Monthly Market Commentary – July 2022

There is no denying that the second quarter has been a particularly testing one for investors, with increasingly aggressive measures from central banks to combat stubbornly high inflation weighing on financial markets. Inflation metrics in the US and UK hit their highest levels since the early 1980s while the equivalent reading for the Eurozone surged to its highest level on record.

The Federal Reserve upped the ante with its monetary policy response, delivering its first 50bp rise in over 20 years at the start of May before following it up with a 75 basis point increase at the subsequent meeting in June, its largest hike since 1994. The Bank of England also increased rates at both its Q2 meetings, albeit at a slower rate of 25 basis point as rate-setters in London decided against a faster pace due to growing concerns surrounding a slowing economy.

While the European Central Bank (ECB) kept its benchmark rate at record lows it has become increasingly hawkish, strongly hinting that it too will begin to raise rates at its July meeting and announcing its huge bond-buying regime will end in the third quarter. The Bank’s Governing Council also convened for an emergency meeting in mid-June in response to growing concerns regarding the divergence of member states’ sovereign bonds.

Guidance from companies to analysts continues to be fairly positive

For equities the declines largely came in the form of derating as share prices declined even while earnings updates for the first quarter remained solid overall.  Guidance from companies to analysts continues to be fairly positive despite cost pressures and earnings estimates remaining marginally higher than at the start of the year.  That said, companies are expected to becomer more realistic in their guidance on future outcomes, especially in the run-up to Q3 results from the end of September.  Markets have discounted at least part of the anticipated bad news but remain still not “cheap” in a historical context, especialliy if earnings come in lower than current estimates.

After recovering from the initial geopolitical shock of Russia’s invasion of Ukraine, global stock markets have been back under pressure for much of the last three months and the MSCI All Country World Index slipped into bear market territory (in local currency terms), defined by a 20% drop from its previous peak. The declines have largely been orderly rather than driven by panic selling, with global shares falling for seven consecutive weeks during April and May. This decline was reduced to around 11% for sterling-based investors after taking into account US dollar strength.

US stocks endured a difficult quarter as selling intensified, with benchmarks posting their worst first six months of the year since 1970. Growth stocks were hit particularly hard as indices slipped into bear market territory after a decline of around 16% for the quarter. Signs that economic activity is slowing are becoming more frequent and clearer as consumer confidence readings, purchasing managers indices’ (PMIs) and housing data all softened. Despite this, the Federal Reserve remains committed to aggressively tightening monetary policy and are widely expected to deliver another 75 basis point hike in July.

The Federal Reserve appears set to maintain this stance until there has been a clear decline in the pace of inflation. US consumer price growth accelerated in May as the annual inflation rate rose to 8.6%, the highest level since December 1981. Although this is a new peak for the cycle, it is only 0.1% higher than the March reading and with commodity markets pulling back from their recent highs there are signs that rising price pressures could be topping out. However, for the Federal Reserve to expedite the process of easing off on aggressive hikes they will likely need to see a substantial decline in these readings. To put the current position of the hiking cycle in an appropriate context, despite cumulative hikes of 125 basis points in the last quarter, rate-setters expect the fed funds rate of 1.75% to rise well above 3% by year-end.

In light of this, it is not too surprising that government bond yields rose significantly during the second quarter. The US 10-year Treasury yield jumped from around 2.34% to a peak of 3.50%, its highest level since 2011, before pulling back to around 3.01%.

UK shares fared better than their US and European counterparts in the quarter, although unlike in the first quarter when they posted a positive return, they fell into negative territory to end the quarter down by a little over 4%. The outperformance was largely due to the benchmark’s composition and a greater weighting to energy and mining stocks, which were boosted by rising commodity prices. It has been a volatile few months for the oil price with international benchmark Brent crude spending most the quarter significantly higher, although a sell-off at the end of June meant a three month change of only around 4%. Russian sanctions due to the war in Ukraine and the threat of further supply disruption are attracting buyers into the market, although growing fears of a forthcoming growth slowdown are checking enthusiasm from the demand side.

A sizable sterling depreciation also helped the benchmark as a significant proportion of component companies earn the majority of their revenues in non-sterling terms. Since the end of March, sterling has fallen by around 8% against the US dollar to trade in the low $1.20s, predominately due to US dollar strength, as can be seen by the comparable decline in the Euro to US dollar rate. This has cushioned the losses in US stocks to some extent, for UK- and European-based investors.

UK government bonds have also come under pressure, as the Bank of England continues to raise interest rates despite signs of a stalling economy. The 10-year gilt yield has risen sharply, rallying around 100 basis points on the quarter to a high of 2.74%, before pulling back a little to trade around 2.26%. As in the US, the latest UK inflation data has made a new peak for the cycle with the consumer price index hitting 9.1% in May and the Bank of England expects inflation to reach 11% in the second half of the year, when the energy price cap is lifted in October. Further interest rate hikes are expected with the Bank of England’s base rate forecast to rise to around 2.8% by year-end, up from the current 1.25%.

A notable drop in June means European stock benchmarks are nursing larger losses than the UK equivalent, although they are holding up better than their US peers. Core government bond yields have risen sharply, on the expectation that the ECB will soon begin raising rates from record lows of -0.5%. The German 10-year bund yield has rallied around 100 basis points in the last quarter, peaking close to 2.0% before settling near 1.37%.

Despite the emergency nature of the latest ECB meeting no action was taken, although a statement indicated a willingness to undertake measures relating to the reinvestment of the proceeds from maturing debt in a bid to contain rising bond yields of the more heavily indebted member states. The Governing Council strongly hinted at a greater inclination to reinvest proceeds from peripheral higher-yielding countries, such as Italy, rather than the likes of Germany. The ECB is also seeking to develop a new policy tool to alleviate what it calls the “fragmentation” in borrowing costs.

While inflation may be close to a peak in some regions, growth is expected to slow as central banks persist in raising rates, meaning a likely continuation of volatile markets. Providing inflation begins to subside as anticipated, bond yields could be closer to their turning point than equities – although this will still likely need some central bank signal to mark the turning point. Overall, we remain cautious for long-term investors. During an investment cycle there will always be fluctuations in share prices and perfecting short-term exit and entry points has historically been problematic, with no single metric showing a successful track record in flagging these turning points.