On some measures, more wealth has been destroyed in the first six months of 2022 than any other six-month period. Very few assets have eked out a positive return this year, with broad measures of both equities and bonds significantly lower.
This simple but effective chart has been doing the rounds. It shows the combined drawdown in US stock and bond markets in USD terms, and clearly illustrates how difficult 2022 has been so far.
Source: Macrobond as at 30 June 2022.
The beginning of the year has seen assets sell off because inflation fears have become more entrenched. That has meant that equities, especially long duration (Growth) stocks have derated significantly. As at 25/07/22, MSCI ACWI is down -18% year to date, with MSCI Growth being c.13% lower relative to MSCI Value over the same period.
Thus far though, earnings have held up well. The concerns that are now starting to enter the market psyche is that corporate earnings may start to weaken.
Credit and bond investors have also experienced negative returns as credit spreads widened and bond yields globally saw meaningful moves to the upside. 10-year government yields in the US for instance approached 3.5% June, a level not seen since 2011.
Commodities, energy stocks and the US Dollar have been the only segments of the market to offer a degree of protection. Crude oil is up 28% since the start of the year, while the US Dollar index has risen by 11% buoyed by its ‘safe haven’ status and expectations that the Fed would be more aggressive in hiking rates versus other central banks.
Source: Bloomberg as at 13 July 2022.
Why has it been so bad?
Stocks and bonds have been hit hard and at the same time – and the reason for this is that inflation surprised strongly. The consensus, which we previously supported, was that inflation would fall at the start of 2022 as supply chain bottlenecks eased and spending on goods shifted to spending on services.
Indeed, supply chains are improving, and spending on services is increasing at the expense of goods. However, the outbreak of war between Russia and the Ukraine was the proverbial black swan that caused a surge in commodity prices and therefore inflation.
Central banks can do nothing to help supply-side issues in the commodity markets, but they have responded to higher inflation with a significant policy pivot. Their hope is that this will create some demand destruction and bring inflation back towards target levels.
The US Fed, for instance, delivered a total of 125 basis points in rate hikes this year, as well as announcing the start of quantitative tightening. Likewise, ECB president Christine Lagarde confirmed plans to withdraw a large-scale bond-buying programme and hiked interest rates for the first time since 2011 at the July meeting. This leaves the door open for the delivery of a total of 75 basis points of hikes by September. Some expect even more.
The effect of higher inflation and higher nominal interest rates has caused equity multiples to fall significantly. Thus far though, there has been little in the way of demand destruction. Consumer spending has held up as households start to eat into their large savings piles that were built up during the pandemic. Corporate earnings have been strong this year and index level earnings estimates have increased since the start of the year.
If we decompose equity returns this year, we see that multiples explain the fall for most markets, apart from emerging markets. It is a slightly different story for global sectors where Consumer Discretionary, Financials, Telecoms and Utilities earnings have fallen this year. Multiples are down for all sectors bar Utilities.
Source: Bloomberg as at 30th June 2022.
The debate now is how the growth-inflation trade-off will pan out in the second half of the year. Inflation should subside significantly. Growth will come lower too, there is no doubt, but by how much is a bigger question.
In recent weeks, markets have started to pay more attention to growth fears again. If growth does disappoint in a meaningful way, then equities could go another leg lower before they reach the bottom, with a fall in earnings contributing more to the decline than multiple contraction. In that recessionary scenario, bonds should start to offer a hedge to stock declines once again. We are seeing evidence that we are close to peak hawkishness and that should allow for bond returns to stabilise.
If earnings disappoint significantly, that could mark the point of capitulation for equity investors. History is clear that equity returns tend to bottom before earnings do. We are looking for evidence of that capitulation before adding equity beta, preferring to get equity exposure via relative value trades. To be clear, we believe that earnings differentials will become a much stronger factor for equity returns in the second half of the year, and that there will be a wide divergence in earnings across sectors.
As attention turns away from inflation to growth in the coming months, bonds and equities should stop falling together. We can see a period in the second half of the year where bonds appreciate, and equities decline.
In the currency markets, the US dollar has performed strongly as US rates have risen more than many other nations. But the strength has come mostly against developed markets rather than emerging market currencies. This can be considered unusual given the equity market sell-off at the same time. Even more unusual is the weak performance of the Japanese Yen. That weakness has provided some cushion to Japanese equities, which have performed better than traditional models might have forecast.
While fears about inflation make way for fears about recession, the US dollar is now catching a haven bid, benefitting from the other side of the smile. Against Sterling, we think that dollar strength will persist, but we are starting to question how much higher it can go against other currencies.
In some of our portfolios, we paired our short EUR-USD too early and are therefore monitoring the moves of the currency pair on the sidelines. Meanwhile, we are paying increased attention to select emerging market currencies, short against the US dollar. We are looking more closely at FX crosses outside of the US dollar for the second half of the year.
In the period after the Global Financial Crisis, investors could rely on a Fed put. When financial markets showed any sign of stress, the Fed would step in with supportive policy. That was all well and good when inflation was too low. But those days are over. The inflationary pressures we are living with today mean that the Fed put is gone.
Does that mean you should avoid all risk-assets? In our view, no.
There are still areas that are attractively valued and have strong fundamentals that do not rely on a Fed put to deliver positive returns. High yield and commodity areas remain attractive, in our view.
Sentiment has been hit quite hard this year but, as noted, we have not yet seen all the signs of full-scale capitulation. Equities can, and very likely will, stage significant rallies in the coming months. That said, we are not convinced that we have hit a low point just yet. Earnings estimates need to adjust lower for that to happen.
Higher inflation has surprised most market participants this year and has caused a significant central bank pivot across much of the world. There is evidence that we are approaching peak inflation and peak hawkishness. However, we must be cognisant that facts could change, and our view may be adjusted.
The dominant driver of the surge in inflation this year has been the exponential rise of commodity prices. This has gathered pace on the back of a series of COVID-19-related supply shocks and was further amplified by Russia’s invasion of Ukraine. Inflationary pressures could be tempered by a further reopening of economies (most notably in China), base effect adjustments, or any signs of easing tensions between Russia and Ukraine.
While the war in Ukraine remains a fluid situation, and difficult to forecast, we have started to observe encouraging signs that other global supply chain disruptions may be easing. For example, available high-frequency data suggests a gradual moderation in global container shipping costs and a continued clearance of US West Coast port backlogs. The recent lockdowns in China have had less impact on supply chains than the lockdowns of 2020 and 2021.
Slower global growth is part of our central thesis, but we see very different recession risks in different markets.
Whether or not we are in a recession depends on the definition you use. Two quarters of negative growth is the often-quoted definition, but the National Bureau of Economic Research uses a more nuanced measure. This states that growth must be negative across a broad range of areas for a recession to be triggered.
The reason we are not in, and possibly not headed for, a recession is that both the consumer and the corporate sector have far stronger balance sheets than ever before – even after the wealth destruction noted previously.
The pandemic forced consumers and some corporates to save. In the US, households still have more than $2 trillion of excess savings sitting in cash or liquid assets. This is allowing them to continue spending, even as real incomes are being squeezed. It is a similar story in most other developed nations.
Because consumers and corporates have taken advantage of exceptionally low rates to refinance debt at longer maturities in recent years, the rise in interest rates is not yet impacting consumers’ ability to service their debt. It is, of course, unpleasant for those purchasing a house to see mortgage costs rising but, for many homeowners, their costs have been fixed for long periods.
There is some nuance to this story by geography, and we do think that the differing debt profiles will have a profound effect on asset returns going forward. This is in contrast to what we have observed in recent years. Companies and households that hold a higher proportion of short-term or floating-rate debt are most vulnerable. We are looking closely at markets such as Australia, where housing debt is very high and tends to carry a variable rate of interest. By contrast, mortgage holders in the US and UK have tended to fix their mortgage rates for longer periods. As such, they are not susceptible to higher rates.
Source: Macrobond as at 30 June 2022. Percentage refers to US earners.
We think the UK consumer will see the greatest squeeze in their real income. The main rate of national insurance contributions has gone up, and Brexit-related developments could continue to push food and energy bills higher. This could result in some of the highest inflation rates of any industrialised country.
Europe is clearly hostage to the decisions of the Kremlin. If Russia cuts off gas supplies to Europe, that will force German, Dutch, and Italian industry to cut production. It is not in Russia’s economic interest to do this, as it will be unable to fund its war machine if inflows cease. However, applying logic here might be a mistake. If the gas situation eases, easier fiscal policies in the second half of the year (relative to other parts of the world) could boost European growth. Were the Next Generation EU funds to be dispersed and spent, it could provide a long-term boost to growth in Europe.
In the US, both corporates and consumers have very strong balance sheets compared to norms when entering a recession. While the US is suffering higher commodity prices, it is not at risk of having those supplies turned off by a third party. While the US is the region where rates have risen fastest, we know that most mortgage debt in the US is fixed rate in nature and households have refinanced at very low rates in the last few years. They may not be able to take equity out of their properties in the same way going forward, but there will not be a sudden increase in mortgage payments for most households.
Australia, Canada, and Norway are markets where a greater proportion of mortgage debt carries a floating rate. As such, those consumers are more vulnerable to higher rates and could experience a deeper consumer slowdown more quickly.
Not all the recent news is downbeat. We have already mentioned that earnings have been robust so far this year. While COVID-19 is still with us, restrictions on travel have been scaled back significantly and the services industry is booming accordingly. Even in China, which still has a zero-COVID policy, lockdowns are easing and mobility metrics improving. The service sector will be a boon to growth in the coming months.
As noted earlier, consumers and corporates have far more robust balance sheets today than heading into any previous recession or slowdown. Most should be able to weather this period of slower growth.
The actions by Russia have catalysed Europe around a single cause and have accelerated fiscal and green spending plans, in our view. If these plans are followed through, it should provide a boost to European growth.
This article was written by Fabio Faltoni and Benjamin Jones, members of Invesco’s Multi Asset team. Click below to learn more.
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