“At today’s meeting the Committee raised the target range for the federal funds rate by 0.75%, bringing the target range to 3 to 3.25%. With today’s action, we have raised interest rates by 3% this year. The median projection for the appropriate level of the federal funds rate is 4.4% at the end of this year, 1% higher than projected in June. The median projection rises to 4.6% at the end of next year and declines to 2.9% by the end of 2025.” excerpts from Federal Reserve Jerome Powell’s statement on the 21^st September.

LAST QUARTER REVIEW

In September, the Federal Reserve (Fed) raised the federal funds rate by 0.75% to the 3%-3.25% range, the third consecutive 0.75% increase, pushing borrowing costs to the highest since 2008 and, as quoted above, promising further increases to come as the American central bank tries to curb persistently high inflationary data. The Fed also revised GDP growth forecasts lower suggesting a 0.2% expansion this year, while inflation, as measured by the PCE (personal consumption expenditure) index, is seen to reach 5.4% in 2022 and 2.8% in 2023. The unemployment rate has also been revised slightly higher to 3.8% this year and 4.4% next year

To use a sporting analogy, last quarter proved a period of two distinct halves for US equities as bargain hunters drove the benchmark S&P 500 up almost 17% from its 2022 (previous) closing low of 3666.77 on the 16^th June to 4283.74 on the 18^th August. By the end of the quarter however, the expectation by some analysts that the bear market might be over, quickly gave way to the recognition that it had simply been a bear market rally (or “dead cat bounce”) as the index ended the quarter down more than 16% from its mid quarter high at just 3585.62. A similar story was reflected in the Dow Jones Industrials and Nasdaq 100 indices.

Perhaps more worryingly, as the Fed desperately tried to get back in front of the interest rate curve, US Treasury (UST) bond yields continued to climb relentlessly higher along the whole interest rate curve. The benchmark 10-year UST note yield broke through the psychological 4% mark briefly for the first time since April 2010 as expectations of continuing increases in base rates for the foreseeable future dented the appetite of investment in government debt.

On the back of the Fed’s aggressive monetary policy, the US dollar, continued to strengthen as the DXY index hit 115.5 on September 28th for the first time since May 2002. Conversely, sterling ($1.0345) traded at its lowest in history before rallying to $1.1145, while the euro ($0.96185) plumbed its lowest level since 2002 against the greenback.

In the UK bond market, the sell off accelerated, as the yield on the benchmark 10-year gilt rose from 2.25% to 4.504%, before rallying to 4.092% as the Bank of England (BOE) raised interest rates (for the seventh consecutive time) by 0.50% to 2.25%, pushing borrowing costs to their highest since 2008 in an attempt to control inflation now running at almost 10%, the highest level in forty years. The BOE was forced to restart its quantitative easing programme through purchasing long dated gilts to avoid a crisis in the debt markets and a meltdown in the UK pensions sector.

The BOE’s crisis response was necessitated by the bond, currency and equity markets’ reaction to the controversial move by UK Chancellor Kwasi Kwarteng in unveiling the biggest tax cutting moves in 50 years in the government’s mini budget on September 23^rd. Designed to stimulate the economy, the “Government Growth Plan” (which is unfunded) included costly reductions in income tax, national insurance and stamp duty.

The European Central Bank (ECB) raised interest rates 0.75% at its September meeting, following the 0.50% July rate hike. The main refinancing rate is now at 1.25%, and the ECB warned interest rates should rise further over the next several meetings to try and curb inflation, anticipated to average 8.1% in 2022, 5.5% in 2023 and 2.3% in 2024, while GDP growth was revised lower to 3.1% in 2022, 0.9% in 2023 and 1.9% in 2024.

There was little change in China as the People’s Bank of China (PBOC) kept steady its key rates at the September fixing with the one-year loan prime rate (LPR) unchanged at 3.65%; while the five-year rate, a reference for mortgages, was maintained at 4.3%. In August, the PBOC had cut key interest rates following a new wave of COVID-19 and a lingering property downturn which has seen the yuan decline against the dollar from 6.68 to 7.13 and economic growth slow dramatically.

At its September meeting, the Bank of Japan (BOJ) maintained its key short-term interest rate at -0.1% and for 10-year bond yields around 0%, advising that it expected its economy to be under continued pressure from high commodity prices as a consequence of the prolonged war in Ukraine. Meanwhile inflation had increased to 3.0% in August 2022, the highest level since September 2014, on the back of rising prices of food and raw materials as well as currency weakness, which has seen the Yen decline sharply against the dollar over the quarter from around 135 to 144, heading back towards its lowest levels in 24 years.

Global oil prices, on the back of the strengthening dollar and aggressive monetary policies from central banks, fell dramatically during the quarter with West Texas Intermediate (WTI) ($80) and Brent Crude ($88) futures prices per barrel both down almost 25% since the end of June to their lowest since early January. Investors meanwhile continue to monitor supplies, as a potential EU ban on Russian crude could be on the horizon, along with speculation that OPEC may intervene further in markets.

European energy supplies have been a major concern for markets as the winter approaches, but those concerns now look more manageable as front-month Dutch gas futures fell to €186 per megawatt hour, after having been as high as €340 in late August, as abundant supplies of Liquid Natural Gas (LNG), particularly from the US, have helped fill EU storage sites. Nevertheless, European natural gas prices are about six times higher than average for the time of year as persistent concerns about tightening supplies were exacerbated in late September by three explosions that struck the Nord Stream 1 and 2 pipelines resulting in what may be irreparable damage to the pipelines running through the Baltic Sea from Russia into Germany.

GDP Data shown are to the 30th June 2022; Interest Rate, Equity & Bond Index Data are to the 30^th September 2022; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzhen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.

CURRENT CONSIDERATIONS

Global equity, bond and currency markets remain driven by inflation expectations and the declared intentions of western world central banks to continue raising interest rates until they are convinced that the threat of persistently high future inflation is past. Additionally, the Ukrainian conflict shows little sign of ending any time soon, suggesting that the potential pressure on energy and some food (wheat for example) supplies and their prices may continue to trouble markets.

The silver lining to the monetary cloud imposed by the central banks is that, for now at least, the price of oil has declined dramatically. Notwithstanding this however, the cost of heating and energy to businesses and homes in the UK and Europe remains at extraordinarily high levels which with winter approaching is adding to market gloom.

From a UK investor’s perspective, an additional silver lining is that investments in both dedicated US and global funds (which are usually heavily invested in Wall Street stocks) will have benefitted from the strength of the greenback against the pound, thereby negating a large part of the market loss in these investments. As an example an investment in S&P 500 index by a British investor would have fallen almost 25% in dollar terms but when allowing for the currency exchange is only down around 7%!

Additionally, while investments held in UK medium and smaller companies have fallen in line with most stock markets during 2022, the proliferation of resource, energy and commodity companies listed in London means the FTSE 100 large cap index has fallen less than 7% year to date. British investors with portfolios heavily weighted towards London and New York stocks have accordingly fared much better than most.

Of course that is not to suggest that this pattern will necessarily continue, as evidence that both the US and the UK economies are probably already in the early stages of recession is revealed and digested by the market. Almost certainly as flagged by the inversion of the US Treasury yield curve which we focused on last quarter and which has since become progressively more pronounced (with the inversion now all the way from the benchmark 10 year note to the 6-month bill), both the American and global economies look set to experience a contraction in growth.

As we have highlighted in this year’s previous market views, the US Treasury bond market has proved incredibly reliable when it comes to forecasting recessions as evidenced by every recession since 1957 being preceded by a yield curve inversion. Research by the St Louis Fed showed that the lag between the inversion and a recession varies with the lag for the 10-year and 1-year yields ranging between 8 and 19 months, with an average of about 13 months.

The yield on the UST 10 year note relative to the 1-year bill has been inverted since the 12^th July and therefore a recession in the US economy is almost certain sometime in 2023. Of course the good news for investors is that the equity market (while not being historically as accurate a predictor as the bond market), is also a forward-looking discounting market, and entered a bear market (i.e. having fallen 20% or more) in June this year, thereby also signalling the coming recession next year.

As ever in these scenarios the key question is how long will the recession last and, more importantly for markets, how soon will Wall Street be ready to signal the end of the contraction and commence a new bull market?  In this context, research provided earlier this year by BNY Mellon Investment Management and Bloomberg that looked at bear markets on Wall Street (using data for the S&P 500 index) over the past century makes for reassuring reading. 

There have been a total of fourteen bear markets prior to this one in the last century, with the one that commenced in September 1937 (the second part of the Great Depression) having the longest duration at just over five years while declining from peak to trough by 60%, and lasting more than twice as long as next longest, namely the dot-com tech bear at the turn of this century (2.5 years with a total decline 49.1%), while the shortest in history occurred in March 2020 (just over a month with a total decline 33.9%). The average duration of the combined 14 bears of just one and a half years is somewhat reassuring as is the average decline from peak to trough of 39.4%.

When we consider that since closing at 4791.06 (a record high) on the 3^rd January this year, the S&P 500 has since fallen almost 25%, we may not have too much further to fall before Wall Street begins discounting the end of the forthcoming recession. More interesting and, potentially reassuring, from the BNY Mellon / Bloomberg research is that twelve months after the official bear market had begun (or fallen 20% from the previous high), the average return from the fourteen data sets was +14%, with just four instances where the return was negative.

The average total cumulative return 24 months after the commencement of the bear markets from the 14 market data sets analysed was +24.3% (again with 4 negative periods), and 36 months later +31.3% (with three negative instances). Perhaps appropriately, we recall Mark Twain’s famous observation, “History seldom repeats, but it does rhyme”.

FORWARD OUTLOOK

Looking at the research, some have understandably suggested that the bear market most analogous to where we are today was in 1980 when Fed Governor Paul Volcker began his legendary aggressive monetary policy to tame inflation. Wall Street investors back then (as in 2022) initially reacted badly to the monetary medicine but after a decline of just over 27% lasting around 18 months, the longest bull market in history subsequently commenced in 1982 (with the S&P 500 + 38% a year after the bear market had commenced). If Jay Powell proves a worthy successor to Volcker, we could eventually see a similar outcome develop this time around.

However, with several market analysts and commentators suggesting that, due to deteriorating corporate earnings for Wall Street stocks, a final leg down could take the S&P 500 to around 3000 (end September 3586), and the Nasdaq to 8000 (10,576) we shall most certainly be recommending keeping our powder dry while selectively continuing to de-risk portfolios as we have been during the summer months. Accordingly, for now we believe caution and risk aversion remain the watchwords whilst being encouraged by some data that suggests we may be getting closer to the time when we might embrace opportunity once again.

In the meantime, portfolios have benefitted from a reallocation away from small and medium cap funds into UK large cap focused funds which have proved to be more resilient due to their dollar earning commodity and resources company exposure. UK stocks also have the advantage of typically offering higher dividends (FTSE 100 yields 3.66%) relative to overseas stocks, while continuing to offer more attractive valuations than on Wall Street and most other stock markets.

UK medium and smaller company sectors have suffered similar declines to other global indices in 2022 with the FTSE 250, FTSE Small Cap and FTSE AIM All-Share down 27%, 21% and 36% respectively year to date, but we perceive attractive potential value in these areas once Wall Street investors have signalled a new bull market looks set to commence. Part of the attraction of these smaller companies lies in the dividends payable with the FTSE 250 currently yielding 2.92% and even the FTSE AIM All-Share yielding 1.37%.

We shall keep a close eye on developments and, in particular, any changes in investor sentiment with respect to both inflation and the strength of the dollar in order to determine when may be an opportune moment to look again to growth, rather than the more defensive positions currently adopted. We continue to view equities as providing the most attractive opportunities on a relative valuation basis (risk reward, yield and liquidity) when compared to investment grade government and corporate bonds, property and alternatives.

In uncertain markets like these, maintaining a well-diversified and balanced portfolio is fundamental. Where appropriate, we will continue to look to decrease allocation to growth funds (with the exception of energy and resources companies in the commodity sector where we expect the outlook to remain positive) and reallocate to more defensive oriented funds aligned to value and income.

Additionally, while returns so far this year have been extremely disappointing, we remain comfortable in continuing to include some exposure to Fixed Interest funds investing in a combination of blue-chip government debt (primarily US Treasuries and UK gilts) and investment grade corporate debt. We envisage that just as with equities, this asset class should offer attractive returns once the Fed has inflation under control and both shorter- and longer-term yields in UST’s begin declining again.

As always, investment risk is at the forefront of our advice and, whilst it is often necessary to undertake adjustments in portfolio allocation to maintain individual preferences, we are confident that our advised portfolios remain well placed in meeting our clients’ needs.

Copyright © Ash-Ridge Asset Management 1^st October, 2022.

Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; Hoisington Investment Management; Macro Voices; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.