With special guest & industry expert Lothar Mentel, CEO of Tatton Investment Management
Through the winter months, equity markets remained generally stable, with Europe and China peaking early on. North American equity markets continued the uptrend into January. Meanwhile, bonds saw a generally benign environment. However, global growth indicators began to slip, with China’s continued regulatory pressure on property and tech companies, and with COVID issues in Hong Kong.
The rumour and subsequent confirmation of war in Ukraine added substantially to the upward pressure on energy and commodity prices. Meanwhile, the renewed spread of COVID through mainland China meant the balance between growth and inflation continued to deteriorate.
Supply chain pressure within the global economy is still impacted by ongoing Covid lockdowns in China, as most economies continue to relax restrictions.
Global equity markets peaked at the beginning of the year. A tightening of fiscal policy from governments and monetary policy from Central Banks, in combination with cooling economic momentum, started to impact equity markets. Typically, at the beginning of a tightening cycle, equities go through a volatile phase, but ultimately, as the cycle continues positive returns prevail.
For the past five weeks, the asset markets have been displaying greater volatility, and created challenging conditions to investors and investment managers alike.
The concerted raising of interest rates by nine major Central Banks and in particular the rate rises in the US and UK were expected (mostly) and yet after a positive response fell to back to familiar volatility. Equities did manage a sharp rally and then gave up those gains, and appear to currently be able only to hold support levels within recent trading ranges. Central banks will need to be sure of a peak and rapid decline in inflationary pressures to soften their monetary policy. Much of this pressure comes from factors beyond the reach of normal policy levers.
At the heart of broad asset market volatility is the fall in the bond markets. Usually, if equities are facing a risk-off period, bond yields tend to dip, meaning their prices head higher. However, the rise in inflation has up-ended usual equity-bond relationship. This time the rise in yields is driving equity markets lower. Central Banks are seeking to prevent asset markets from destabilising the real economy. To that end, they are trying to adjust domestic demand in line with reduced output levels from China and Russia and have little idea of when those constraints will ease.
As the Governor of the Bank of England Andrew Bailey said, labour markets continue to remain tight in the UK and US (although for different reasons.) This is only adding to supply-side problems. For both the US and UK, the uncomfortable truth is that consumer confidence has to be influenced to persuade households to stop spending as much. History and precedent suggests that also we need companies to cut their costs. The Bank of England doesn’t anticipate that happening before energy price rises due in October this year– their forecast is for UK household energy bills to rise another 40% at that point.
Ultimately, it is businesses that are being squeezed by the policy actions. They are more interest-rate sensitive than households. That squeeze is coming from policy rates rising which causes government bond yields to rise, and also from credit spreads rising. The Bank of England forecast for UK GDP to contract by 0.25% in 2023 implies a sharp rise in corporate distress and default.
There are few obvious catalysts for markets to rally. China, the heavyweight in EM equities in recent years has implemented ideological crackdowns on several significant sectors, such as technology, education and property developers. Policy to offset these decisions has been limited, although there are some signs that authorities may change tune – such as with a weaker currency to promote exports. However, more recently the zero Covid policy has led to another round of regional lockdowns. Chinese equities have notably adjusted lower running counter to other EM regions, such as Latin America, that have performed well supported by higher commodity prices. All in all, EM trades at reasonable low valuations, and we have adopted a patient outlook for this sector.
The war in Ukraine has impacted European equities through its geographic proximity and energy reliance on Russian fossil fuels, meaning that, geopolitical risks from the war are concentrated in Europe. However, despite relative equity valuations compared to the US are already at attractive levels, the situation in Europe can still deteriorate, without impacting the wider global economy to the same extent.
Returning to the Bank of England, it has had communication difficulties for years now. Even though yesterday’s messages were tough, they should be congratulated for their honesty and clarity, demonstrating that financial conditions are set to stay tight. Declared policy will be set to keep a lid on demand in the economy, and to potentially lower it. Against this background, despite moving to cheaper levels in absolute terms, relative valuations in equities are not strong enough to lead returns and Tatton is adapting to this pressured environment with our tactical portfolio allocations.
In this current investment environment, with volatility high in all markets, there is a deep incentive to remain on the sidelines but institutional investors can’t stay there forever. It would be better if markets stabilised and began a steady climb back up but we could get sharp bear-squeezes as well.
Risk premia have generally risen to more attractive levels now. It is possible that there is a further resetting to cheaper equity markets. However, we expect that risks will dissipate in the medium-term making equities more attractive than they presently look. As long term investors we are patient and meeting the challenge from capital markets head on, but volatility sometimes takes time to settle and the direction of the cycle to become clear.
This material has been written by Tatton Investment Management and is for information purposes only and must not be considered as financial advice. We always recommend that investors seek financial advice before making any financial decisions. The value of investments can go down as well as up, and investors may get back less than originally invested.
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