Investment market update: September 2022

27/04/2024

High levels of inflation and concerns economies will experience recessions later this year continue to affect investment markets.

Last week has been dominated by the mini-budget backlash as investors baulked at the Chancellor’s plans to cut taxes and increase borrowing, sending sterling spiraling and gilt yields rocketing.

A lot of the features in Kwasi Kwarteng’s mini-budget were known in advance, but there were some additional tax cuts and limited guidance on how they would be funded. The government has been caught off guard by the scale of the reaction, with the IMF stepping in to roundly criticise the approach which it warned could add fuel to the inflationary fire and heighten inequality. With investors hitting the panic button and parts of the pension market coming under systemic pressures as gilt prices plunged, the Bank of England announced it would recommence purchasing gilts (despite previous plans to shrink its balance sheet) to help drop the pressure and restore a degree of stability.

The government is focusing on economic growth at a time when the Bank of England is trying to slow the economy down – predominantly through interest rate increases. The Bank recognises that the economy is operating at full capacity and if it accelerates from here, it will generate more inflation rather than improve living standards. As a result, the Bank of England and the Treasury risk pulling in opposite directions with monetary tightening and fiscal easing making for uneasy bedfellows.

Because the economy is operating at full capacity, the government is unlikely to achieve its 2.5% growth target particularly soon – and that means less tax revenue at a time when the government is already borrowing at heightened levels. This is exacerbated by the fact that the tax cuts were targeted at the highest income cohort, which is the group that is least likely to spend them. For Sir Keir Starmer and Shadow Chancellor, Rachel Reeves, this was low hanging political fruit and they struck a buoyant tone at their annual conference this week – no wonder with the polls opening up in Labour’s favour at levels not seen since Tony Blair’s 2001 landslide.

Another reason why markets reacted so poorly is that the government’s borrowing costs are likely to increase.  The government will be borrowing more money next week at what could be a higher interest rate. Over the coming years, the sheer volume of new borrowing and the higher rate of interest on those loans could push yields up further still. Borrowing in a way which the markets believe won’t generate much growth and which will need to be offset by higher interest rates is why the markets are so rattled.

Sharp falls in the pound have led to expectations of more aggressive interest rate hikes, which if they come to fruition would lead to higher costs for mortgage holders. We have seen many mortgage lenders withdrawing loans and while this will only be temporary, they need the market to stabilise so that they know what rate to offer loans at.

Declines in the pound, which fell to all-time lows against the dollar last Tuesday, mean that the goods we buy that come from abroad (most notably oil) will become more expensive. At a time when inflation is the greatest concern to most households, a plunge in the pound makes it worse. The pound has rallied back to $1.12 but markets will want further reassurances from the Chancellor and Liz Truss who met with the Office of Budget Responsibility at the tail end of last week to present their debt cutting plans in a bid to quell investor concerns.

The turmoil in Britain had a ripple effect across global markets, pushing Italian and German bond yields sharply higher. US bond yields also rose, and stocks pushed lower still with the S&P 500 hitting its lowest level since November 2020. Tech once again was the whipping boy for market sentiment after analysts downgraded Apple as iPhone 14 demand looks set to soften.

In Ukraine, Vladimir Putin’s sham referendums have unsurprisingly yielded the intended outcome and the Russian president and on Friday past the Russians held a ceremony to annex four eastern regions of Ukraine in the face of condemnation and derision from Western leaders. New sanctions from the US will follow and Joe Biden has said America will “never, never, never” recognise Russia’s claim to the annexed regions. Concerningly Sweden and Denmark have this week identified numerous leaks in the Nord Stream 1 and 2 pipelines with seismologists reporting underwater blasts before the leaks appeared and NATO pointing to sabotage, an accusation Moscow branded “predictable and stupid”.

Markets in a Minute

• The FTSE 100 fell 1.33% over the week.
• The 10 year gilt yield jumped around 1% after the mini-budget to 4.5% on Tuesday before falling back to 4.03% at the time of writing.
• Next (-9.2%) revised guidance lower after weak August trading and the cost of living crisis hit consumer confidence.
• Apple (-5.7%) announced it would move iPhone 14 manufacturing to India as it seeks to diversify supply chains away from China.
• Housebuilders were hit by the mortgage market turbulence with Barratt (-14.8%) and Taylor Wimpey (-12.7%) led the FTSE 100 lower, as did property search platform, Rightmove (-15.1%).
• Nike felt the impact of the strong dollar, rising transport costs and higher markdowns with shares down 9% in after-hours trading.

While the stock market is experiencing volatility, remember to focus on your long-term goals. Guarantees cannot be made, but, historically, markets have bounced back from downturns and delivered returns when you look at the bigger picture.

United Kingdom

The UK economic downturn is already underway. GDP growth was negative in Q2 and it’s likely that the economy contracted again in Q3. Inflation hit 9.9% in August and the Bank of England’s strict 2% inflation target means more rate hikes are on the way despite the slowing economy.

The upcoming fiscal support package from the new prime minister, Liz Truss, could be as large as 8% of GDP. It will be a combination of energy price caps and a reversal of the tax hikes implemented by the former chancellor, Rishi Sunak.

The unemployment rate at 3.6% is the lowest since 1973 and this is providing support to household incomes ahead of the wintertime energy price surge. The Truss stimulus, however, creates the risk of further BOE tightening. The UK’s recession may not be deep, but the recovery could be disappointingly sluggish.

United States

Inflation remains the dominant macroeconomic issue for US markets. Inflation dynamics were mixed over the quarter. Encouragingly, retail gasoline prices fell by more than 20% from mid-June, supply chains are tentatively healing, and some of the most volatile drivers of US inflation, such as durable goods prices, are moderating.

The labour market, however, is still red-hot with two available job openings for every unemployed worker. High-quality measures of wage inflation were running at a blistering 7% clip through August. Wages are a sticky driver of inflation and put pressure on the Fed to move decisively into a restrictive monetary policy setting. Lowering inflation requires the Fed to engineer an economic slowdown through higher rates and/or lower asset prices. It’s an unfavourable macro backdrop for investors. The good news is that these concerns are, at least partially, already reflected in the markets. The S&P 500 is down 17% on the year to Sept. 14. Industry consensus earnings estimates for 2022 and 2023 are in a downgrade cycle – even if we think they have further to fall. US 10-year Treasury yields have risen almost 200 basis points this year and at 3.4% offer a decent yield (in excess of expected inflation and our estimate of fair value). We are not bullish on the economic outlook, particularly given the heightened uncertainty around the path forward, but with a degree of pessimism already in the price, we believe that maintaining overall positioning near strategic targets is warranted.

Eurozone

The region has a challenging winter ahead. High energy costs are expected to depress consumer spending and industrial production. Persistently high inflation should see the European Central Bank (ECB) continue to tighten monetary policy. The Russia-Ukraine war is no closer to being resolved and Italian political uncertainty continues to place upward pressure on Italian bond yields.

Nearly €400 billion in government support measures have been announced in response to the energy crisis, and more packages seem likely. The European Union (EU) has announced a plan for 10% in energy saving and an EU-wide price cap that will be at least partly funded by a windfall tax on energy producers.

Measures of industrial production are beginning to decline in response to energy prices, and it’s difficult to see the region avoiding at least a mild recession. The severity of this year’s winter will be important since a colder than usual season will generate a deeper recession.

European growth, however, should rebound in the spring. Inflation should be on a downward trend, and this should limit the amount of ECB tightening.

Japan

Japan is unique among the major advanced economies with its benign inflation backdrop and accommodative monetary policy stance. The yen has been a casualty of that policy divergence, depreciating nearly 20% against the US dollar in the year to mid-September.

Some investors are now challenging the Bank of Japan’s commitment to policy accommodation. However, we believe the Bank of Japan will maintain its yield-curve control for now. Importantly, most measures of underlying inflation are still running well below the Bank of Japan’s 2% target, the yen’s boost to import prices is likely to be a transitory phenomenon, and wage growth remains tepid. It would take a significant change in domestic demand for a policy pivot to occur before Governor Kuroda’s term expires in April 2023..

China

The Chinese economy has weakened significantly in 2022 on the back of rolling COVID-19 lockdowns and the property sector slump. While policymakers have started to stimulate the economy with rate cuts and infrastructure spending, these measures have thus far proven inadequate to reinvigorate growth.

We expect China to grow at a meager 2-3% pace in 2022 with the potential for these risks to bleed into 2023 as a slowing developed market consumer may also begin to weigh on the tradeable goods sector. The Politburo meeting in late October will be an important watch point for investors. Expectations are that President Xi Jinping will consolidate power for a third five-year term. From a macroeconomic perspective, any plans to relax COVID-19 restrictions or to relax the focus on high quality growth in favour of shorter-term performance will be closely scrutinised. Given elevated economic and policy uncertainty in China, our exposures have primarily been targeting the market as an alpha opportunity, with our underlying active managers looking to add value by differentiating winners and losers at the security level.