Mondial Dubai - Chart Of The Week: Recent Episodes
Mondial Dubai
A weekly look at the markets and why this weeks Chart is important. To receive the Chart of The Week directly into your inbox email us at info@mondialdubai.com . Podcast content is provided by Momentum Global Asset Managers, all rights reserved.
What the chart shows
This week’s chart shows the calendar year returns of nine major asset classes for the last ten years in US dollar terms, giving a clear picture of the volatility within the investment sphere. Asset class fortunes clearly vary each year and there is a number of examples when one year’s star performer may falter the next (see commodities from 2021/22 to 2023), or vice versa, when the class straggler jumps to the front (see US high yield bonds from 2015 to 2016). We can see that no single asset class stays a winner forever – a notion the US equity market has been challenging recently. Only once did an asset class remain on top for two consecutive years – commodities from 2021 to 2022. However, the subsequent plunge in 2023 serves as a stark reminder that trends can change rapidly.
Why is this important?
The message from this week’s chart is a simple one: no single asset class consistently stays on top. This emphasises the need for diversification, providing a safety net against the unpredictable volatility experienced by individual asset classes each year. It is extremely difficult to select the best performing asset classes every year and winners rarely stay as winners. A key takeaway here is to avoid getting swayed by exciting stories – just because an asset class did well in the past doesn’t guarantee its future success. The best performer of one year can quickly become a laggard the next and short-term predictions often miss the mark. Even asset classes with prolonged success, like US equities, can’t guarantee perpetual dominance. Investors need to be prepared for anything, and we advocate the practice of investing in undervalued asset classes following downturns, weathering temporary setbacks and patiently waiting their comeback. After a highly unusual year in 2023, where economies and equity markets defied widespread pessimism and faced the steepest monetary tightening in 40 years, coupled with returns heavily concentrated in a narrow range of stocks, caution and selectivity are crucial in 2024. Given current valuations and uncertainties, a broad diversification approach will be maintained in portfolios, waiting for valuation opportunities to emerge in preferred assets and markets, remaining wary of extended valuations and excess leverage.
What does the chart show?
This chart shows the S&P 500 earnings yield compared to the yield on 10-year US Treasuries since 2010 as a way of measuring the Equity Risk Premium (ERP) over time. The S&P 500 earnings yield gauges the earnings generated by index constituents relative to the index’s current price. When earnings yields are low compared to historical values, this suggests equity markets are overvalued as earnings are not keeping up with price gains, the reciprocal of the Price/Earnings (PE) ratio. A popular way for investors to measure ERP is to compare this to the yield on 10-year US Treasuries - the additional return investors are compensated with for taking on higher risk relative to risk-free assets. For investors, this can show the relative attractiveness of stocks compared to bonds and determine allocation weights between asset classes in portfolios. As shown in the chart, the ERP for the S&P 500 (illustrated by the gap between the two yields), is currently at its lowest point in 12 years, since 2007.
Why is this important?
The S&P 500 has experienced a significant surge in 2023, and valuations have outpaced earnings growth. Consequently, there has been a decline in the broad market’s earnings yield, indicating a potential overvaluation of these equities. With valuations so stretched against a backdrop of recession risks and a potential downturn in company earnings, the uncertain economic climate does not seem to be factored into markets. On the other hand, Treasury yields have spiked following numerous rate hikes by the Federal Reserve, and with inflation figures cooling, markets now predict we are nearing peak rates. However, some investors argue that ERPs are no longer comparable to historical levels, asserting that current equity valuations are justified given the recent advancements in technology. Optimists foresee these developments will lead to increased productivity, and consequently the higher earnings potential of companies. Furthermore, following the recent debate surrounding the quality of US credit, questions have been raised regarding whether US Treasuries can still be used as a benchmark for risk-free assets. Albeit that most investors still view US government bonds as the cornerstone of multi-asset portfolios, which provide a safe haven in times of economic uncertainty. Regardless, investors need to determine whether the ERP is worthwhile when investing in US equities - where valuations are arguably stretched - given the real yields that US treasuries are offering today.
What does the chart show?
This chart illustrates the trends in US 30-year treasury yields over the last three years compared with the total outstanding US public marketable debt, highlighting how the rise in yields aligns with an increase in public borrowing. Over the last week, the yields on these bonds climbed to the highest levels seen this year, reaching 4.32% following concerns regarding the trajectory of US debt leading to a credit ratings downgrade enforced by Fitch, and an announcement by the Treasury of an increase in borrowing in Q3. This is only the second ratings downgrade ever, after the S&P global ratings agency’s downgrade in 2011, and has put the spotlight back on the USA’s worsening fiscal outlook.
Bonds are rated by assessing the financial strength of issuers such as governments and corporates, ranking their ability to meet debt payments. These ratings are often used by investors when allocating risk in a portfolio and determine how much interest a borrower pays when raising funds in capital markets. The change from AAA to AA+ comes following the introduction of tax cuts and new spending initiatives, alongside a number of economic shocks which have contributed to a US debt burden that is projected to reach 115% of Gross Domestic Product by 2025. Furthermore, several political standoffs concerning the US debt ceiling have prompted a reassessment of policymakers' commitments to address the country’s sizeable and increasing debt. The downgrade now means that Fitch no longer regards US credit, often seen as the world’s risk-free asset benchmark, to be of the highest quality.
Why is this important?
US treasuries play a pivotal role in global markets and have long been a cornerstone of investor’s portfolios due to their widely acknowledged safe-haven status. As a benchmark for risk free assets, they impact interest rates and investment decisions worldwide. Consequently, the finances of the US and fiscal trajectory directly influence investor’s perception of risk and the government’s ability to service its debt, and therefore can have large impacts on the demand and pricing of US treasuries. Since Fitch’s decision last week, many have dismissed the verdict as irrelevant and unnecessary. Critics including the Treasury secretary Janet Yellen have pointed to the resilience of the US economy, with growth so far this year surprising to the upside and the resolution of the US debt ceiling debate, arguing that the US’s ability to make a repayment on its debt remains unquestionable.
Prominent investors such as Jamie Dimon and Warren Buffet, have similarly downplayed the significance of the news, stating that Fitch’s statement provides markets with no information that is not already priced into markets and that US treasuries remain the preferred asset haven of choice. Whilst US fixed income markets experienced sell-offs last week, these were also attributed to a ramp up of bonds sales to fund the widening budget deficit, rather than solely being a response to the ratings change. While it is important for investors to monitor the government’s handling of US finances, what is currently likely to have more of an impact on bond rates is the shifting outlook for economic growth, inflation, and interest rates. The US always expects to be number one, so whilst the ratings downgrade is not likely to have a lasting impact on markets, it may have rattled the nation’s pride and also provides fuel for political debates in the upcoming elections.
What does the chart show?
This chart shows the total aggregated private investment in Artificial Intelligence (AI) from 2013 to 2022 by country. As AI becomes more and more integrated into the economy, the race for dominance in this transformative technology has intensified, with private investment acting as a key indicator of influence. The US, China, and the UK are the clear leaders, with private investment over the decade totalling $248.9 billion, $94.8 billion and $18.2 billion respectively. As a leading player in this movement, the US has demonstrated its commitment to keep up with the rapid pace of innovation, having passed more legislation relating to AI than any other country. Notably, the US has mandated comprehensive training for all AI-involved workers to be aware of its capabilities and associated risks.
Why is this important?
The widespread integration of AI has come with a whole new range of possibilities, alongside causes for concern. Questions continue to be asked on how these new advancements will impact the economy with regards to productivity, wages, unemployment, and sustainability. Forecasts predict a potential 7% year-on-year increase in Gross Domestic Product over 10 years, driven by boosts to productivity. Furthermore, companies have reported improved outcomes in costs, enhanced collaboration across business units, and more efficient organisational processes. These optimistic forecasts have already been reflected in markets with the NASDAQ-100 Technology Sector Index up more than 50% this year. Therefore, the country which takes the reins in terms of market power will wield an immense level of influence and have the potential for huge economic gains. However, as the adage goes, with great power comes great responsibility! Given the potential for massive disruption with regards to cyber security and mass unemployment if not implemented appropriately, governments will need to carefully craft regulatory frameworks to control a phenomenon dominated by a small set of private sector players fuelled by profit motives and fierce competition, rather than economic sustainability and society’s best interests. Security risks aside, there is also the danger of a new wave of de-globalisation as the gap widens between developed and emerging countries. Large language models, like Google’s recent release of PaLm (which required 360 times more data and was 160 times more expensive to produce than the first ChatGPT-2 model), present higher technical and financial barriers to entry in the AI space. Emerging nations may struggle to keep pace with the AI wave and may start falling behind as developed nations reduce their overall dependence on cheap foreign supply chains. If the current trend in investment continues, the US may be faced with the task of deciding how AI will shape our future.
What does the chart show?
This chart shows the spreads on US corporate debt. Spreads, which are the difference between the yields on a fixed income security and the yields on the almost risk-free US treasuries, show the risk associated with that security. A wider spread indicates a riskier security, given that investors require higher yields, taking on greater risk of a firm defaulting, due to things like weaker balance sheets or when economic conditions are more difficult. US corporate debt is then divided into the two separate groups of investment grade (IG), which is considered lower risk and then the riskier high yield (HY) credit with their groups determined by ratings given by agencies such as S&P and Moody’s. The market’s interpretation of their relative riskiness can then be seen using credit spreads. US HY credit has an average spread of around 500 basis points (bps) with IG credit’s average spread closer to 150 bps. The spreads of both groups currently sit below their long-term averages with HY at 418 bps and IG at 124 bps.
Why is this important?
The recent perfect storm of higher interest rates, cooling economic activity, and the US banking crisis have resulted in extremely difficult credit conditions for US firms. The Federal Reserve’s Senior Loan Officer survey showed a significant proportion of banks were tightening up their standards for business loans and the firms that are able to take out loans will find their interest expenses greatly increased after years of easy money. The impact of these tough conditions is already evident with bond default rates and bankruptcies on the rise. If an inverted yield curve is once again a successful predictor of a recession in the US, default and bankruptcy rates are likely to worsen. Despite the issues facing US corporate borrowers, bond markets don’t seem to have got the message. Having risen throughout 2022 as recession expectations grew, the spreads on both IG and HY credit have fallen below their long-term averages, effectively suggesting that the outlook for these bonds is better than it normally would be. HY corporate borrowers with their weaker balance sheets, lower quality businesses, and more cyclical revenues are especially vulnerable to an economic downturn, and yet spreads have given no indication of any nervousness. Either corporate bond markets are unconvinced by the noise surrounding the likelihood of an impending recession, or they simply believe that US firms will be able to weather any difficult periods, possibly due to the expectations of fiscal or monetary support. There are also hopes that a future easing of credit conditions will relieve US firms of any real pressure from higher interest rates. However, with core inflation expected to keep rates higher for longer, US corporate borrowers and their debt may begin to face more problems than they expected.
What does the chart show?
This chart shows the target interest rates of several major central banks. Central bank interest rates are a monetary tool that, among other things, are used to help control inflation within an economy by stimulating or cooling economic activity. When central banks raise interest rates they discourage borrowing and spending among businesses and consumers. This may damage short-term economic growth but can be necessary when inflation is too high. Alternatively, the lowering of interest rates helps to stimulate growth by encouraging borrowing and spending. The graph shows how, across most major economies, central banks have been forced to raise interest rates from the historic lows seen during the pandemic, to tackle high levels of inflation. Over the past year and a half, rates have risen from virtually 0% to as high as 5.25%. For many monetary authorities, these are the highest that rates have been since before the 2008 financial crisis. One outlier is China where rates, which were at much higher levels during the pandemic, have instead been cut. The rate on the People’s Bank of China (PBOC) medium-term lending facility (MLF) currently sits at 2.65%.
Why is this important?
While activity in economies such as the US and the Eurozone has continued to surprise to the upside, China’s momentum since reopening has already begun to falter. Year-on-year growth in key areas, such as retail sales and industrial output, is still positive but has disappointed especially given last year’s low base during lockdowns. Chinese exports declined in May and are unlikely to recover as global activity struggles under the load of higher rates. The focus now turns to the Chinese authorities who are under pressure to hit the 5% growth target set at the beginning of the year. The cutting of the main policy rate shows some intent by the PBOC, but a cut of just 10 basis points is unlikely to make enough of a difference. It is possible that China is wary of the kind of measures seen recently in western economies, given the inflationary consequences of those policies. China itself has suffered from a stimulus driven rise and subsequent fall of its property market which has yet to fully recover. However, with inflation nearing deflationary levels, there is certainly some room for the PBOC to cut rates. Some fiscal stimulus is also expected to target problem areas, such as the property sector and youth unemployment. Some tax breaks have already been implemented, but measures so far have been underwhelming. It is also possible that more than just monetary and fiscal stimulus is required to help change China’s fortunes. For now, however, the focus remains on whether Chinese authorities are as concerned about the economy’s faltering momentum as some onlookers are.
What does the chart show?
This chart shows the performance of a variety of major asset classes in the first half of 2023. Global Developed Market Equities, as shown by the MSCI World index, continued their strong performance from the end of last year to finish +15% despite facing difficulties during the US banking crisis in early March. The turmoil during the crisis helped drive the price of gold which has since slightly receded to finish +5.2%. Emerging Market Equities (as measured by the MSCI Emerging Market Equity Index) lagged Developed Market Equities, but still finished the first half of the year almost +5%. Even with all the uncertainty in markets, US Fixed Income Securities have remained stable so far this year, with US Treasuries and US Investment Grade credit returning +1.6% and +3.2% respectively. Having outperformed significantly in 2022, Commodities have struggled to date in 2023, finishing the first half of the year -7.1%.
Why is this important?
2023 has been a fascinating year so far, as markets recover from a difficult 2022. At first glance there are reasons for optimism, with positive performance in equities in both Developed and Emerging Markets. However, there are concerns over the breadth of this year’s Equity rally, especially in the US where the majority of returns are attributable to just a few large stocks, mainly in the high-growth technology industry. Outside of these firms, returns have been muted, suggesting that an element of caution is still prevalent for the months ahead for the wider market. The performance of Fixed Income Securities also seems to indicate significant levels of uncertainty. Investors have struggled to reach a decision on future economic outlook, as inflation and economic strength have continued to defy expectations, despite the ongoing rate hikes. This has led to fluctuations in bond markets throughout 2023. Even with this uncertainty in bond markets, both Treasuries and Investment Grade Credit have delivered positive returns to investors so far this year. Fears of an impending recession are more evident in the performance of Commodities. Expectations of a cooldown in economic activity have driven commodity prices steadily downwards throughout the year. While this steady decline has brought the price of Commodities down from their 2022 peaks, which has helped to ease inflation, prices are still higher than their pre-pandemic levels, leading to suggestions that this may simply be a normalisation from the extreme levels seen last year, rather than due to increasing fears of a recession. Wide deviations in asset class performance this year have contributed further to the uncertainty in markets, but while short-term risks remain, the volatility in markets mean that longer-term opportunities are continuing to emerge.
What does the chart show?
This chart shows the currency composition of the foreign exchange reserves of global central banks. The holding of reserves by central banks is an important tool for ensuring the stability of a country’s currency, which provides predictability to businesses, investors, or financial institutions that operate internationally. Countries with less stable financial institutions hold reserves in more reliable and globally accepted currencies, such as the US Dollar (USD) or the Euro, to back up the value of their own currencies. In 2000 almost 90% of global reserves were held in either Euros or USD. The decline of this figure to 78% at the end of 2022 has been driven almost entirely by a falling proportion of reserves being held in USD, that has fallen from 71% to 58%. Reserves held in Chinese Yuan have risen to 2.69%.
Why is this important?
There are few better ways of showing the USA’s economic and financial might than the pre-eminence of the USD in both global trade and as the preferred foreign exchange reserve currency. However, with the proportion of foreign reserves being held in USD having gradually declined since the year 2000, questions are being asked whether the dominance of the Dollar will last. Rising geopolitical tensions have led to some countries such as Brazil and Russia raising security concerns over US weaponisation of the Dollar. Last year the US was able to freeze $130 billion of Russian reserves as retaliation for their invasion of Ukraine. One issue in reducing reliance on the Dollar is finding a suitable alternative. The price of gold surged higher late last year due to large central bank purchases with the precious metal being identified as a possible Dollar replacement for backing up a currency. There are also suggestions that the Chinese Yuan could act as a reserve currency for countries that are unable or unwilling to deal in Dollars. In recent years, China has emerged as a rival to the US’s financial and political dominance which has led to rising tensions between the two superpowers. However, with just 2.7% of global reserves being held in Yuan, the Dollar remains a clear favourite. To increase the global influence of the Yuan, China has also gone after another, arguably more important pillar of Dollar dominance: global trade. In 2018 China opened an oil exchange where contracts for the world’s most traded commodity were settled in Yuan rather than Dollars. However, China’s more stringent capital controls and less developed financial system have meant that traders have remained wary and so the proportion of global trades being settled on the Shanghai exchange has risen to just 5%. The Dollar’s position as the global reserve currency of choice appears to still be strong and the lack of a realistic alternative means that it may well stay that way for some time.
What does the chart show?
This chart shows the year-on-year core inflation for the UK, US, and Eurozone. The core inflation rate, which is different to the more commonly used headline inflation rate, shows the change in the price of the same basket of goods but excludes things that have more transitory or volatile price changes, such as food and energy. Both food and energy are commodities that can be traded on exchanges which is what makes fluctuations in their prices more volatile so do not reflect longer term price changes. With a basket made up of less volatile goods and services, core inflation tends to change at a slower pace than the headline inflation rate. Having risen steadily in the US, Eurozone, and UK throughout 2022, rising above 6% in the US and UK, and reaching 5.7% in the Eurozone, there are now indications that core inflation is starting to fall in the US and Eurozone. However, in the UK core inflation has continued to rise reaching 6.8%, its highest level since March 1992.
Why is this important?
Last year’s combination of supply chain difficulties and Russia’s invasion of Ukraine drove up commodity prices and with them, headline levels of inflation. Since then, the steady declines in prices have begun to move headline figures back towards their long-term target level of 2%. However, even with headline inflation showing signs of having peaked, central banks continue to indicate that the fight against inflation is far from over as stickier core inflation remains stubbornly high. This problem is particularly relevant in the UK where, despite a falling headline rate, core levels have continued to rise. The issue has largely been attributed to the UK’s labour market which has remained tight, unlike in the US and Eurozone where it has shown signs of cooling. The UK’s high inflation has led to an 18-month run of falling real wages but with the labour market remaining consistently tight, the effects of workers having more bargaining power when it comes to wage increases are emerging. Average wages in the UK rose by 7.5% year-on-year in April, giving a clear indication that the UK has entered a wage-price spiral with an ongoing feedback loop of higher prices leading to higher wages, leading to higher prices. The consequences of sticky core inflation are clear. While other central banks are considering pauses or even cuts to rates by the end of the year, markets are now expecting five more hikes from the Bank of England in 2023, putting further pressure on UK households and businesses as borrowing costs rise. Growth in the UK has surprised to the upside so far this year with the economy defying the expectation of it being the worst-performing G7 economy. However, the possibility of further hikes in the near future means that those predictions may still come true.
What does the chart show?
This chart shows the price of a barrel of Brent Crude Oil over the past five years, which is one of the major benchmarks used to set global oil prices. Given crude oil’s ability to be refined into widely used products such as petrol, diesel and the chemicals needed to make plastics, it is one of the most traded commodities in the world with the price often being used as an indicator for global economic activity. Prices fell below USD20 in 2020 when global output collapsed during the COVID-19 pandemic but recovered strongly as post-pandemic activity began to return. The aftermath of the pandemic, combined with the Russia-Ukraine war, saw the price of oil spike in early 2022 reaching almost USD128 per barrel and not falling below USD100 until August 2022. Since then, the price of oil has continued to decline throughout 2023 falling to approximately USD76 today.
Why is this important?
Oil continues to be one of the most important commodities in the world and over the past year has been a useful metric for gaining insights into the two main themes that have been prevalent in markets recently: inflation and the possibility of a recession. Rising commodity prices were one of the drivers of the extraordinary rates of inflation seen last year and oil was no exception. This year the falling price of oil is expected to bring some relief to economies struggling with inflation. However, more interestingly are the reasons behind oil’s steady decline in 2023. Predictions of a recession in western economies has meant that demand for oil was expected to fall, but this drop in demand was expected to be offset by increased demand from a Chinese economy coming out of COVID-19 lockdown restrictions. At the beginning of the year the expectation was that this boost could push the price of oil back up to USD100. China’s re-emergence has so far underperformed expectations, and although things like air travel in China remain below their pre-pandemic levels, the continued decline in the oil price suggests that China’s disappointing performance isn’t expected to change any time soon. The steady decline of the oil price is a concern for some countries that rely heavily on revenues from the export of oil. In April, the Organisation of the Petroleum Exporting Countries (OPEC), which represents 40% of the world’s crude oil production, announced a further production cut of 3.66m barrels per day, equivalent to about 3.7% of global demand. This cut resulted in a brief spike in price before the decline continued, forcing OPEC to extend the duration of production cuts by a year to the end of 2024. Whether this has the desired impact of propping up the price of oil is yet to be seen, but so far, the reaction has been muted. If the oil price continues to trend downwards, it will be clear that markets are sharply focused on an expected decline in global economic activity.
What does the chart show?
This chart shows the current US average 30-year (Y) fixed mortgage rate versus the number of mortgage refinancings. The 30Y fixed mortgage rate is the average rate offered by mortgage providers on home loans to borrowers. This rate then stays the same throughout the entirety of the 30-year term unless the loan is refinanced, or the home is sold. The refinancing index gives an indication of the number of mortgage refinancings in the US housing market. The index is rebased to 100 at 1990 levels, with an April 2023 value of 443 suggesting that the number of refinancings was more than 4x times higher than when the index was first measured. This value is still significantly lower than the index value of 4,781 seen during the earliest stages of COVID-19. Having fallen steadily to as low as 2.88% is early 2021, the average offered rate has risen dramatically to 7.13%.
Why is this important?
The state of the US housing market is closely linked to the health of the US economy as a whole. Rising house prices generates a wealth effect for consumers whose houses will often be their most valuable asset. The housing market is also one of the ways interest rate hikes from the Fed feed through to consumers, and eventually tackle inflation. Higher rates increase the cost of borrowing as seen by the increase in the average mortgage rate. The expectation is that higher monthly mortgage payments lead to lower demand for other goods from consumers, and so economic activity cools. However, the US housing market is unique globally in that the dominant home mortgage product is a 30-year fixed rate mortgage, meaning that until it is refinanced the borrower pays the same rate for the entire term. In other countries the dominant mortgage product is either a shorter-term mortgage that needs to be refinanced more frequently, or a variable rate mortgage that matches a base rate such as the local central bank rate. When interest rates fell during the pandemic, the average offered 30Y rate fell too, reaching an all-time low of 2.88%. Consumers jumped at the opportunity to refinance and lock in a historically low rate for their mortgages with the volume of refinancings at its highest since 2013. The effect is that US consumers have remained largely unaffected by the Fed’s aggressive rate hikes. The volume of refinancings has plummeted and the proportion of newly built versus existing home sales currently sits at twice its historical average, both suggesting that US homeowners are extremely unwilling to give up their low-rate mortgages. Consumption has recently been the sole driver in helping the US economy avoid a downturn. The surprisingly healthy position of US homeowners could help to explain why.
What does the chart show?
This chart shows the five-year return of the MSCI World Socially Responsible Investment (SRI) Index against the MSCI World Index. The MSCI World Index covers the performance of large and mid-cap stocks across 23 developed markets. Covering about 85% of the market capitalisation of those markets, it is used as an indicator for the overall market performance of stocks in developed countries. The MSCI World SRI Index has the same geographical coverage but provides additional exposure to companies with good Environmental, Social, and Governance (ESG) ratings while excluding companies that have a negative environmental or social impact. This involves the exclusion of companies involved in areas such as fossil fuels, gambling, and weapons production. The performance of the two indexes has been closely linked given their similarities. However, over the past five-years the World SRI Index has outperformed the World Index by 11.5%.
Why is this important?
ESG investing has seen a significant growth in popularity in recent years, as investors become more aware of environmental and social issues such as climate change and labour practices. This has led to a shift in investor practices towards strategies that more closely align with their values. As ESG investing has grown in popularity, a common misconception has emerged alongside it, which is that investors need to sacrifice financial returns in order for their investments to have a positive impact. However, studies are increasingly showing that companies and strategies that include an analysis of ESG factors tend to outperform those that do not over the long run. There are several reasons for this outperformance which is expected to continue. Firstly, incorporating considerations for ESG factors in an investment strategy can help investors avoid certain risks that may result in a share price decline, such as environmentally harmful accidents or reputational damage. An ESG analysis can be considered as just another layer of risk analysis rather than an entirely different strategy. Furthermore, as markets and governments encourage more sustainable practices, exposure to areas such as green energy production enables investors to capture upwards secular trends within more ESG friendly industries. Although ESG strategies can experience periods of underperformance, including last year when rising energy prices saw fossil fuel companies achieve record levels of profit, the nature of ESG themes mean that they are inherently long-term and so can deliver substantial returns over time.
What does the chart show?
This chart shows the results of the latest quarterly Federal Reserve Senior Loan Officer Opinion Survey (SLOOS) combined with recessionary periods in the US. The survey is completed by senior loan officers at 80 US commercial banks and at US branches of 24 foreign banks. It aims to provide information on the availability and demand for credit and loans in the United States. The results show the net proportion of officers that are tightening standards for various types of loans. The latest survey results show that a net 46% of respondents were tightening standards for commercial and industrial loans for large and medium businesses, with 46.7% tightening standards for small businesses since the last survey in January. Consumers also faced tighter credit conditions with 30.4% of respondents tightening the standards for credit card loans for consumers. Over the past 30 years, significantly tighter credit conditions have coincided closely with economic slowdowns and recessions.
Why is this important?
Although the earliest stages of the US banking crisis occurred around two months ago, its effects are still being closely monitored. Credit conditions have already come under pressure from the Federal Reserve’s aggressive rate hikes last year and so there were hopes that the slowing rate of hikes might ease some of the tightness in credit markets. However, the results of the latest SLOOS have shown that the increased caution among major US lenders after the crisis has instead tightened conditions further. Comparisons with similar scenarios in the past are easy to make, with the rapid credit crunch expected to cool activity and lead to a recession as it has done in the past. The US economy has shown signs of cooling with Gross Domestic Product (GDP) growth of 1.1% in the first quarter of 2023, marking a deceleration from the 2.6% GDP growth seen in the last quarter of 2022. The concern is that this growth was almost entirely driven by consumption which grew by 3.7% and helped offset the cooldowns in the more interest rate sensitive areas of housing and business investment. The question now is how long consumption can continue to be the sole driver of growth. Consumer credit card debt reached an all-time high of $989 billion at the end of April despite credit conditions tightening just as much for consumers as they have for businesses. Indicators such as rising credit card delinquency rates suggest that the vast reserves built up over the COVID-19 pandemic may be starting to run dry, but the levels remain comfortably below what they were before the pandemic. Despite numerous indicators pointing towards an impending recession, the unwavering resilience of US consumers continues to fuel economic growth, exhibiting remarkable endurance and showing minimal signs of halting their contributions.
What does the chart show?
This chart shows the number of initial public offerings (IPOs) that have occurred each month in the United States (US) on either the New York Stock Exchange or the NASDAQ. An IPO is the process by which a private company raises capital from investors by issuing stock to the public for the first time. When the COVID-19 pandemic first struck in March 2020 IPO numbers fell sharply. However, during the pandemic, private companies saw the extraordinarily high valuations as an excellent opportunity to raise capital leading to a record 473 IPOs in the US in the first quarter of 2021. Rising uncertainty and diminishing valuations have meant that the quantity of IPOs has fallen steadily since then. In Q4 2022, only 12 companies went public in the US. However, the latest figures may potentially show a reversal of this trend. IPO numbers rose in Q1 2023 to 34.
Why is this important?
An IPO represents a major decision for private firms. Although going public provides a company with a new source of capital, it also exposes the company’s operations and finances to intense government and public scrutiny which can expose problems. Undertaking an IPO itself can also be a long, difficult, and expensive process. Therefore, for a company to go ahead with an IPO, they must not only be completely confident about the state of their finances, but also confident about future economic and market conditions. The quantity of IPOs can therefore be an excellent indicator of corporate sentiment, with a better outlook being matched by higher numbers of IPOs. Last year’s economic and geopolitical turmoil meant that corporate sentiment was at close to all-time lows going into 2023. With the recent turmoil among banks, as well as ongoing fears of a recession, it may be hard to believe that firms have anything to look forward to and with IPO numbers still below their pre-pandemic levels, it’s clear that many are still taking a risk-off approach. However, for a decision as important as an IPO, companies, just like investors, must ignore the noise and consider a longer-term outlook. For some, the prospect of an economic environment that may have looser monetary policy, less supply chain pressure, and a labour market more favourable for hiring, is clearly enough to spur a recovery.
What does the chart show?
This chart shows the market-weighted average price to earnings (P/E) ratio of major equity indices in the US, UK, and Europe, as well as the Morgan Stanley Capital International (MSCI) World index, which is made up of holdings across all developed market equity markets. The P/E ratio divides a company’s share price by the company’s earnings per share to give a valuation metric that can be compared across industries, countries, and over periods of time. Ratios will change as investors’ expectations of future earnings change. A high P/E ratio does not necessarily mean that a company is overvalued but may instead indicate that investors have high expectations for future earnings. Ratios in developed markets have been climbing steadily over the past decade before rising sharply during the pandemic due to loose financial conditions. The significant deratings in equity markets in 2022 brought P/E ratios down from record levels but in the US, valuations remain elevated relative to historical levels. A more pessimistic outlook for Europe and the UK has meant the P/E ratio has fallen to as low as 10. During the market lows of the 2008 Financial Crisis, P/E ratios fell as low as 7.5 and 6.4 in the UK and Europe respectively.
Why is this important?
The aftermath of periods of difficulty in equity markets have provided excellent opportunities for those in search of undervalued stocks. Large equity deratings are often followed by bumper returns as shown by the 20% average one-year return for the S&P 500 in periods after which it has fallen by 25% or more. Following the difficulties seen across all developed equity markets in 2022, there may be some cause for optimism as investors hope for a rebound from a market bottom. Trying to time these market bottoms is inadvisable, but an analysis of historical lows reveals a number of similar characteristics. Newspaper reports around the date of lows paint pictures of fear and desperation throughout markets and valuation metrics such as P/E ratios sit well below long-term averages. Investors hoping to catch the rebound from lows would struggle to find similarities in today’s economic climate. Sentiment indicators remain strong and the falls in P/E ratios have simply returned to levels closer to their long-term averages from levels that were considered excessively high, rather than collapsing to historic lows. However, P/E ratios for certain markets have fallen to levels that can offer excellent opportunities to value investors. As stability returns to markets, it is these opportunities that will enjoy the bumper returns that investors seek.
What does the chart show?
This chart shows the performance of the Invesco Additional Tier-One (AT1) Bond Exchange Traded Fund (ETF). The ETF tracks the performance of a global universe of AT1 bonds, a form of debt issued by banks that can be converted into equity when the issuer is in distress. If a bank’s capital ratio (which measures a bank’s financial health by comparing its capital to its level of risk) falls below a certain threshold, then banks can recapitalise by converting such debt to strengthen their balance sheet. However, the higher risk of being converted into equity in a distressed situation, when equity valuations are likely depressed, means that investors require higher yields on AT1 bonds than they would otherwise. However, the recent turmoil in the banking sector has led to investors abandoning this particular type of asset, with the AT1 ETF down over 15% over the past two weeks.
Why is this important?
The higher yields offered by AT1 bonds are because it is the riskiest form of debt within a company’s hierarchy of bonds. Other bondholders are protected from losses by the existence of the AT1 layer of debt. However, before even AT1 bondholders suffer losses, equity investors are the first to be wiped out if a bank were to go under. This hierarchy of claims was disrupted this week when Credit Suisse was sold to UBS. $17bn of Credit Suisse AT1 bonds were wiped out by the Swiss authorities while Credit Suisse shareholders received a payment for their shares, albeit at a large discount. This sudden disruption to the normal hierarchy has put the spotlight on the $260bn AT1 market. Fearing similar scenarios for other banks, investors have offloaded AT1 bonds as seen by the poor performance of the AT1 ETF. Investors are fearful of an asset class that they feel they cannot trust. However, it is possible that these fears are baseless. Other financial regulators such as the European Central Bank and the Bank of England have been quick to reassure investors that the hierarchy of risk is still the same as normal under their regimes. Despite this reassurance, AT1 bonds now sit at valuation levels not seen since the early days of the COVID-19 pandemic. As is often the case, an emotional reaction in investing rarely yields positive results. Instead, investors who are able to use tried and tested processes to look through the noise and emotion are those who are most likely to benefit.
What does the chart show?
This chart shows Global Exchange-Traded Fund (ETF) flows across a variety of asset classes and time periods. These flows are given as a proportion of current holdings and indicate which asset classes are most popular with investors. Over the past year, the majority of major asset class ETFs have seen inflows, with only commodity ETFs seeing outflows. Fixed Income ETFs and Alternatives ETFs, which give investors exposure to hedge funds, have seen the largest inflows over the past year of 14.9% and 18.60% respectively. More recently Fixed Income and Alternatives ETFs have also received the largest inflows, with Alternatives ETFs seeing a 4.70% inflow. Over the past month, ETFs in all major asset classes have received net inflows.
Why is this important?
ETF flows can provide an interesting insight into how investors have reacted to changing market conditions and their future expectations. The inflows seen across almost all major asset class ETFs over the past year might suggest that investors were full of confidence. However, data released by BlackRock showed that while inflows were positive in 2022, they were almost 28% lower than what they were in 20211. Where these inflows went may be of more interest. After several years of artificially suppressed Fixed Income yields, the large inflows into Fixed Income ETFs reflected the market’s strong appetite for the improved yields on offer as interest rates rose sharply over the past year. However, the combined fall in bonds and stocks also saw investors scrambling to find other sources of returns, as shown by the large flows into Alternatives ETFs. Alternative investments such as trend-following strategies have a low correlation with markets and performed well over the last year. Investors held back in 2022 in the face of extreme uncertainty, but the net positive inflows across all asset classes since the beginning of the year suggests an improved outlook for 2023, as confidence among investors begins to return.
What does the chart show?
This chart shows the year-on-year change in the level of Personal Consumption Expenditure (PCE) in the US and the savings rate of US individuals. US PCE is used to reflect changes in the behaviour of consumers. PCE growth tends to fluctuate around 2% during periods of economic stability. However, during the recessions of 2008 and 2020, PCE growth was significantly weaker. After the pandemic, PCE growth rebounded sharply and has since remained high as pent-up demand from the pandemic was released and inflation forced consumers to spend more for the same goods. The savings rate, which shows the personal saving of disposable income by US households changes as consumers react to changing levels of economic uncertainty. During the uncertainty of the 2008 and 2020 recessions, there were spikes in the saving rate as households chose to better prepare themselves against economic headwinds. However, since April 2021, the savings rate has consistently fallen with the rate, reaching an almost record low of 2.4% in September 2022. Since then, the rate has risen slightly to 3.4%.
Why is this important?
Although the data provides an interesting insight into the behaviour of consumers during periods of uncertainty, we may be able to learn more from this chart by applying it elsewhere. The most significant changes to consumer behaviour came both during, and in the aftermath of the pandemic lockdowns. The savings built up during lockdowns were released as a wave of pent-up demand, as savings and consumption habits reversed. China, which reopened late last year, has already been through the first phase of this process. Estimates of the level of excess savings among Chinese households sit at around $2 trillion. By comparison, the Fed estimates that US households accumulated about $2.3 trillion in savings through 2020 and the summer of 2021. Of these excess US savings, about 25% of these were then decumulated in the post-pandemic consumption surge. While this spending was credited with helping support Gross Domestic Product growth in the face of aggressive rate hikes, it was also partly to blame for the soaring inflation that necessitated the hikes in the first place. If Chinese households follow the example of US consumers, we can expect a similarly sized surge of demand for goods and services.
The reaction to China reopening has been an improvement in the outlook of major economies that were convinced of an imminent recession just months ago. However, inflation expectations have not been similarly reflected in this change. Two-year inflation expectations have barely risen, and markets are still expecting a cut in the Fed base rate by the end of the year. However, the effects of other 2022 inflation drivers have significantly eased. The Fed Supply Chain Pressure Index is down 78% from its peak and the cost of shipping between the US and China has fallen by 93%. The inflationary impact of the war in Ukraine has also fallen significantly, with natural gas and wheat futures down 75% and 44% from their respective peaks. Investors must be careful not to forget the lessons learned last year, but China’s reopening could likely be a welcome boost to a flagging global economy.
What does the chart show?
This chart shows the Momentum Global Investment Management Risk Aversion Index over the past five years. The Index combines several different measures, such as global credit spreads, and forex and equity implied volatility to gauge what the current level of risk aversion is in markets. Risk aversion can be used as a measure of how tolerant investors are to taking on risk, given current and expected economic and financial conditions. During the early stages of the COVID-19 pandemic, risk aversion levels rose significantly. Since then, the Index has fluctuated as fiscal and monetary support provided stability throughout the pandemic before rising inflation fears, followed by the war in Ukraine, saw risk levels rise in H2 2021 and remain high for most of 2022. Since then, the markets appetite for risk has improved to levels not seen since early 2021.
Why is this important?
Risk appetite affects all asset classes differently and understanding how assets react to different types of risk is an important skill for any investor to have. The most volatile assets are the most sensitive to changing risk appetite levels, with excess returns during periods of economic stability and security being matched by excess losses when conditions change for the worse. During the pandemic, the ultra-loose monetary policy that was implemented by central banks allowed for highly risky assets, such as non-profitable tech stocks and cryptocurrencies, to post extraordinary returns in a short period. For those expecting a recession in 2023 after a difficult 2022, the falling levels of risk aversion come as surprise. This highlights just how unpredictable many aspects of financial markets can be. However, rather than trying to predict levels of risk, investors can take steps to protect themselves against it. With a good understanding of how risk affects different securities, an investor can build a portfolio of assets with a diverse range of responses to changing economic conditions. With diversification comes protection and outperformance during periods of uncertainty and volatility.
What does the chart show?
This chart shows the yield of Japanese 10-year government bonds versus the yield on 10-year Japanese Yen swaps over the past two years. Currency swaps such as these allow for investors to be exposed to a foreign currency and its interest rates. They are indicative of the market’s expectations for the yield on government bonds and are normally closely linked to the yield of the bonds themselves. Since 2016, the Bank of Japan (BoJ) has used bond purchasing programs to keep the yield on its 10-year bond artificially low to try and stimulate a stagnant and deflationary economy. The ceiling for the 10-year rate was set at 0.25% up until December last year (2022), when it was shifted upwards to 0.50%. Although the BoJ has persevered stubbornly with its yield curve control (YCC), market expectations for the yield, as seen in the swaps market, currently sits significantly higher at 0.93%.
Why is this important?
Over the last year, rising global rates have heaped huge amounts of pressure on the BoJ’s YCC program. Despite slightly raising the ceiling last month, the BoJ is continuing to purchase billions of dollars of government debt with $72 billion spent on Thursday and Friday of last week alone. As inflation in Japan has ticked above 3%, wages have begun to show signs of growth, and the swap rate has climbed higher, speculators have placed huge bets on the YCC program coming to an end. If the program was to come to an end or even just eased further, the results could be dramatic. The Yen has already shown signs of strengthening and would be expected to spike higher as money poured back into the country. The risk would be that the glimmers of wage growth and inflation that Japan is currently seeing would grind to a halt. Some onlookers expect an end to the program as early as this week as the cost becomes too much, but with Governor Haruhiko Kuroda’s term ending in April, there are those who believe the program may not end until then. The bank has faced pressure of this type before, but with the desired outcomes of inflation and wage growth finally emerging, we can expect a big decision on the future of the policy sometime soon.
What does the chart show?
This chart shows the levels of inflation across five major global economies as measured by year-on-year Consumer Price Index (CPI) growth. A combination of factors such as pent-up consumer demand and easy monetary and fiscal conditions from the pandemic; supply chain pressures; and record high gas prices caused by the Russia-Ukraine conflict saw inflation in the US, UK, and Eurozone economies reach significantly above-target levels in 2022. US inflation reached 9.1% in June, and in the UK and Eurozone, levels are only just showing signs of peaking at 11.1% and 10.6% respectively. Even Japan, which historically has struggled more with deflation than inflation, has seen year-on-year CPI growth of 3.8%. As these major economies struggle to tackle rising levels of inflation, China has stood out as an exception. Inflation did not rise above 2.8% last year and is currently lower than what it was before the pandemic.
Why is this important?
The global response to the inflation crisis has been an aggressive tightening of monetary policy, except for Japan, which has only gone as far as relaxing some limits on their yield curve control mechanism. The Federal Reserve increased its headline rate by 425 basis points last year and the European Central Bank hiked rates above 0% for the first time since 2016. The effects of this have already begun to be seen. Interest rate sensitive industries, such as housing, have suffered as mortgages have risen and there is now an expectation that there will be a recession in 2023, as economic activity cools. China’s inflation, which has remained subdued due to strict COVID-19 restrictions and difficulties in the Chinese property market, means that the country has not been forced to aggressively tighten monetary conditions. Instead, with COVID-19 restrictions easing, China is now in a position where it can use monetary and fiscal measures to help stimulate its own recovery from the pandemic, while other economies continue to tackle high levels of inflation. There is likely to be significant pent-up demand from Chinese consumers and businesses alike but with global activity cooling and energy prices falling, the country may not face the inflationary pressures that other economies did last year. After three years of difficulties tackling the pandemic, China may well be emerging at just the right time.
What does the chart show?
The chart shows the calendar year performance of an index that tracks US dollar-denominated sovereign debt for every year since 1978, as well as the year-to-date (YTD) performance for this year. Historically the performance of US debt has fluctuated significantly around an average return of 7% per annum but has the potential to produce excellent returns. In 1982, the index returned 27.97% throughout the year. In 2009 the index had its worst full calendar year performance, falling 3.72%. These statistics help put into context the astonishing performance of US Sovereign debt this year. US treasuries have fallen 11.9% so far this year which, if they end the year unchanged, would be the worst year for bonds for almost a century when bonds fell by 15% in 1931.
Why is this important?
This year has been a difficult one in markets with seemingly no hiding place for investors. Equities have fallen with bonds as the typically negative correlation between the two asset classes has deteriorated in the high inflationary environment. Real assets have declined in value on rising interest rates despite the higher inflation helping them at the margins. Even commodities, which started the year with record levels of performance, have fallen back to just above-average levels. However extraordinarily difficult this year has felt for investors, it is important that it be remembered as just that, extraordinary. Price fluctuations are driven by short-term shocks that produce an emotional response in markets. Although this year has been difficult, as shown by the above chart, we can also see that a more measured, long-term approach has historically proved to be beneficial to investors. If we look to the future, the sharp downturns in certain markets have also provided opportunities to invest in high-quality securities at below-average prices as some investors overreact to negative sentiment. These kinds of value opportunities have been less prevalent in recent years as asset prices have become inflated above their fair values but now provide a good reason to be optimistic about the future.
What does the chart show?
This chart shows the average returns of the major US equity indexes in the last week before Christmas and the first week after Christmas, alongside the average weekly performance of the indexes since 1985. The data suggests that in the weeks before and after Christmas, US markets regularly perform better than they do compared to other weeks of the year. The NASDAQ performs especially strongly, returning 0.7% and 0.87% on average in the first week before and after Christmas respectively. Compared to the average weekly performance of 0.31%, this is a significant outperformance. The S&P 500 and Dow Jones Industrial Average (DIJA) also outperform their weekly averages both before and after Christmas.
Why is this important?
The tendency for markets to rise during the Christmas period is a widely observed phenomenon known as the ‘Santa Claus rally’. Explanations for what causes this rally can range significantly. One explanation is that investor optimism fuelled by Christmas spirit leads to the buying of stocks. Another is that over the holiday period lower market activity from institutions reduces liquidity and causes higher levels of volatility, even though that could also lead to higher-than-average losses. Whatever the explanation, short-term fluctuations in market prices can be caused by a number of factors that are virtually impossible to predict. At first glance, the Santa Claus rally may seem like an amusing quirk that opportunistic traders can use to make a quick return, but the normal risks are just as prevalent during the holiday period. Despite abnormally high average returns during the weeks before and after Christmas, stocks actually fell 40% during the observed periods. The Santa Claus rally can therefore be seen as a seasonal reminder to investors: Short-term bets on market movements are not a sustainable investment strategy. Having a well-diversified portfolio with a longer-term outlook can help investors ride short-term market fluctuations and enjoy more sustainable returns, meaning more enjoyable Christmases for years to come.
What does the chart show?
The chart shows the US Dollar value of negative nominal-yielding bonds in developed markets. Debt that yields less than 0% means that investors should lose money if they hold it to maturity. Yet at its peak in December 2020 the value of developed market negative yielding debt was over $18 trillion, largely made up of ultra-low yielding government bonds which were the result of the loose monetary policy seen in places, such as Japan and the Eurozone. Since then, the dollar value of negative-yielding debt has fallen sharply to under $2 trillion. Over the past year, central banks have tightened monetary policy in response to inflation and so yields have risen dramatically, which has reduced the amount of negative-yielding debt to its lowest levels since 2015.
Why is this important?
In recent months, any indication that central banks may begin to pivot away from their current hawkish policies has been followed by sharp rallies in equity and bond markets. In both October and July of this year, global equity markets returned over 7% driven by expectations of pivots in central bank strategy. Low rates and quantitative easing have been largely responsible for the strong performance in equity markets over the past decade, and investors are eager to not miss out on another bull-market run. However, these same policies have been blamed for the high inflation that central banks are so keen to bring under control and so they will be unwilling to return to the excesses that caused these issues. It is important to consider that before 2014, negative-yielding debt was virtually unheard of and only came about as a result of excessively loose monetary policy. With around $2 trillion of negative-yielding debt remaining, symptoms of these policies remain, and so further tightening may still be necessary before there is a true return to ‘normal’. A pivot in policy is unlikely to be a return to loose monetary policy, but instead a pause in rate hikes at a level closer to the historic average base rates. For the Federal Reserve, this would be 4.61%, a far cry from the 0.25% rate that held for so long. The era of easy money coming to an end may be unpleasant for some, but for those who know where to look, opportunities are emerging across all asset classes.
What does the chart show?
This chart shows quarter-on-quarter German GDP growth alongside the results of the IFO German Business Sentiment survey. The IFO Business Sentiment survey not only provides insight into how German businesses feel about the current economic climate but also their expectations towards the future climate. A score of above 100 suggests that businesses expect an increase in economic activity, while a score under 100 suggests that businesses expect a contraction. Historically, business sentiment surveys such as these have closely aligned with the level of change in economic activity and so are used as leading indicators for where an economy may be headed in the future. However, in Germany a significant disconnect has emerged between business sentiment and economic growth. The results of the latest sentiment survey came in at 84.4, a level not seen since the 2008 financial crisis. Despite this, German GDP growth remained positive last quarter with the economy growing 0.3% in Q3.
Why is this important?
If the historic alignment between sentiment and activity continues, then this dramatic separation can mean one of two things. The first scenario is that German businesses are in a negative sentiment ‘bubble’. Although global economic activity is widely expected to cool and so some negative sentiment is to be expected, the combination of the war in Ukraine, record levels of inflation and slowing economic activity may be combining to give businesses an excessive sense of pessimism. The outlook is undeniably bleak, but all hope is not lost. Although still high, gas prices have fallen significantly from their August peak as storage levels have risen and there are signs that inflation may be easing in other areas. Consumers face a challenging environment but have emerged from the pandemic in a healthier financial state than before. A level of sentiment worse than it was during the pandemic may therefore be unjustified. However, if German business expectations are accurate, which historically they have been, the German economy faces a meltdown of epic proportions. The ECB has failed to act decisively to tackle the record levels of inflation in the Eurozone, and there are few signs of the Ukraine-Russia conflict ending as we head into winter when gas demand is highest. Levels of consumer spending, which recently have largely driven growth in Germany, are likely to tighten as the cost of living rises and German businesses will suffer as a result. Many global economies are asking themselves if a recession will happen at some point. For Germany, a better question may instead be how bad their recession is going to be.
What does the chart show?
This chart shows the DXY US dollar strength index (in red) and the Goldman Sachs US Financial Conditions Index (in blue) for 2022. The DXY Index measures the strength of the Dollar against a basket of other major currencies. The GSUSFCI Index measures the financial condition of the US economy using a basket of components, such as corporate bond spreads, equity market levels, and the yield curve. The index has been suggested as a guide to inform the Federal Reserve’s (Fed) policy decisions. The easier policy is needed when trying to encourage growth, but increased tightness is necessary to keep inflation under control. A strong dollar has a tightening impact on growth and can ease inflationary pressures. Throughout the year, the strength of the dollar and the tightness of financial conditions have steadily increased as the Fed has been aiming to bring inflation under control. However, both indexes have recently seen sharp declines.
Why is this important?
With signs suggesting that inflation in the US has peaked and with some leading indicators showing signs of cooling economic activity, global markets are expecting a pivot in the Fed’s policy to a less hawkish stance. Although inflation remains high, Fed policy has a lagging effect on economic activity, and so, despite certain economic indicators, such as labor markets and GDP growth, still showing signs of strength, there are many who believe that the Fed’s dramatic rate rises throughout the year have already pushed the economy into a recession at some point next year. An easing of financial conditions will therefore be necessary as the Fed attempts to pull off a ‘soft-landing’, and the sharp reversals in the upward trends of the DXY and GSUSFC Indexes show that markets believe that will happen. However, Chairman Jerome Powell and the Fed have surprised markets several times this year with their policy decisions. With the conviction of a pivot as strong as this, the next Federal Open Market Committee meeting could heavily disappoint.
What does the chart show?
This chart shows a breakdown of quarterly US Gross Domestic Product (GDP) growth (in annualised terms) into its key contributors: personal consumption, investment, government spending, and the net value of exports minus imports. All activity within an economy can be assigned to one of these groups, and the quarterly change in their levels produces the result for quarterly GDP growth. Following two successive quarters of negative growth, which many believe constitutes a recession, the economy grew at an annualised pace of 2.6% in the third quarter of 2022. This growth was largely driven by an increase in the level of exports and a fall in the level of imports. Government spending increased slightly, as did consumption. Levels of investment shrunk for the second quarter in a row.
Why is this important?
Although at first glance a rebound into positive territory for GDP growth may allay fears over an upcoming recession in the US, if we take off the mask there are signs that the future may be a bit more painful. The shrinking trade deficit that helped drive growth in Q3 is widely seen as a one-off event. The strength of the dollar means foreign goods are now cheaper and imports are expected to rise with exports falling. Although consumers emerged from the pandemic in relatively healthy financial positions, inflation and rising interest rates have dampened consumer sentiment with the rate of growth of consumption falling steadily. The fall in investment may be a clearer sign of what lies ahead. Investment levels can be used as an indicator of sentiment among businesses and sharply rising interest rates have caused investment levels to decline for two quarters in a row, suggesting that businesses are becoming more nervous about a future slowdown in economic activity. We believe that the strength of the dollar and a cooling global economy are likely to hurt the US trade balance, and if investment and consumption continue their downward trend then the risk of a decline in GDP followed by a recession in 2023, appears increasingly likely.
What does the chart show?
This chart shows the year-to-date (YTD) Returns of trend-following strategies versus global equities and global bonds. Trend-following strategies attempt to exploit the direction that markets are moving, with a variety of investment time horizons ranging from intraday to many weeks, or even months. During bull runs, when markets are making positive returns, these strategies will position themselves long, but during market downturns, these markets will switch to short positions and will therefore make positive returns, even when asset prices are falling. As such, these strategies rely on an ability to accurately time market movements, which historically has proved very difficult to do and can, therefore, pose extremely high risks to those that attempt to do so. However, trend-following strategies can be rewarding for those that get them right. YTD trend following strategies have returned 36%, a significantly better return than the return of -20% of global bonds and equities. These returns have been driven by clear trends in steadily falling stocks and bonds, and the steady rise in the strength of the dollar.
Why is this important?
One of the key aspects of building an optimal portfolio is managing risk through the diversification of assets. Over the past 20 years, the negative correlation between stock and bond returns and the generally positive returns across both asset classes has given rise to the 60/40 stock/bond portfolio. However, this correlation has been shown to become positive during periods of high market uncertainty, especially when inflation is high, which minimises attempts to diversify away risk. This has meant that YTD, a standard 60/40 portfolio has been one of the poorest performing strategies. Further diversification is, therefore, necessary to properly manage risk. Exposure to trend-following strategies can provide a further level of diversification to a portfolio, adding the ability to make gains, even when all traditional assets are falling. Although these strategies can be more volatile and can undergo long periods of volatility or negative returns, especially when markets do not show clear trends in any direction and rather move sideways, these strategies can help control drawdowns when other asset classes fall in value. Diversification is key for helping limit volatility and manage risk. Understanding which asset classes and strategies properly diversify a portfolio can therefore be important for providing steadier returns over the long run.
What does the chart show?
This chart shows the median five-year annualised return of stocks at a given Cyclically Adjusted Price-to-Earnings ratio (CAPE) for an equally weighted universe of all UK stocks with a market cap over £100m, over the past 30 years. The CAPE ratio is a valuation tool that measures a company’s share price relative to its earnings per share over an extended period of time. There is a clear relationship between CAPE ratios and subsequent five-year returns, with a lower CAPE ratio being a good indicator of an undervalued market with opportunities for returns. At the beginning of the year, the CAPE ratio for this universe of stocks stood at 22.6x, one of the highest on record. UK markets have suffered this year with the FTSE All-Share down over 7% in GBP terms. This fall in share prices has brought the median CAPE ratio down to just 14.3x, which is not far from being the lowest we have seen in a long time.
Why is this important?
In recent years loose monetary policy, excess liquidity and near-zero interest rates have pushed stock valuations considerably higher. In many cases share prices have risen far beyond levels that could reasonably reflect the fair values of companies. This has meant that investing using a value-based approach has been harder as well-valued companies with good opportunities for future growth have become rarer and rarer. However, the economic headwinds and uncertainty in markets have led to almost indiscriminate selling across UK markets as some investors have grown fearful. Prices have fallen and although earnings have also been affected, their declines are far less relative to falls in share prices. Some valuations across the market still remain elevated, but the median CAPE ratio for this particular universe of stocks has now fallen to levels that historically have provided excellent opportunities to investors that know where to find value. Despite the economic turmoil and uncertainty facing markets, there remains reason to be positive for those willing to take a longer-term approach to investing.
Additional Note: A data error resulted in the publishing of an inaccurate chart for the 06/10/2022 Chart of the Week Podcast. The error has since been amended and the updated chart can be found here. We apologise for any inconvenience caused.
What does the chart show?
This chart shows the relative performance of a variety of major asset classes from the end of June to the end of September. Global equities, as captured by the MSCI World Index, started the quarter in the midst of a rally, but the gains were erased later in the quarter with equities returning -7.1% in USD terms. Global Bonds also rallied early in the quarter but also saw their gains subside. High yield credit and US Treasuries were the two strongest performers with returns of -2.7% and -5% respectively. Commodities continued to decline from their earlier peaks. Oil fell to just over $85 per barrel at the end of September, a decline of -25% from its early June highs with a -16.7% decline throughout the quarter. Gold also declined throughout the quarter with a return of -8.4%.
Why is this important?
Despite having rallied until the first half of August, major asset classes suffered throughout the third quarter. The initial rally, which was driven by hopes that weakening economic data might force a pivot in strategy from the Federal Reserve and other Central Banks, saw global equities rise as much as 10%. However, persisting inflation saw increasingly hawkish moves by central banks with the Fed leading the way. This quickly put an end to hopes for a more dovish pivot in the short term. Monetary tightening combined with high levels of inflation have damaged the confidence of consumers and businesses. These headwinds have contributed further to a slowdown in economic activity and fears of a recession. This has helped push commodity prices from their peaks, although they remain high. Supply chain pressures are also showing signs of easing, raising hopes for a return to more natural price levels. Significant uncertainty surrounding the depth and duration of the now expected recession, as well as developments in the war in Ukraine, means that fear is extremely prevalent in markets. Although short-term timing risks remain, the substantial corrections in markets mean that longer-term opportunities are now beginning to emerge.
What does the chart show?
This chart shows the relationship between changes in the US M2 money supply and the monthly returns of the US stock market since 2000. The M2 money supply is a measure of the levels of cash in an economy held outside of the private banking sector, which is largely made up of deposits in current accounts. Other highly liquid assets are also included in the measure. Control of the money supply is one of the key tools used by the US Federal Reserve (Fed) to either control inflation or stimulate an economy. Increasing the money supply through quantitative easing or by lowering interest rates to encourage borrowing helps to stimulate an economy. A reduction in the money supply, through quantitative tightening or interest rate hikes, helps reduce inflation by lowering overall economic activity. As can be seen on the chart, there are large increases in the money supply during recessionary periods, as the Fed seeks to stimulate a stagnating economy. We can also see that performance in the stock market is closely linked to growth in the money supply. Monetary stimulus is a key driver of growth and so when the money supply grows, investors increase their expectations for the growth of companies, which drives growth in the stock market.
Why is this important?
The US stock market has had a disappointing year so far with the S&P 500 index down 22% YTD. This has largely been driven by a significant pivot to a strategy of monetary tightening by the Fed to tackle the rampant inflation in the US following a long period of loose monetary policy during the Covid-19 pandemic. In 2022 alone, the Fed base rate has risen from 0.25% to 3.25% and the Fed has begun a policy of quantitative tightening through the offloading of assets on its balance sheet. This has increased expectations for a recession, as higher borrowing costs cool economic activity and limit growth. An inverted yield curve and falling levels of confidence among manufacturers and consumers are all indicators of an impending recession. For investors this presents a difficult dilemma. Cooling economic activity and reduced growth will damage the balance sheets of many companies. However, for some there is an element of moral hazard. As we have seen, recessions have led to the need of monetary stimulus in the past and with it, sharp reversals in the future growth expectations for companies. Historically, some of the strongest periods of stock market growth have come during recessions following announcements of monetary stimulus. Close attention is paid to any comment or news from the Fed, as investors hope to ‘catch the bottom’ of the stock market by looking for any signs of a pivot in strategy. With some indicators suggesting that a recession is imminent, there are those who expect the reversal in the Fed’s strategy soon. However, inflation remains persistently above desired levels and other indicators, such as the labour market and companies’ balance sheets, remain healthy. The market’s base rate expectations have changed significantly throughout the year and with Fed Chairman Jerome Powell stating that decisions will be taken on a case-by-case basis, it is possible that not even he knows what the Fed’s position will be in a year’s time.
What does the chart show?
This chart shows the foreign currency reserves for the UK, Japan, and China in US Dollar terms. Foreign currency reserves are very important to a country’s economic health. Commodities are often priced in dollar terms and so dollars are needed to purchase them. When trading with foreign nations, having a store of their currency is necessary to purchase their goods. Central Banks hold foreign currencies that importers can exchange into local currencies to import foreign goods. A country with a negative balance of trade needs foreign currency reserves to pay for its imports. The store of foreign currencies can also be used by a central bank to stabilise the price of their own currency. If a local currency is devaluing heavily against another, then a central bank can sell their reserves of the foreign currency bringing the price of its own currency up. Japan and China are both examples of countries that have recently manipulated their own currencies in some way. Their large reserves of over $1.1 trillion and $3 trillion respectively have allowed them to do this. In comparison, the UK’s foreign currency reserves sit at just $110 billion.
Why is this important?
Currency valuations have been thrown into the spotlight in recent months. Global uncertainty and the frontloading of interest rate hikes by the Federal Reserve have led to significant inflows of capital into the US. The US Dollar has surged in value at the expense of other currencies reaching parity with the Euro for the first time since 2002 and pushing the value of the Yen down to as low as ¥145 per dollar. In the UK, the release of new Chancellor Kwasi Kwarteng’s so called ‘mini-budget’ saw the value of the Pound drop sharply to as low as $1.033. Although the value of the pound has been gradually falling in recent months, the sharp drop is unlike anything that the Pound has experienced before. There is now an expectation that some sort of intervention may be needed to stabilise the currency. The Bank of England (BoE) has already shown its willingness to intervene in markets to limit volatility with its purchases of long-term gilts. However, when compared to historical examples of currency interventions, the BoE’s options are limited. Just last week, the Japanese government intervened to halt the slide in the value of the Yen. In a one-off move, a bulk sale of Dollars for Yen saw the price of the Yen rise to ¥141 from ¥145 against the Dollar. Although the interest differential between the two countries means that downward pressure on the Yen is maintained, the move could offput some speculators who have helped drive down the value of the Yen. China’s vast foreign currency reserves have allowed it to limit volatility in its own currency through moderate levels of intervention. The UK’s large current account deficit and smaller currency reserves mean that they are less able to intervene in the same way that Japan and China have in the past. Instead, the BoE may resort to other measures. With the next Monetary Policy Committee meeting not until November, markets have priced in an unprecedented 150 basis points rise of the BoE rate with some suggesting there could be an emergency rate rise before then. A dramatic rise in rates increases is likely to contribute further to an economic slowdown further down the line. Already facing high inflation and now battling the risk of a spiralling currency, the BoE has a difficult task ahead.
What does the chart show?
This chart shows an aggregation of the yield-to-worst (YTW) of US corporate credit. The YTW is the lowest possible yield that can be received from a bond without it defaulting. Companies can redeem or ‘call’ their bonds, returning the initial amount borrowed to the lender before the previously agreed maturity date and the lender will no longer receive the future coupon payments. The YTW is the amount of yield a lender would receive if the bond was ‘called’ as soon as possible. Demand for US corporate credit has fallen sharply in recent months and the inverse relationship between the price and the yield on bonds has meant that yields have risen sharply in response. Yields are currently 5.14%, above what they were during the earliest stages of the Covid-19 pandemic and at levels not seen since the Global Financial Crisis (GFC).
Why is this important?
Corporate bond prices and yields can be a good indicator of the market’s confidence in a company or the economy as a whole. When confidence is high, investors are willing to lend money to firms at lower rates, confident that they are unlikely to default. Many investors hoped that the healthy balance sheets and strong cash reserves that firms built up over Covid-19 would see them through the expected economic slowdown. However, persistently high inflation and rising rates have meant that firms are burning through record amounts of cash. Fears of a recession continue to grow and the outlook for firms becomes bleaker. Lending to firms is now riskier and companies have been forced to offer better rates to attract financing for their debt. Demand for bonds has collapsed, and the prices have fallen so yields have soared. However, although yields are currently at levels not seen since the GFC, the spreads between corporate and treasury yields tell a different story. The yields on risk-free US Treasuries have also risen this year and while the spread between the two has increased to around 150bp; it is only slightly above its 10-year average of 133bp. By comparison during the pandemic, corporate bond spreads rose above 400bps. Today’s lower levels could indicate that while there are certainly rising levels of caution surrounding corporate debt, this is more based on macroeconomic uncertainty rather than a widespread fear of default that drives corporate debt spreads. Therefore, while US corporate bond yields are rising at a rate that shows no signs of slowing investors can still have reason to be optimistic about US companies’ ability to survive what is predicted to be a difficult period ahead.
What does the chart show?
This chart shows US year-on-year Consumer Price Inflation (CPI) and the level of US unemployment since 1950. Inflation in the US has recently been at its highest level in around 40 years with the latest data from August putting year-on-year inflation at 8.5%. Alternatively, unemployment in the US has reached as low as 3.6% following a sharp recovery from the record levels of unemployment seen during the Covid-19 pandemic. Inflation and unemployment have always been linked, with periods of high unemployment often coinciding with lower levels of inflation and vice versa.
Until the 1970s this link was seen to be causational with economic expansions driving up prices, encouraging businesses to grow and hire more employees. This idea was disproved in the late 1970s when expansionary fiscal and monetary policy was used to try and bring down high levels of unemployment in the US. However, rising prices and declining confidence instead produced a combination of higher inflation and unemployment that only a federal funds rate as high as 19% and a difficult recessionary period could bring under control.
Why is this important?
The relationship between inflation and unemployment is extremely relevant to the situation facing the US economy today. With the Fed making tackling inflation its number one priority, US jobs data is one indicator as to how effective the Fed’s strategy is proving to be. Although the relationship is not causal, historical data suggests that inflation does not tend to peak until labour markets show signs of loosening. The Fed has a mandate to keep unemployment low, but a tight labour market can lead to a wage-price spiral; which, when combined with global macro events such as supply chain issues and the Ukraine-Russia crisis, has contributed to the persistent levels of inflation.
The Fed faces a tough balancing act between acting too strongly and strangling economic growth, and not acting strongly enough and allowing high inflation to persist. The US labour market has shown some early signs of cooling in response to the Fed’s more hawkish policy but still remains tight. Several similarities can be drawn between the current situation and the stagflationary period of the late 1970s. High oil prices have driven up inflation, and the US now faces a fall in confidence and a stagnation of economic growth. Rising interest rates combined with persistently higher prices may now result in a stagflationary period in the future. In the 1970s, the Fed acted decisively to tackle the issue inflicting a recession in the process. There are some who believe that the Fed must have its own ‘Volcker moment’1 if it wants to effectively deal with the issue.
https://en.wikipedia.org/wiki/Volcker_Rule
What does the chart show?
This chart shows the price of the Euro against the Dollar over the past three years. The price reflects the markets demand for Euros relative to the Dollar. Following steady declines since its peak at $1.58 back in 2008 and a more recent peak of $1.22 at the end of 2020, the price of €1 dropped below $1 for the first time since 2002, reaching a two-decade intraday low of $0.9934 early last week. With a strong Dollar and the Euro steadily weakening, the reaching of the parity level between the Dollar and the Euro is largely seen as symbolic. Minor currency fluctuations are caused by changes in an economy’s balance of trade or by high levels of inflation. However, the decline in the strength of the Euro can also be seen as indicative of future expectations for the economic performance of the Eurozone as a whole.
Why is this important?
Over the past six months, Europe has grappled with the effects of the Russia-Ukraine conflict. Inflation has hit record levels and is expected to remain high, as gas prices have reached record levels. Fears of a complete shutoff of Russian gas in response to European sanctions over the country’s invasion of Ukraine have forced many countries to implement plans to ration energy usage over the winter months. High inflation, a cost-of-living crisis and fears of a global economic slowdown have given rise to a stagflationary environment in Europe. Political instability in Italy and a gloomy outlook for the Eurozone area have also contributed to higher uncertainty, causing outflows of money from Europe to the Dollar which has historically been seen as a haven during periods of uncertainty. The European Central Bank (ECB) recently raised rates for the first time since 2011 with a 50-basis point hike that surprised many onlookers, but the pace of its rate hikes has lagged behind those of other major central banks causing outflows as savers search for more attractive returns on their cash. Speculators have predicted further declines in the Euro’s value with a net short position of 44,100 futures contracts being built up. Should the currency continue to decline, it may exacerbate the high levels of inflation by increasing the costs of imports, further damaging Eurozone consumer confidence which already sits below levels seen during the Covid-19 pandemic. However, with further ECB rate hikes expected and early indications that the continents energy crisis may not be as dramatic as previously feared, there is a chance that the widespread money flows away from the Euro could reverse and the currency could stage a recovery in the long run.
What does the chart show?
This chart shows the JP Morgan Emerging Markets Bond Exchange Traded Fund (ETF) over the past five years. The ETF tracks the performance of US dollar denominated government bonds issued by over 30 different emerging market countries such as China, Mexico, and Indonesia. The ETF gives an indication of the market’s confidence in the economies of emerging markets (EM) and can be used by investors to gain exposure to emerging market debt. The increased economic and political risks that are associated with emerging markets mean that yields on emerging market debt tend to be higher than in developed markets for governments to attract the necessary financing of their debt. As demand falls for EM debt, the inverse relationship between the price and yields of bonds means that borrowing becomes more expensive. Demand for emerging market bonds has collapsed over recent months with the ETF down 18% year-to-date, levels not seen since the early stages of the Covid-19 pandemic.
Why is this important?
Global macroeconomic factors have combined to produce an almost perfect storm that poses strong economic headwinds to emerging markets, spooking investors. With the Federal Reserve sharply raising rates to tackle inflation and with the growing risks of a potential recession, capital outflows from emerging markets to developed markets, such as the US, have been significant. The trade-weighted dollar index currently sits at its highest level in nearly two decades. A stronger dollar, as well as higher oil and food prices has drained the foreign exchange reserves of several countries leading to significant economic turmoil. Earlier this year, Sri Lanka defaulted on its debt repayments as the country’s government was overthrown. Pakistan and Ghana also face liquidity crises with bond yields spiralling higher, and both countries are now looking to their creditors and the International Monetary Fund for support. Emerging market assets are extremely sensitive to economic and political turmoil and the dramatic decline in demand for emerging market bonds serves as an indicator for a difficult global economic situation. However, there are suggestions that the outlook for emerging markets is not as bleak as previously feared. Although many economies are facing difficulties, default rates are not expected to rise significantly. Markets may have already priced in the expected economic turmoil and many EM countries are on a sounder financial footing than during previous monetary tightening cycles. Investors willing to ride out short-term volatility may see emerging markets as a longer-term opportunity.
What does the chart show?
The chart shows US two, five, ten, and thirty-year inflation breakeven rates, derived from the difference between conventional and inflation-adjusted government bond yields of the same maturity. Their values indicate what market participants expect inflation to average annually over the next two, five, ten, and thirty years. It is coined the breakeven rate as it refers to the average level of inflation that would be needed to make an investor indifferent between buying an index-linked bond, or a nominal bond. If an investor thinks inflation will exceed this breakeven rate over the period, they will buy the inflation-linked bond; contrastingly, if inflation is not expected to hit this level, they will buy the nominal bond. Breakeven rates in the US have fallen from their highs earlier this year in a sign that investors are moving to price in lower inflation for the years ahead.
Why is this important?
US data indicated that whilst still elevated on an annualised basis, inflation showed signs of slowing. For July, the Consumer Price Index (CPI) reading came in flat at 0% month-on-month and the core equivalent rose by 0.3%, both readings came in lower than analysts’ expectations. Investors reacted positively to the release, with some relief that the worst may now be behind us, looking beyond the economic slowdown. However, Fed officials remain determined to wait for prolonged cooler inflation, defending the central bank’s aggressive hikes, before any change in outlook. The timing and the path to a normalised environment remain uncertain, with the sticky elements of inflation remaining elevated. Unlike the Global Financial Crisis, this cycle is not driven by the need for financial deleveraging, and the balance sheets of households, businesses, and banks are generally strong. This will help to minimise the slowdown ahead and gives the scope for economies to bounce back quite quickly. At the same time, valuation opportunities have emerged for longer-term investors. With careful diversification, we believe it is important to take advantage of setbacks in markets, as the cycle evolves and ride out any short-term volatility to participate in full, in those longer-term opportunities.
What does the chart show?
The chart shows China’s trade balance (level of exports minus the level of imports) over the past seven years. China is the largest exporter in the world by value and has historically operated at a trade surplus. During the pandemic, an aggressive zero-Covid policy saw the complete lockdown of many of China’s most productive cities, such as Shanghai and Shenzhen. This led to a collapse in export levels and the country fell into a trade deficit. Since then, export levels have recovered strongly, but with the Chinese government still pursuing its zero-Covid policy and with major production hubs moving in and out of lockdowns, the trade balance has fluctuated wildly. However, the most recent data released in July saw the level of exports surprise significantly to the upside, with China’s trade balance rising to an all-time high of $101.3 billion, breaking the record set in June.
Why is this important?
With tensions rising between China and the US in the aftermath of US House Speaker Nancy Pelosi’s visit to Taiwan, China’s position on the global stage has been thrust into the spotlight. Many believe that China is now able to challenge the US both economically and militarily, and the country’s sizeable trade surplus may support this, having a large trade surplus can be an indicator of a thriving economy. Higher levels of exports boosts growth and employment within an economy, both of which are desirable for a country, and China’s surplus far outweighs the US deficit of almost $80 billion.
The lockdown of Chinese factories saw US consumer prices soar earlier this year, as supplies to the US were squeezed. With the US already working to tackle high levels of inflation, China’s domestic policy is having a heightened impact around the world, an indication of China’s greater clout on the global stage. However, while China’s most recent figures may suggest a positive outlook, a deeper dive into the statistics reveals a different story. In the first half of this year China’s economy grew by 2.5% which may seem impressive by global standards but is significantly below the government’s target of 5.5% annually. Of this 2.5%, exports contributed 0.9%.
An over reliance on exports for growth could be problematic for China; with 20% of China’s GDP coming from exports, it is possible that it has a mutually dependent relationship with its foreign customers. 34% of Chinese exports go to the EU and US and with expectations of a recession high in those regions, China can expect to see demand for its exports fall and with it, the high growth rates that it has enjoyed for so long. There are suggestions that China’s exceptional export performance may only have been driven by an easing of strict lockdowns, with factories only now being able to fulfil orders after months of being shut down.
What does the chart show?
The chart shows expectation of future interest rates in the US for upcoming Federal Open Market Committee (FOMC) meetings up until January 2024. Calculated using data from Fed funds futures, it shows the number of interest rate hikes/cuts that markets are expecting between now and future FOMC meeting dates. It also shows the expected policy rate at those dates. According to the market, the Fed policy rate is expected to continue to rise sharply with at least three more rate hikes by November this year, bringing it above 3% as the Fed looks to tackle the high levels of inflation. The hikes are then expected to continue into 2023 but at a slower rate until a reversal in February. With cooling economic data increasing fears of a recession, the Fed is expected to begin a period of rate cutting until early 2024, bringing the rate down to around 2.7% by 2024
Why is this important?
As the 26-27 July FOMC meeting drew to a close, the Fed announced its second consecutive 75 basis point rate hike, as it seeks to tackle the rampant levels of inflation in the US economy. A 9.1% year-on-year Consumer Price Index print in July reinforced that inflation remains a persistent problem for the Fed to tackle. Economic data released throughout July also pointed towards a slowdown in growth. The US technically entered a recession, as Gross Domestic Product fell by 0.9% in the second quarter, with house sales and jobless claims also indicating that a downturn is imminent. Despite cooling economic data and further rate hikes to come, equity markets have rallied in the US returning 9.3% over July, with growth stocks leading the way. This rally has been driven by economic data and inflation expectations leading markets to believe that the monetary tightening cycle may not be as strong as previously feared. However, this expectation relies on inflation being brought under control in the coming months. Past data suggests that long-term predictions of the Fed rate are rarely accurate, and Fed Chairman Powell has declared future changes will be determined entirely by the data, offering no forward guidance. With such high uncertainty, it is difficult to determine whether a corner has been turned or whether this is simply just another bear market rally. However, with careful diversification, blending risk assets with defensive and low-correlated assets, we believe it is important to ride out the volatility and stay invested.
What does the chart show?
The chart shows consumer confidence indices for the US, UK, and the Eurozone area since 2005. Consumer confidence is a measure of how confident consumers feel about the state of the economy and the stability of their income. A fall in consumer confidence provides an indication of a future fall in consumer spending, as households face uncertainty and may therefore look to save more of their income, leading to a cooling of economic activity. Consumer confidence was showing signs of rolling over even before Covid-19 struck, but fiscal and monetary stimuli during the pandemic boosted confidence levels, following their sharp drop. UK consumer confidence has fallen below the levels seen during the Covid pandemic and currently sits around levels last seen during the Global Financial Crisis in 2009, while the Eurozone’s sits at levels not seen since the earliest days of the pandemic. US consumers are also growing more pessimistic, with confidence levels having fallen for the third consecutive month following the strong recovery seen post-pandemic.
Why is this important?
Record levels of inflation, dramatically tightening monetary policy, and high food and energy prices have now forced many households to reconsider their economic situations, as growing fears of an imminent recession take hold. Demand for labour remains high, and households are sitting on excess savings, suggesting that consumers are not in a completely unfavourable position. With inflation high and consumer confidence low, consumers are already starting to cut back heavily on discretionary spending. Bleak expectations among households may become self-fulfilling, as consumption is drastically cut and economic activity cools. With careful diversification, blending risk assets with defensive and non-correlated assets, we believe it is important to ride out the volatility and stay invested, to participate fully in longer-term opportunities emerging.
What does the chart show?
Inflation remains one of the key concerns in markets. The chart shows the US, Turkey, and Sri Lanka Consumer Price Index (CPI) year-on-year over the last five years. June inflation numbers once again surprised on the upside in the US at 9.1% year-on-year (vs 8.8% expected), its highest reading since November 1981. The surge in inflation is due to a mixture of supply disruptions, elevated global demand, as well as surging energy prices following Russia’s invasion of Ukraine. The inflationary surge has not been limited to the US – Europe and the UK are also experiencing red-hot inflation figures (with UK inflation hitting 40-year highs this week). However, Turkey and Sri Lanka are battling far worse economic situations, facing whopping 78.6% and 54.6% year-on-year rises in prices respectively. While external macroeconomic factors are partly to blame, internal politics and poor policy-making have exacerbated matters and resulted not just in economic catastrophe, but also in the collapse of the Sri Lankan government.
Why is this important?
Global inflation has led to many central banks tightening monetary policy and raising key interest rates. Turkey is facing similar surges in consumer prices, reaching levels not seen for 24 years. The central bank was forced by president Recep Tayyip Erdoğan to slash interest rates towards the end of last year, exacerbating existing inflationary pressures. Deteriorating confidence in the country has also worsened the inflation backdrop with the currency plunging versus the dollar; consequently pushing up import costs and intensifying price growth. Of course, the US is a much larger, diverse and more established economy than Turkey and Sri Lanka combined, so we should be careful about drawing any parallels. However, policymakers should take note of just how quickly inflation can get out of control if it is not contained quickly, or if central bank independence is jeopardised.
What does the chart show?
The chart shows the 5-year breakeven inflation rates for the US, UK and Germany which measure the market’s expectation of what the annual inflation rate will be five years from now, over the subsequent five years, on average. It is a measure of future inflation which is widely watched by policymakers and smooths out the effects of sudden short-term price shocks. Over the past few months, headline inflation as well as inflation expectations have been rising on the back of transport bottlenecks, labour shortages, supply-side shocks and higher energy prices. Recently the ‘5-year, 5-year’ breakeven measures of inflation have fallen from their peaks of this year, indicating that we might be at a turning point.
Why is this important? An important signal of the extent to which inflation becomes embedded, is longer-term inflation expectations. For much of the past nine months, inflationary concerns have dominated the narrative but in recent weeks the fear of recession has taken hold and inflation expectations have fallen. High energy and food prices are dampening consumer confidence and discretionary spending; corporate margins are under pressure from surging producer input prices, and rising interest rates are discouraging spending and investment. As we move through the second half of the year, two of the biggest drags on markets will be lifted: inflation is likely to have peaked, and the Fed’s tightening will be coming close to an end, ahead of other central banks. A soft landing will be tough for the Fed to engineer, but recent market moves suggest that there is seemingly little priced-in for that favourable outcome.
What does the chart show?
This week we reflect on the year-to-date performance of a number of major asset classes. The data runs from 31 December 2021 to 30 June 2022, showing total returns in US dollars. The war in Ukraine put further upward pressure on energy prices, with oil advancing over the six-month period. The weakest performer over the period was global equities (MSCI World) due to weakened investor sentiment in the face of intense uncertainties about inflation, growth and the unfolding impact of the war in Ukraine. Both global investment grade and high yield credit were also challenged as yields rose, even though default rates have not moved much (yet). Gold has held up better, but is still in negative territory year-to-date.
Why is this important?
The first half of 2022 has seen several different asset classes suffer considerable losses, including equities, credit and sovereign bonds, whilst oil enjoyed a strong period. Recession concerns have increasingly intensified over the last six months due to the surge in energy and food prices triggered by Russia’s invasion of Ukraine and central banks misjudging the persistence of inflation now evident. Many central banks have shifted rapidly to more aggressive tightening than investors were expecting at the end of 2021 and a key concern is that the cumulative effect of these rate hikes will eventually push the economy into recession and more recently, markets are unwinding previous hawkish bets with rate cuts now being priced in by mid-2023. Together with the tightening of monetary policy and rise in bond yields this presents a more challenging environment for markets. The next few months are likely to be volatile and uncertain in markets, but as we move through the second half of the year inflation is likely to have peaked and the Fed’s tightening well underway. With careful diversification, we believe it is important to ride out the short-term volatility and stay invested for longer-term opportunities emerging.
What does the chart show?
The chart shows the US 10-year government bond yield (blue line) and the share price performance of the S&P Banks Index relative to the S&P 500 (yellow line). An upward sloping yellow line indicates the S&P Banks Index is outperforming the broader S&P 500 Index, whereas a downward sloping line means it is underperforming. Through time there has been a fairly close relationship between the two – higher yields have been positive for banks whilst lower yields are often associated with underperformance. Since the bottom of the pandemic, until the beginning of this year, the S&P Banks Index had generally been outperforming the broader market as government bond yields were growing higher across the entire yield curve. However, despite the Fed indicating they would be raising interest rates and shrinking their balance sheet faster than previously anticipated this year, banks have failed to keep the outperformance up. In fact, more recently we have seen bank stocks underperforming broader markets whilst the yield on the benchmark 10-year treasury index has climbed to 3.2% from 1.5% at the end of 2021.
Why is this important?
The chart illustrates the recent divergence between the two series which have previously moved strongly together, with banks trailing behind despite the tightening in financial conditions. Financial stocks can benefit from increasing interest rates through higher net interest income (the difference between income earned and income paid out). However, they benefit most from a steeper yield curve, as they can lend on the long end and borrow at the short end, pocketing in the spread, but this year short term rates have been rising faster than longer rates, which ended up hurting banks’ profitability.
A major factor in whether these stocks will stage a recovery will be how the Fed combats inflation, which is at its highest level in decades, and how the US yield curve moves as a consequence. The outlook still remains extremely uncertain, and we can’t be certain about future returns, but with lower share prices in the face of a rising interest rate environment coupled with robust profitability, metrics could result in a near-term opportunity.
What does the chart show?
The chart shows the Momentum Risk Aversion Index since December 2002, a proprietary index that measures a degree of risk aversion within global markets across equities, fixed income and commodities. Today, the index sits quite a way above its long-term median (yellow line), at levels seen less than 10% of the time, albeit below the peaks reached earlier this year, in the early stages of Russia’s invasion of Ukraine. Such a high level of risk aversion means that market participants have been shifting away from the riskier assets, in favour of those investments expected to be defensive.
Why is this important?
Investor confidence continues to evaporate amidst geopolitical uncertainty linked to the Ukraine war, supply chain disruptions and central banks’ increasingly aggressive tightening paths. Multi-decade high inflation is fuelling fears over whether a soft landing can be achieved and many investors may need to see inflation figures peaking out before risk appetite could steady or improve. The outlook remains extremely uncertain and whilst central bank policy tightening is now well flagged, the bulk of the tightening probably lies ahead. Economic growth is expected to slow and inflation should peak in coming months but the timing, pace and extent of these shifts is highly uncertain. During periods of heightened risk aversion, investors tend to rotate out of risk assets which in turn puts pressure on their prices.
This can sometimes turn into an opportunity, for patient investors who are willing to go against the crowd and hunt for bargains. With careful diversification, we believe it is important to ride out the short-term volatility and stay invested for the longer-term opportunities being presented
What does the chart show?
The chart shows the headline interest rates at central banks around the world over the last five years. The recent surge in energy and food prices triggered by Russia’s invasion of Ukraine was an exogenous shock that could not have been foreseen, but central banks misjudged the broadening and persistence of the inflation surge that started long before then, and now well evident. Policy catch-up is underway, with many central banks around the world shifting rapidly to aggressive tightening. In contrast, Asia is not suffering the same inflationary problems as the US and Europe. In China, inflation is not as high, and their central bank is easing policy. The People’s Bank of China (PBOC) has shifted from policy tightening towards stimulus, with cuts in its lending rate and injections of liquidity. Meanwhile, the Bank of Japan (BOJ) is maintaining interest rates of -0.1% and has reaffirmed its commitment to yield curve control by purchasing Japanese Government Bond’s (JGB) without limit to keep 10-year yields around 0%.
Why is this important?
The Fed has led the way, with a rate rise of 50bps in May (in line with expectations), the first of this size since 2000, and signalling two further 50bps rises in its next two policy meetings, with more rises to follow. It has also brought forward its plans to remove liquidity from the financial system, with quantitative tightening beginning in June at the rate of $47.5bn per month, before moving to $95bn per month within three months. With the Fed’s much more aggressive tightening than other central banks and rapidly rising interest rate differentials in favour of the dollar, further rises cannot be ruled out. The European Central Bank (ECB) has been later to respond to the inflationary surge and has also become increasingly hawkish recently, signalling an end to its huge asset purchase programme along with its first interest rate rise in July, and an end to negative policy rates during the third quarter. While central bank policy tightening is now well flagged and at least in part discounted by markets, the bulk of the tightening probably lies ahead, in particular the withdrawal of liquidity is only now beginning. Despite the resurgence and spread of Covid-19 in China, there could be opportunities that lie beyond these short-term challenges. The PBOC is not under as much pressure to combat red-hot inflation by raising interest rates and are instead in a position where they can cut rates to help stimulate growth. This is another good example of the opportunity in active management, if we’re selective in terms of timing and positioning, then we could take advantage of any attractive entry points that may present themselves.
What does the chart show?
The chart shows the Bloomberg Agriculture, Energy and Industrial Metals indices’ prices since 2000. Commodities have rallied strongly this year, continuing the trend that started right after the pandemic lows in March 2020, boosted by energy and food supply shortages amid higher demand. The rally was exacerbated by the war in Ukraine whose immediate consequences produced further surges in energy and other commodity prices and led to more disruptions to key commodity markets and supply chains, worsening the damage inflicted by the pandemic.
Why is this important?
There are both demand and supply side reasons for the sharp rallies in commodity prices we have witnessed recently. The demand side is associated with the reopening of some regions in China, following Coronavirus-induced lockdowns, boosting the demand for raw materials. On the supply side, disruptions in supply chains as well as sanctions imposed on Russia have also strengthened the rally. Ultra-loose monetary and fiscal stimulus adding fuel to the fire of post-pandemic release of pent-up demand, triggering excess demand in supply-constrained markets, in turn has led to high and persistent inflation. War in Ukraine exacerbated these existing economic imbalances by driving commodity prices higher, and, in damaging consumer and business confidence, especially in Europe, it has created even greater challenges for central banks as they begin the process of attempting to unwind excessive policy stimulus without triggering recession. The longer the war drags on, the greater the risk of longer lasting economic damage, transmitted primarily through global energy and agricultural commodity prices.
What does the chart show?
The chart shows the performance of the MSCI World ESG Leaders index and the MSCI World Quality index since the end of 2020. 2021 saw strong performance for ESG and quality stocks, accelerated by pandemic-related trends, with ESG funds also benefitting from events such as COP26, putting issues around sustainability into the spotlight. ESG and quality stocks typically trade at higher valuation multiples, because of their naturally lower risk and higher sustainability of returns. This, however, has been a headwind so far this year as investors have struggled to justify stretched valuation levels amidst the Fed’s commencement of their hiking cycle.
Why is this important?
Changing investor sentiment towards ESG investing over the last couple of year has fuelled a lot of demand and greater investment into ESG funds, which pushed valuations higher. It is easy to be swayed by positive sustainable messaging made by companies, but it is important to consider that the valuation opportunities might not necessarily be present. We advocate an integrated approach, whereby one considers the ESG risks, or indeed opportunities, as part of a broader appraisal of company fundamentals, valuation and technicals. We consider ESG-integrated strategies (analysis of all ESG factors in investment decisions), plus positive or negative screening (where certain stocks are included or excluded based on their ESG criteria). So far this year ESG funds have not outperformed but we believe that going forward, considering ESG risks and positioning a portfolio to help mitigate some of these risks, should provide a positive alpha source due to lower cost of capital and higher investor flows.
What does the chart show?
The chart shows the price-to-earnings (P/E) ratio for the MSCI World, MSCI World Growth and MSCI World Information Technology indices. The P/E ratio measures the relationship between a company’s stock price and its earnings per share (EPS), giving investors a sense of the valuation of the company, or broader market, and how much investors are paying for the earnings of a business. Companies with high P/E ratios are often growth stocks and can, at times, be overvalued compared to their current fundamentals. Similarly, companies with low P/E ratios are referred to as value stocks and are sometimes considered as undervalued. Markets are battling with surging inflation and rising interest rates, which is proving to be more challenging for growth stocks, with the US tech-heavy Nasdaq index recording its worst monthly return in April since 2008. The valuations of the broad global equity index as well as the technology and growth indices have now declined back to pre-pandemic levels.
Why is this important?
Investors in growth stocks have been spooked by central banks’ much more aggressive monetary and fiscal tightening paths. Growth stocks are more sensitive to interest rate rises as investors expect higher earnings further out in the future, and the higher interest rate used to discount their future earnings increases, meaning the present value of those earnings (in theory, the share price) decreases. As investors continue to flee from risky assets, even the stressed valuations we are seeing today may still look overly optimistic and not fully reflective of the heightened uncertainties and risks economies are currently facing. Although we can’t be certain about future returns, long-term investors recognise that patience may be rewarded with strong gains. If growth equities continue to become cheaper, with the risks appropriately discounted, eventually longer-term buying windows may arise.
What does the chart show?
The chart shows the performance of various currencies versus the US dollar as well as the performance of the US dollar trade-weighted index (a measure of the value of the USD against a basket of other major currencies) year-to-date. All major currencies have fallen significantly this year and the USD trade-weighted index has risen as markets position for an increasing divergence in monetary policy paths between the US and other major economies. The Japanese yen has struggled so far this year as the Bank of Japan (BoJ) continue to run with ultra-loose monetary policy. The euro and sterling have also suffered as investors have started to question how far the European Central Bank (ECB) and Bank of England (BoE) will be able to raise rates this year without having severe economic ramifications. Additionally, the recent depreciation of China’s currency against the dollar comes as the country grapples with a resurgence in Coronavirus, dampening the outlook for global growth, further bolstering the dollar which is traditionally seen as a safe-haven currency when investors flee from risky assets (despite Q1 GDP in the US unexpectedly falling nearly 1.5%).
Why is this important?
As investors flee to the US dollar, this would hurt US multinationals who need to convert their weaker foreign currency revenues back into a stronger dollar. A stronger dollar would not be beneficial to US exporters, particularly at a time when slower global growth potentially means lower demand for their products and services. However, a stronger currency may be advantageous to the Fed who might welcome the downward pressure a stronger dollar exerts on the current multi-decade high inflation rates, which in turn may give policymakers more flexibility as they may not need to raise interest rates as high as they otherwise might have. For other economies around the world, a stronger dollar makes dollar-priced goods and services more costly to buy in their local currencies. With recessionary risks to the eurozone, the UK facing a potential economic slowdown and the BoJ committed to retaining ultra-loose monetary policy, the US dollar may not be ready to cool off just yet.
What does the chart show?
The chart shows the US Treasury yield curve (red line) and the US breakeven yield curve (blue line) as at 4 May 2022. The first compares the yields available on similar US treasury bonds with different maturities. Its “normal” shape is upward sloping, with higher yields on bonds with longer maturities, reflecting investors being compensated for tying up their capital for longer and being more at risk of changes in inflation and interest rates levels. The breakeven yields, instead, indicate the maximum level to which bond yields can move to in the next year before investors start experiencing a net negative total return. The higher the breakeven yield compared to the bond yield, the more the investor can withstand a yield rally.
Why is this important?
With the Fed tightening monetary policy and increasing policy rates, the front end of the curve has repriced substantially, moving from a 0.2% yield on a 2-year bond only 12 months ago, to the current value of around 2.8%. The long end has also come up, though by a lesser extent, with the 10-year yield having come up from 1.6% to 3% over the same period. Bond investors have experienced very poor total returns over the period, -4.3% and -9.2% respectively for the 2-year and 10-year maturities, as rising yields (or falling bond prices) overwhelmed the lower starting yields.
However today the situation is substantially different. The risk of bond yields rising is still very high, but starting yields are a lot higher than a year ago, which provides a good buffer for bond investors. For instance, an investor in the 2-year US treasury bond would need to see yields going up by about a further 1.9% over the next year before eroding all the gains made on the income and roll-down side. Long-term investors have a lower buffer, because of the longer duration (and hence interest rates sensitivity) of their income streams, but right now the longer end of the yield curve seems to be less at risk of big swings.
Is it time to be interested in government bonds again?
What does the chart show?
This week we look at one of the top performing equity sub asset classes this year, namely listed infrastructure. Listed infrastructure encompasses companies that manage and operate critical infrastructure assets, from electric or water utilities networks, to gas pipelines, toll roads and telecommunication towers. Listed infrastructure is up around 5% year to date in US dollar terms, compared to the headline global equity index down 13%. Unsurprisingly, given the dynamics within the energy market at the moment, it has been the midstream energy (including oil and gas pipelines) names performing best, up near 20% in aggregate. Utilities have been surprisingly resilient in aggregate in the face of higher bond yields which have historically been a headwind. Nonetheless, the stability of their earnings profiles is attractive during stressed periods for markets. Furthermore, some utilities are able to pass through inflation relatively quickly which is beneficial in the current environment.
Why is this important?
Infrastructure has been one of our preferred asset classes for some time now given a combination of attractive relative valuations vs. many core equity and bond markets, strong longer term structural tailwinds, positive shorter term technical dynamics (none more prevalent that higher power prices benefitting certain renewable energy related assets) and inflation-linkage embedded into many of the underlying company revenues or individual projects. After a challenging couple of years for the asset class (the pandemic crippled a lot of transport infrastructure assets and it lacks the glamour of big tech) it has shown its worth this year and the benefits of owning it in a multi-asset portfolio. If we stretch returns back to pre-pandemic days, the S&P infrastructure index is still someway behind broader global equities, but the year-to-date outperformance has done a lot to ‘bridge’ this gap and over the last two years, listed infrastructure (as measured by this index) is now ahead of global equities.
What does the chart show?
This week’s chart shows the exchange rate of the Japanese yen against the US dollar (showing JPY per 1 USD). The yen’s recent depreciation (illustrated by an upward sloping line) started in early 2021 though it has recently depreciated against the dollar every day for 13 days up to 19 April – its longest losing streak since 1971* – and now sits at its weakest level since May 2002, as divergence between monetary policy paths weighs on the Japanese currency. Yen weakness has traditionally been beneficial for Japan’s export-driven economy (as their translated earnings are worth more in yen terms), but at these levels companies are more concerned about how it will further inflate fuel and raw material imports which are already surging due to the war in Ukraine. Japan is a large importer of oil and gas, and the big price rises in those markets pushed the country’s trade deficit to its widest point in eight years in January.
Why is this important?
Many investors have often owned the Japanese yen as a safe haven asset during periods of financial and geopolitical stress. Yet so far this year the currency has weakened over 10% against the dollar, leading some to question its traditional diversification role. On many metrics the yen looks cheap now. However, further hawkish comments from Fed officials have continued to widen the policy divergence between the Bank of Japan (BoJ) and the Fed. The BoJ’s pledge to continue stimulus measures in order to boost Japan’s economy and maintain interest rates of -0.1% massively differs from other key central banks, particularly the Fed, where policymakers have already started raising interest rates this year to combat surging inflation. Whilst US consumer inflation sits at 8.5% today, in Japan it is just 0.9%. The BoJ has also reaffirmed its commitment to yield curve control by purchasing Japanese Government Bonds (JGBs) without limit to keep 10-year yields near 0% which has widened the gap between yields on JBGs and US Treasuries. The surge in inflation across western countries has made central banks like the Fed increasingly hawkish and determined to push ahead with their rate rises despite uncertainties of the financial ramifications from the war in Ukraine whereas Japan’s central bank remains unwaveringly dovish.
*Bloomberg data only dates back to 1971
What does the chart show?
The chart shows the performance of the MSCI World sector indices year-to-date, in total return dollar terms. The notable outperformers so far this year have been the energy and metal sectors supported by higher underlying commodity prices, boosted by elevated demand and tight supply. Financials began the year outperforming most other sectors as the outlook for a higher interest rate environment benefits these companies through higher net interest income, however, Russia’s invasion of Ukraine spooked investors, sending most sectors into negative territory.
The worst performing sectors this year have been information technology, consumer discretionary, and communication services. The prospect of higher interest rates has a greater negative impact on growth stocks as the interest rate used to discount their higher future earnings increases, meaning the present value of those earnings decreases. Furthermore, the consumer discretionary sector is more sensitive to prospects of lower growth and slower consumer spending.
Why is this important?
The first quarter of 2022 was driven by two powerful shocks: Russia’s invasion of Ukraine and the Fed’s sharp hawkish shift in policy. The immediate consequences of the war produced surges in energy and other commodity prices and further disruptions to key commodity markets and supply chains, exacerbating the damage inflicted by the pandemic. It is now the indirect consequences of the war that are increasingly driving financial markets and are likely to do so in the months ahead.
The focus has shifted to the inflationary implications, the surge in commodity prices, damage to supply chains, the risk of shortages, and the extent to which central banks will tighten policy to combat this more persistent inflation. The large-cap UK equity index has been a standout performer year to date, buoyed by its significant weight to energy and miners. A lot of ‘value’ managers have benefitted from long-standing overweights to these sectors. On the other hand, the technology dominant US market has endured a more challenging period, as have ‘growth-focused managers with overweights in tech and consumer discretionary stocks.
What does the chart show?
The first quarter of 2022 saw the worst quarterly performance of US Treasuries (government bonds) on record as the Fed moved to tackle soaring consumer prices by withdrawing stimulus and hiking interest rates. Markets now see a strong possibility that the Fed will increase rates by 50bps at its May meeting. The expectations for a more hawkish Fed led to a sell-off in Treasuries across all maturities. Given the inverse relationship between bond prices and yields, the first three months of 2022 has seen yields rise sharply with shorter-dated debt bearing the brunt of the Fed’s more hawkish stance.
Why is this important?
Driven by fears that central banks will have to be more aggressive in suppressing multi-decade high inflation, global bond markets have experienced heightened volatility so far this year. Fed Chair Powell recently signalled his willingness to support a 50bps hike at May’s Federal Open Market Committee (FOMC), with other Fed officials also echoing his stance. Fed policymakers have expressed that combatting rising inflation is their top priority and they may be willing to risk slower growth in order to reach the Fed’s 2% target. Shorter-dated debt has especially suffered with 2-year Treasury yields rising the most in one quarter since 1984 and last week, the 2-year yield exceeded the 10-year yield for the first time since 2019 (a yield curve inversion is seen by many as an indicator of a recession), reinforcing the view that these steeper rate hikes by the Fed may cause a recession due to demand destruction. Investors have become accustomed to Treasuries playing a reliably defensive role in portfolios in recent decades, and whilst they might continue to do so at times, particularly at points of market crisis, high inflation and low bond yields pose a key risk and we anticipate more volatile periods ahead for the world’s favoured safe-haven asset class.
What does the chart show?
This chart shows the calendar year total returns for the MSCI Europe ex UK index and the maximum drawdown the index experienced over each calendar year since 2000. Maximum drawdown reflects the greatest peak-to-trough fall over the period (the worst possible loss an investor could have made if they had bought at the peak and sold at the trough in the same calendar year). European equity markets have experienced heightened volatility in the past two months and uncertainty around the ramifications of the war in Ukraine which has weakened market sentiment. In light of the rapidly evolving situation, investors are finding a level which discounts the heightened risks and the financial consequences (which will be felt more in Europe given its higher dependence on Russian gas). Despite recent volatility, this year’s maximum drawdown (so far) of -21.4% is only marginally worse than the average calendar year maximum drawdown of -20.9% since 2000.
Why is this important?
Even during the strongest years for markets, there are always periods where markets fall. Volatility and capital loss are part of investing in any financial market and should be anticipated. Europe is more exposed to the financial consequences of the war than other regions and some of these financial implications are yet to become apparent. There are also other factors spooking the market at the moment: most notably Eurozone inflation reaching a record high of 5.9% in February – implying that tighter monetary policy and potentially slower economic growth lie ahead. After their sizeable falls, markets are rapidly discounting these risks and are offering some longer-term buying opportunities. Times like this tend to lead to a compression of investor time horizons. Now, more than ever, is a time for longer term perspective, riding out the short-term volatility, to participate in the recovery whose timing is unpredictable, but which surely lies ahead.
What does the chart show?
The chart shows the returns of various mainstream bond indices rebased to 100 from December 2019. Markets reacted as the Federal Reserve lifted interest rates by 25 basis points last week, as it faces the highest level of inflation in forty years, with a sell-off in US Treasuries (blue line) and US (inflation-linked) TIPS (red line). Rising inflation reduces the appeal of low-yielding debt where the purchasing power of principal and coupon payments are depleted as consumer prices surge. The bond sell-off (and subsequent rise in yields) has been seen worldwide as central banks wind back pandemic-era stimulus to combat rapidly elevating consumer prices and rapidly switch to monetary tightening. The steep sell-off emphasises the degree to which some investors have underestimated how far central banks are willing to go in order to tackle rising inflation (just three rate hikes of 0.25% were priced in at the start of the year in the US, a long way from current expectations, covered below).
Why is this important?
US consumer price inflation soared to 7.9% last month, with Russia’s invasion of Ukraine prompting sharp jumps in commodity prices, exacerbating existing inflationary pressures. Fed Chair Powell’s comments reinforced the view that the key concern from the war in Ukraine is that it will add fuel to rising inflation, leaving it more persistent in the economy, opening the door to tightening monetary policy at a faster rate than initially anticipated. Markets have priced in a further 190 basis points worth of rises at the remaining six FOMC meetings this year, effectively provisioning for at least one rise above 25 basis points. Powell’s remarks sparked a sell-off in government debt, sending yields higher with the moves particularly sharper for short-maturities. Government bonds are offering little or no downside protection amidst geopolitical turmoil. US Treasuries are currently set for one of, if not their worst, quarter ever. They are certainly not a source of risk-free return they were perhaps once perceived to be!
It is also noticeable how poorly (dollar denominated) emerging market sovereign debt has performed this year. This, in part, is explained by direct Russia exposure but that was never really more than low single digits. We think there is likely an element of ‘baby out with the bathwater’ here and so it is an asset class we have spent more time on recently and have recently added to in some portfolios.
What does the chart show?
The chart shows the price-to-earnings (P/E) ratio for the MSCI China index (Chinese equities) relative to the MSCI ACWI index (global equities). The P/E ratio measures the relationship between a company’s stock price and its earnings per share (EPS), giving investors a sense of the valuation of the company, or broader market, and how much investors are paying for the earnings of a business. Companies with high P/E ratios are often growth stocks and can, at times, be overvalued compared to their current fundamentals. Similarly, companies with low P/E ratios are referred to as value stocks and are sometimes considered as undervalued. Over the last twelve months, the valuation of Chinese equities relative to broader global equities has declined to sit at historic lows.
Why is this important?
Investors in Chinese equities — both onshore and offshore listed names — have been spooked by the long-running crackdown by President Xi’s administration on companies in the technology, property and education sectors; default concerns in the property sector; lockdowns in wealthy cities, including tech-focused Shenzhen, as the country grapples with rising Covid cases; slowing economic growth and more recently, concerns over China’s support for Russia in Ukraine, which it denies. MSCI China’s relative valuation sat at its lowest level in over fifteen years this week as US regulators threatened to delist several Chinese companies (listed in the US) unless they provided detailed audit documents that supported their financial statements. However, Chinese stocks performed a major U-turn on Wednesday and rebounded very strongly (the Hang Seng rose +9% with tech stocks up significantly more) as China’s top economic official intervened to reassure investors. The State Council said Beijing will take strong measures to boost the economy this quarter, would take steps to prevent further risks building in the property market and will keep the stock market stable, though details of such stimulus measures didn’t appear to be provided. There is certainly a lot of bad news already in the price of Chinese equities. These historically low relative valuation levels certainly warrant a closer look at the region.
What does the chart show?
The chart shows the German 10-year inflation breakeven rate, derived from the difference between conventional nominal and inflation adjusted government bond yields of the same maturity. Its value indicates what market participants expect inflation to average annually over the next 10 years. It is coined the breakeven rate as it refers to the average level of inflation that would need to be achieved to make an investor indifferent from buying an inflation linked bond or a nominal bond. If you think inflation will exceed this breakeven rate over the period, buy the inflation linked bond; if you think inflation will fail to hit this level, buy the nominal bond. Germany’s 10-year breakeven rate has risen materially in recent weeks amidst soaring commodity prices leading to further rises in inflation expectations. The rate has recently surged as much as 43 basis points since the beginning of March to an all-time high of 2.62%, in a sign that investors are moving to price in higher, persistent inflation for the years ahead.
Why is this important?
Prior to events in Ukraine, the ECB had been widely expected to draw back stimulus at a faster pace in an attempt to tame inflation – with the Euro Area flash CPI print for February coming in at 5.8%, its highest level since the formation of the single currency. Now, Russia’s invasion of Ukraine has unleashed significant uncertainty since the EU relies on Russia for some 40% of its gas supplies. In the last few days the EU has committed to cut Russian gas imports by two-thirds within a year, and we have also seen the US and UK move to ban Russian oil imports. Energy prices are a key component of inflation baskets and thus these developments are expected to push inflation sharply and rapidly higher. These risks surrounding higher energy prices are unlikely to dissipate in the short term and remain a threat to short-term market stability. The ECB is now widely expected to keep its monetary policy settings unchanged at its March meeting (which will have been announced by the time this note is published) a 180-degree turn since its shift to a more hawkish stance at the February meeting. With the price of oil and gas soaring in a very short space of time, economies have little time to react to absorb those jumps and its impact on consumer spending and confidence could instead tip economies into recession and prove to be deflationary over the long-term. Who would want to be a central banker now?!
What does the chart show?
Given recent events, we thought it would be a good opportunity to examine past wars/conflicts and analyse the drawdowns of the US equity market (as measured by the Dow Jones Industrial Average index) and how long it took for the index to return to its prior peak. Major wars clearly impact stock markets by creating uncertainty, hitting investor sentiment, and potentially damaging economic activity. However, analysing past military conflicts shows that permanent damage wasn’t inflicted on markets, and they eventually recover. The Dow Jones initially sold off around 6% from 10th February but has rebounded since. For most events we have charted, markets returned to their prior peak in less than 60 trading days (3 months). The exceptions are the Cold War and the Gulf War which took 107 and 137 trading days respectively to recover. Whilst these might look significantly longer than the other events charted, during WWII it took the Dow 1,368 trading days to recover and throughout the Global Financial Crisis it took 1,359 trading days. In all of the conflicts charted, the US equity market never fell more than 20%.
Why is this important?
The rapid and alarming turn of events in Ukraine has shaken markets and compounds an already uncertain environment due to high inflation and central bank monetary tightening. We expect the direct global economic impact to be limited as Ukraine and Russia are smaller economies compared to more developed economies. This unwelcome turn of events in Eastern Europe is unlikely to cause a major bear market but rather a short-term shock. We do not underestimate the disaster that this brings but wars do end and this one is expected to be of limited duration and spread. It comes at a time when the global economy and corporate sector are recovering robustly from the Covid-19 pandemic and while there is likely to be some knock to confidence, directly from the escalation in Ukraine and from second order effects including higher energy prices, the broader impact should be limited.
What does the chart show?
The chart shows the quarterly net flows and total assets in sustainable or ESG (environmental, social and governance) funds since 2011. The last two years have seen a stark increase in demand for these funds, accelerated by the pandemic as well as events such as COP26 which have put issues around sustainability into the spotlight.
With total assets of $2.4trn in Q1 2020 more than doubling to $4.6trn by the end of 2021 it highlights the greater consideration that investors are giving to responsible and sustainable investing. Whilst rising markets over the period have supported the increase in assets, the extent of the rise has also been helped by much higher flows, with these sustainable funds recording net flows of close to $190bn in Q4 2021.
Why is this important?
Coinciding with a heightened focus on sustainability, there has been a proliferation of ESG-labelled strategies in the last two years. Issues of greenwashing (where managers’ marketing material and disclosures paint an impressive picture of the level of ESG integration that masks the reality within) are becoming more prominent. Morningstar recently announced the culling of 1,200 funds, totalling $1.4trn in assets, from its sustainable fund universe after an investigation into fund manager disclosures.
Taking time to properly research, meet and understand managers’ approaches and processes is integral in navigating this issue. It is also crucial that investors never lose sight of the fundamentals. It is easy to be swayed by positive sustainable messaging made by companies and fund managers, but business fundamentals might not necessarily stack up. We advocate an integrated approach, whereby one considers the ESG risks, or indeed opportunities, as part of a broader appraisal of company fundamentals.
What does the chart show?
The chart shows the Atlanta Fed’s Flexible-Price and Sticky-Price Consumer Price Indices (CPI) since 1970. The Flexible-Price CPI (green line) represents goods and services included in the CPI that change price relatively frequently, whereas the Sticky-Price CPI (blue line) represents those changing price relatively slowly. For example, some sticky prices are those for medical care services, alcoholic beverages, household furnishings while things like new vehicles, fuel and gas, or bakery products are part of the flexible price items. The latest readings showed the US headline CPI index at 7.5% year-on-year, once again above analysts’ estimates. The Atlanta Fed’s flexible price component is, as expected, sitting at all-time highs at 17.8% year-on-year, whereas the sticky price component is up 4.2% on a year-on-year basis, its highest since 1991.
Why is this important?
As sticky prices are more gradual to change, when these prices are set, they include expectations about future inflation to a greater degree than flexible prices, which tend to be more responsive to short-term changes in the current economic environment. Last year the debate was on whether the inflation spike was transitory or not and now that the “transitory team” has badly lost the match, we are all gauging when it will come back to lower levels. The sticky price component therefore may provide key insight when trying to gauge where inflation is heading. In January, the flexible measure reduced slightly from 17.9% to 17.8% whereas the sticky metric has reached new highs, this could indicate that the supply chain and pandemic related pressures are improving but inflation expectations are shifting meaningfully higher. When the sticky price items are hitting multi-decade highs, the risks of inflation becoming persistent cannot be dismissed. Markets are in the process of adjusting rapidly to this new reality, and already financial conditions have been tightened significantly by the policy pivot.
What does the chart show?
Last week, Facebook (now known as Meta, reflecting Mark Zuckerberg’s desire to focus on construction of the virtual metaverse) saw its market value drop by $250bn in a single day following its quarterly earnings release that missed expectations and was accompanied with lower future earnings guidance. That $250bn drop was the largest one-day drop (in market value terms) ever recorded in US stock market history. To put this into context, that is the equivalent of an entire Nike disappearing in a day, or a Netflix, or two Goldman Sachs, or three Fords. Each are as staggering as the last!
Why is this important?
Facebook missed on earnings expectations last week, albeit by only 4% at the headline level, revealed its daily active users (DAUs) fell for the first time in the company’s 18 year history and lowered future earnings guidance, not helped by huge investment expenses associated with building the metaverse. Furthermore, it also warned it might shut down Facebook and Instagram in Europe if new data protection legislation isn’t adopted. No doubt plenty here to challenge the future growth trajectory of this business but we think a key takeaway is that when company valuations become too overstretched it need not take a huge disappointment for Mr Market to punish a stock severely. Companies priced for perfection, despite how popular and glamourous they might be, can suddenly look far from that in share price terms if those once stellar earnings suddenly look a little more challenged. We should disclose Facebook/Meta was an exception this quarter with the other tech giants actually delivering strong earnings updates on the whole but it serves as a handy reminder of the importance of valuation within one’s investment selection.
What does the chart show?
After a volatile start to the year, US equity benchmarks, the S&P 500 and NASDAQ, have ended the month trading well below their highs of the beginning of the month and mid-November respectively. The S&P 500 ended the month down -5.2% and the NASDAQ down -9.0% in local terms. The chart shows the net monthly fund flows of the Invesco QQQ Trust since 1999, one of the most actively traded exchange-traded funds (ETFs) in the world. The fund only invests in non-financial stocks listed on the NASDAQ, which has naturally seen higher weightings to large tech names. It ultimately is trying to track the performance of the NASDAQ 100 Index. In January 2022, the monthly outflows reached levels not seen since the 2000s, reflective of the changing investor sentiment after weeks of turmoil in US large cap companies. $6.2bn was exited during January with the majority of the outflows taking place towards the end of the month, suggesting that investors have been taking profits after a number of very strong years for US equity markets in addition to concerns over inflation and interest rate rises.
Why is this important?
US large cap stocks have suffered a volatile start to 2022, largely attributed to the Fed signalling tighter monetary policy this year in order to combat the highest inflation levels seen in decades. Expectations of rising interest rates have driven investors to reassess the valuations of large cap growth stocks as these are generally more sensitive to interest rate movements. With such a significant shift in the monetary policy landscape coming into view, we expect the best returns are now likely to come from a very different cohort of stocks than those that have led returns over the past decade. We continue to see a lot of opportunities in value stocks, which have generally proved resilient during the sell-off in January. As well as maintaining broad diversification, we believe it is more important than ever to include a significant allocation to value stocks in portfolios, across a broad range of industries and geographies.
What does the chart show?
US equity markets have fallen under strong pressure recently, as expectations build that the Fed will unwind monetary stimulus measures quicker than expected. In fact, markets are now expecting the Fed to increase interest rates as much as four times this year, starting in March, to fight surging inflation. Higher interest rates raise borrowing costs for all businesses as well as making companies’ future earnings worth less in terms of discounted value. The effect is magnified for tech and other growth companies, whose earnings are further out in the future.
The prospect of a faster pace of rate hikes sent US equities to their lowest levels so far this year. Coupled with concerns over the effect that the Omicron variant has had on economic activity as well as rising geopolitical tensions, the S&P 500 experienced its third consecutive weekly decline with tech shares and growth stocks being amongst the worst performing, which drove the NASDAQ and Russell 2000 down 13% and 11% YTD.
Why is this important?
With the fiscal stimulus measures of the past few years disappearing into the rear-view mirror as we head into a rising rates cycle and a quantitative tightening environment, the backdrop isn’t particularly reassuring. During periods of volatility, markets can swing wildly as investors reduce risk and reposition their portfolios in light of changing news flow. Making rational, informed decisions during periods of heightened uncertainty is not an easy task, and fear can dominate in the short-term. A more prudent approach is to build additional diversification levers, which can reduce volatility and drawdowns, smoothing the investment journey – an approach that we promote and implement.
What does the chart show?
The chart shows the Federal Reserve’s FOMC (Federal Open Market Committee) ‘dot plot’ – essentially each official’s expectations on where interest rates will be at future dates. Each dot represents an individual’s prediction as to what the federal funds rate will be at the end of each year until 2024 and then longer-term views. The median of all dots is then used as a basis to set the official rate forecast. Since its introduction, the Fed dot plot has become one of the most closely watched news releases among investors. The most recent projections from the FOMC meeting dated 15th December (so admittedly now a bit dated) indicated three rate rises before the end of 2022 and another three moves in 2023. Only two members were pointing to four rate rises this year. Looking at the median of the dots from December’s meeting against prior dot plots from September and June shows the shift to a more hawkish stance in response to inflation levels not seen in decades. It is noticeable that the dots show a wide range of predicted outcomes for the long-term, and even as soon as 2023, reflecting a great deal of uncertainty.
Why is this important?
A tightening labour market and inflation at multi-decade highs have pushed the Fed to adopt a more hawkish stance. Minutes from the December FOMC meeting showed officials voted to maintain the current target rate of 0% - 0.25%, but that members were on board with accelerating the tapering of the bond buying programme adopted at the onset of the pandemic. The pace of tapering will be increased from $15bn to $30bn per month beginning this month. This would result in the Fed ending its purchase program (quantitative easing) by March 2022 if there are no further changes, giving greater flexibility to raise interest rates. They have also now pointed towards quantitative tightening soon after commencing rate rises. Interestingly the market is now pricing in four rate rises through 2022, ahead of current Fed projections. You might often hear this referred to as the Fed being ‘behind the curve’. Importantly, with four rises now factored into market/government bond prices, if the Fed doesn’t see these through then positive capital returns could be made in government bonds. However, a faster and sharper move higher would almost certainly be negative.
What does the chart show?
The chart shows the US 10 year government yield (red line) and the share price performance of the MSCI World Financials Index relative to the MSCI World Index (blue line). An upward sloping blue line indicates the MSCI World Financials Index is outperforming the broader MSCI World Index, whereas a downward sloping line means it is underperforming. Since the beginning of the year, the performance of the MSCI World Financials Index has bettered the broader index. The yield on the benchmark 10-year Treasury bond has climbed for seven consecutive days to 1.77%, now above the highs of last year. Through time there has been a fairly tight relationship between the two. Higher yields have been positive for financial equities whilst lower yields are often associated with underperformance.
Why is this important?
Minutes from December’s US Federal Reserve meeting were released last week which pointed to the central bank potentially raising interest rates and shrinking their balance sheet faster than previously anticipated, in response to consumer prices rising to multi-decade highs and the labour market showing strong signs of recovery. This triggered a sell-off in US government bonds in anticipation of tighter policy from the Fed which coincided with a sharp increase in bond yields. We saw this feed through into the equity market. Higher bond yields have a greater negative impact on growth stocks than value names, as the interest rate used to discount their higher future earnings increases, meaning the present value of those earnings (in theory, the share price) decreases. This has hit tech stocks, whose valuations are better supported in a lower interest rate environment. Financial stocks, on the other hand, can benefit from increasing interest rates through higher net interest income (the difference between income earned and income paid out). Furthermore, banks have started to release loan loss provisions set aside earlier in the pandemic and more of this is expected which should be supportive for earnings. So far this year we have seen financials outperform the broader equity market by over 5%.
What does the chart show?
For our first chart of 2022, we thought we would reflect on the performance of a number of asset classes in 2021. The strongest performer which we chart here was global equities (blue line) boosted by loose monetary policy for most of the year, government stimulus packages and a recovery from the most severe lockdown restrictions. The MSCI World Index rallied 20% in 2021 in contrast to the MSCI Emerging Markets index which fell 5% over the same period, weighed down by tightened regulations in China which particularly targeted the education and tech sectors, along with default concerns within the country’s real estate market. What was more remarkable was the returns seen in certain commodity markets, including UK natural gas (+294%) and oil (+50%). Government bonds were more challenged as higher inflation and the prospect of tightening monetary policy saw yields continue to rise, ending the year with a -7% total return. Rising cases of Covid-19, stemming from the Omicron wave, and surging inflation threatened investor returns towards the end of the year. However, global equity markets pulled through the increased volatility and these developments failed to ruin the year’s rally.
Why is this important?
The year started on a high after last November’s vaccine success and it has largely been one way for risk assets since then. There was a handful of small drawdowns in global equity markets in 2021, but these proved short lived. Given obvious uncertainties around further mutations of Covid-19, how central banks will tackle surging inflation and geopolitical tensions in Europe and Asia, markets have looked through a lot of the ambiguity of late and whilst they have come a long way since the lows of 2020, there is still much disparity, and thus opportunity, within. 2021 was really a year to stay invested and not try and time the market. Anyone who sat on the sidelines waiting for a better entry point will likely be ruing that decision. Finally, last year proved that bonds are not risk free. They still have a role to play in more defensive portfolios, but investors should look to diversify their diversifiers as the classical ‘60/40’ portfolio will be challenged going forward.
What this chart shows
The US equity market looks set to top the charts again this year amongst the global developed equity markets, with the S&P 500 up 25.1% YTD, compared to returns of 9.7%, 11.6% and 1.3% from Europe, the UK and Japan, respectively (in USD terms). We thought it would be worth diving a little deeper into the world’s largest equity market, now flirting with a 70% weight in the global MSCI World index. The chart shows what we call the US equity value spread (blue line), measured by taking the average valuation, as measured by the price-to-book (P/B) ratio, within the cheapest quintile of companies relative to the average valuation of the entire universe. In other words, the blue line shows the valuation discount between the cheapest quintile and the entire universe average.
The green line shows the actual average P/B of the cheapest quintile, thus measuring the absolute valuation level. The P/B ratio is used to compare a company’s current market value to the book value of its equity (assets minus liabilities) and a lower P/B ratio can be indicative of an undervalued stock. There are two key takeaways from the chart. Firstly, the absolute valuation level of the cheapest quintile has increased materially and isn’t far off historic highs. However, despite this the value spread remains extreme, near a 65% discount, implying the universe average has been pushed higher by a cohort of very expensive stocks, which we know to be the technology giants, the key beneficiaries of the pandemic.
Why is this important?
These have been challenging times for value stocks, with a difficult post-GFC period compounded with the pandemic-induced sell-off and continued performance divergence between value and growth stocks. The value spread narrowed following ‘Vaccine Monday’ in November 2020 through Q1 this year but it did little to close the discount. The high absolute valuation of even the cheapest quintile today raises further questions around the valuation headwind for US equities; even beneath the household names the opportunity set looks less compelling today, notwithstanding the extreme value spread. We think the better opportunities lay outside the US, where absolute valuations are not as high and the value spread appears just as extreme.
We hope you have enjoyed receiving our weekly charts throughout this year and we look forward to continuing to deliver updates to you next year. For now, we wish you a safe and enjoyable festive period and best wishes into 2022. Might it be the year when value stocks stage a sustained recovery?
What does the chart show?
The chart shows the yield to maturity on Chinese high yield (sometimes referred to as “junk”) bonds over the last 5 years. High yield bonds are rated below investment grade bonds by credit rating agencies due to their higher perceived risk of default. They typically offer higher yields in order to compensate for the increase in credit (and sometimes liquidity) risk. In recent weeks, the yield on this broad index has moved north of 20% indicating the spiralling cost of borrowing for sub-investment grade rated Chinese companies. What began as a confidence crisis around the health of Chinese property developer Evergrande has reverberated to numerous other real estate firms that have either already defaulted or appear close to default. This of course has led to fears of broader market contagion.
Why is this important?
The market has suffered another wave of selling as the latest news on Evergrande suggests that the property developer is very close to default, with some investors claiming that they have not received bond payments after the end of a 30-day grace period on Monday (6th December). The sharp increase in yields (that coincides with a sharp decline in bond prices) shows how regulatory restrictions on borrowing and slowing home sales have pressured the real estate sector in China, which today accounts for approximately 55% of China’s high yield market but would have been higher in the past. Demonstrating the severity of the situation, on Monday the People’s Bank of China (PBOC) said it would reduce financial institutions’ reserve requirements by 0.5% which would free up 1.2tn yuan ($188bn) of liquidity for the banking system, in a move widely seen as intending to reassure investors if the troubled real estate developer collapses. However, there does seem to be an element of the ‘baby being thrown out with the bathwater’ with some less correlated and higher quality credits also impacted amidst a broad market selloff. You hear us say this a lot but it is another good example of the opportunity in active management, taking advantage of market mispricing to selectively identify attractive entry points for long term investments.