It has been a turbulent time for investment portfolios, dominated by the impact of actual and expected interest rate rises as central banks continue to fight inflation. Equity markets dipped in June, but generally rallied as the quarterly results season progressed. By August, the S&P 500 was 17% up from the June low. However, the optimism was short lived as central banks on both sides of the Atlantic made it clear they were prepared to raise rates aggressively to counter the surge in inflation. Equity markets fell back and by the end of the quarter the S&P 500 reached a new low for the year.
The US Federal Reserve (Fed) has now raised interest rates by 3% over the last six months and is expected to make further tightening moves at the remaining meetings this year. They are also reducing their balance sheet, reversing the quantitative easing put in place during the pandemic. The pace of tightening elsewhere has been more modest. The Bank of England (BoE), who moved earlier than the Fed, has only raised rates by 2.15% since its first move in December last year. The European Central Bank has been slower to act, and only started to raise rates in July by 0.5%, accelerating the tightening further in August with a 0.75% move. In the Far East, Japan has stubbornly held back from rate rises and China, with a continuation of lockdown policies, has moved to ease rather than tighten. The increased interest differential between the US and the rest of the world, combined with the economic woes in Europe and the war in Ukraine, has seen the dollar strengthen against most other currencies.
In the UK, newly appointed Prime Minister, Liz Truss, and her Chancellor, Kwasi Kwarteng, delivered a ‘mini budget’ in an effort to boost the economy. However, this was seen as boosting inflation at a time when the BoE is raising rates to fight inflation. Borrowing to cut taxes was not favourably received by markets and triggered a sharp sell-off in both sterling and gilts. Pension funds have been encouraged since 1997 to hedge their liabilities using fixed income strategies. In recent years, pension funds have taken leveraged exposure to fixed income to match the interest rate risk. As interest rates rose, there were collateral calls on pension funds and the sell-off became exaggerated. As the bond price falls became precipitous, the BoE had to step in to support the market by buying gilts. This provided some stability and some of the losses were reversed. Read more about this in 'Why do "risk free" investments go wrong?'
The war in Ukraine continues and, with Ukraine taking back territory, Putin is getting more aggressive by further reducing supplies of gas to Europe. Many countries in Europe have been building gas reserves for the winter and regulating to cut demand, however, it still looks as if this winter could be particularly difficult. As fears of a global recession grow, the oil price has been declining which may ease some inflationary fears. However, historic price rises are still feeding through, and in the Eurozone inflation has topped 10%. The cost-of-living crisis is leading to higher wage demands which if met will continue to push prices higher.
Overall, it has been a difficult quarter for both equities and bonds. The markets have priced in considerable further tightening and a challenging economic backdrop. Curiously as we enter the final quarter, weaker economic data may be taken positively by both bond and equity markets, as this could see less monetary tightening than the market fears. We will have to watch wage settlements closely, but with the oil price down by over 30% from the high earlier this year, some of the inflationary pressures may ease as we move into the new year.
Reassuringly, government bond yields have already priced in considerable further tightening and corporate spreads now reflect the heightened credit risk. As ever, we recommend a selective approach to equity markets, favouring companies which have strong pricing power and robust balance sheets. Our investment process seeks to capture companies with resilient business models, that are well-placed to generate returns over the long-term. This does not mean the portfolios will not participate in market declines, but we remain of the view that our investment philosophy and the holdings in our portfolios will recover.
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