be unjustifiable.
Within the equity space Europe and North America have been the more sensitive markets year to date. Asian markets such as Hong Kong and Greater China, while still facing mounting economic challenges, are a few thousand kilometers away from the geopolitical issues in Europe and Ukraine, thus feeling less pressure. Whether markets have reached the bottom or are yet to get there remains a speculative argument. While closely observing events, we focus our attention on key aspects within the asset class, besides retaining a long-term approach. Exiting the asset class entirely to then sitting on cash while events unfold could be as risky as being fully invested, as waiting for risks to subside can be an indefinite and costly process. The constructive approach remains to be diversified and identify credible long-term investment themes, avoiding emotional behavior dictated by fear. Various investment themes are still intact and could offer greater opportunities going forward.
Our alternative investments in commercial real estate and alternative credit opportunities remain resilient investments aiding diversification and helping performance. Precious metals have had more turbulent times with gold just below the break-even year-to-date, and other metals correcting more and so far, partly failing to act as inflation-protection holdings. Crypto markets proved to be more corelated to equities than most prominent backers and advocates marketed and preached, with the most prominent crypto coins going through roller-coaster swings and several market participants experiencing distress due to coin collapses.
Given the declines already seen this year, the question everyone seeks an answer to now is not whether the outlook darkened but rather, will it be much worse than the market already expects? The economic outlook has deteriorated markedly since the start of the year. Lingering inflation concerns have been compounded by the spike in commodity prices following the tragic war in Ukraine and the supply chain problems arising from Covid lockdowns in China. And while risks remain, we should remember that markets have already fallen a long way. So selling stocks now and buying them back at a later date would require an ability to time the market. As such, focusing on diversification accross asset classes remain a key pillar in the portfolio construction and risk management within the long-term investment strategy implementation.