Market update: Exploring Extremes

Read the highlights:

• How has the first part of the year affected investors?

  It has been a difficult and unusual year so far in terms of portfolio performance, which was not entirely unexpected.

  To give an example, if we were to look at a traditional 60/40 US-based portfolio invested 60% in equities and 40% in bonds, data shows that this year you would be down more than 20%. That’s the worst performance we’ve seen since 1964.

• How have specific parts of the market fared?

  Let’s look at examples from a few specific parts of the market. If I take the US Long-Term Treasury Bond index, for example, there’s been the worst performance we’ve seen for long-term bonds in the US since 1973. This is not helped by the fact that the starting yield on bonds was already so low that there has been very little in the way of yield to compensate for the capital losses that have been suffered over this period.

  Similarly, in the equity market we’ve had a severe derating of indices this year, particularly of the S&P 500 in the US which was full of technology and growth stocks which have seen their multiples come down very quickly in recent months.

• How are bonds and equities performing?

  For the last 20 years we’ve been in a period where bonds and equities have been in a negative correlation phase. That has meant that when equities have been falling bonds have been going up, and vice versa. This has helped to reduce volatility in portfolios and to produce exceptionally good risk-adjusted returns over that period.

  However, at Investec we have cautioned for a while that if a higher inflation environment were to break out, we could see a return to a more positively-correlated environment. This would involve rising bond yields (falling bond prices) and falling equity prices. That is exactly what has happened in the first few months of this year.

• What about currencies?

  The focus on the sterling exchange versus the US dollar makes it look as though the pound is very weak, however that’s as much a function of the strong dollar as of the weak pound. The weakest currency this year among major currencies is the yen, which has fallen about 18% versus the dollar, as Japan has failed to raise interest rates when the rest of the world has been moving in that direction.

• Have we seen a ‘rate shock’?

  There’s been extraordinary movement in interest rate expectations this year. The market is currently saying that US rates will peak somewhere shy of 3.5% in about 18 months, then will begin to decline shortly afterwards, but between now and then we’ve still got some way to go in terms of further raises. It’s a similar picture in the UK. The market is forecasting that the peak of 2% should come in about two years, and then we should see reductions thereafter.

  The key factor driving rising interest is inflation. Even before Russia invaded Ukraine, inflation expectations were creeping up thanks to the pandemic and shortages in the gas market.

  Global inflation is now expected to reach 6.7% in 2022, having started the year around 4%. In 2023 and 2024 the forecasts come down, but certainly not back to previous levels. The concern in many quarters is that having been taken by surprise about how consistently high inflation has been, it may turn out to be somewhat stickier than we might hope.

• What has this meant for the bond markets?

  The US 10-year treasury yield (an important figure, because it is used as the discount rate for almost all global financial assets) has risen from 1.5% at the beginning of the year to over 3% now. This gives us a big repricing anchor to financial assets. It’s been of similar magnitude in the UK, where yields have moved from 1% at the start of the year to around 2.5% today.

  Although we’ve been in an extraordinary downtrend of bond yields for the last 40 years, there’s now a lot of conversation around whether we’re going through a long-term regime change in which bond yields will remain permanently at a somewhat higher level. A lot of that will depend on how central banks handle the inflation situation, and what the effect of huge global debts will be.

• What is the implication for the equity market?

  The other function of the rate shock has been what it’s done to the relative performance of growth stocks and value stocks, otherwise known as long-duration and short-duration stocks. At the beginning of the year there was a big gap in growth stocks relative to value stocks; this was driven initially by the release of the Federal Reserve Bank’s minutes for its December meeting, in which it betrayed the fact that it would potentially be accelerating the process of tightening monetary policy.

  After that, the movements between growth and value were relatively consistent until April when, following the invasion of Ukraine, it became clear that there was even more inflationary pressure in the system.

  Since the beginning of June, the markets are worrying as much about growth as anything else. The value stocks have sold off as much as growth stocks have and we’ve seen some quite large profit-taking in some of the more cyclical areas of the market such as mining stocks and oil and gas companies.

• How did the market get such a big rate shock so wrong?

  I believe this has a lot to do with dividend discounted cash flow models. If you’re valuing cash flows and earnings a long way into the future, the net present value of these companies is highly dependent on the discount rate you use. The discount rate is linked to a combination of the ten-year yield and the Equity Risk Premium, which has also gone up. This means the net present value has fallen dramatically.

• What could rising interest rates do to the housing market?

  The US mortgage market has seen extraordinary movement in the 30-year fixed rate, which has gone from just over 3% at the start of the year to 6% now. For a typical US mortgage based on median house price, this will add about $10,000 a year to a borrower’s interest bill.

  In the UK, meanwhile, we are seeing five-year fixed interest rates going up from 1.3% to about 2.4% and we expect that to start weighing on the housing market here in the UK too.

• What is the probability of a recession happening?

  Analysis from J.P. Morgan suggests that the S&P 500 in the US is pricing at an 85% probability of a recession, while the Euro Stoxx Index in Europe is pricing at an 80% probability of a recession. There’s no doubt we’re heading in a direction that may result in a recession, and the markets have recognised that to some degree, although it’s not fully priced in at this point.

• What is the outlook for earnings expectations?

  One thing that is holding up well is earnings expectations for markets.

  In 2020 we saw a big drop in earnings expectations due to the pandemic, followed by strong acceleration in 2021. In 2022 we’re currently tracking for around 10% earnings growth, but we have to ask how sustainable that is and whether companies are going to have to confess to the demand slowdown that we’re seeing in some areas and what effect that will have on margins. There is therefore a risk that over the summer we’ll see some reduction in earnings expectations for this year.

• Is there a risk of a liquidity shock?

  The final potential shock is liquidity. One measure of this is looking at US money supply using money of zero maturity, which effectively means all the money that can be made available very quickly to consumers, investors or the banking sector. And despite strong growth last year, there are now signs that some of the liquidity is coming out of the system.

  The other indicator is growth or shrinkage of central bank balance sheets. We’re at the point where lots of major central banks around the world are shrinking their balance sheets; the US Federal Reserve started its policy of quantitative tightening in the middle of June, but we have yet to see the effects of this liquidity being withdrawn from the market.

  As we’ve highlighted in the past, however, periods where the aggregate central bank global balance sheet starts to shrink can be a period of strong headwinds for financial assets.

• What is Investec doing during this period?

  In terms of tactical asset allocation decisions, in October we reduced risk and raised money for cash, putting more money into infrastructure which we feel is a good long-term asset because it has exposure to higher inflation, and also into absolute return and hedge funds, particularly those that benefit from higher volatility in markets.

  On the first big market fall in mid-March, we rebalanced in favour of equities but then, just a couple of weeks later, we reduced our risk budget again, taking money out of equities and putting more money into absolute return and a bit more into cash.

  Lastly, we have started tip-toeing into some of the risk areas, but actually the lowest-risk risk you can put into portfolios at this point which is investment grade credit, taking money out of cash which is still low yield and putting money into the bonds of very strong companies where we know the credit risk is exceptionally low.

  Right now, our tactical asset allocation will leave us underweight in fixed income, underweight in equities, overweight in alternatives, overweight in real estate and a little bit underweight in cash at the moment, but that’s because we’ve deployed a lot of it into the alternatives area.

  The other point I’d make is that balance portfolios, which is what most of our clients have, are much less volatile than what makes the headlines.

• What might the future hold?

  There are still plenty of things to negotiate going forward: the post-Covid reopening; geopolitical transformation including the balance of power between the US and China; the threat of people moving to bring supply chains back home; and the energy transition with strong demand for materials that make batteries and electric vehicles. These are all factors that might result in inflationary issues over the longer term.

• What is our overall conclusion?

  Our view is that inflation is set to remain higher than it was pre-pandemic, and this will lead to tighter monetary policy.

  Volatility will also remain elevated. One’s investment horizon does influence risk appetite on that basis, and the longer this horizon is the better. Equities remain the best long-term asset class to deliver the desired returns for investors, but with that possibly comes higher volatility. Investors need to consider different ways to diversify risk across portfolios, and for that reason we’ve made investments in alternative assets, for example. The key message, though, is that now is not the time to be selling.