June 2022
What we think the next six months will look like from a global investment perspective
Welcome to our latest market update
This month, we’re taking a look at what we think the next six months will look like from a global investment perspective. We’re grateful to our friends at James Hambro & Partners of their input into this.
As always, we hope you find our updates both useful and insightful. Should you have any questions or wish to discuss anything in more detail then please just get in touch.
The background
The first quarter of the year was clearly a challenging period for investors and there has been no let up for stock markets in the second quarter, with financial conditions remaining somewhat unsettled through the months of April and May. The immediate causes were familiar with still-rising inflation expectations and increasingly forceful central bank commentary on interest rates driving up bond yields and pushing down equity valuations.
The market weakness that persisted in May has taken a slightly different emphasis, with recent moves suggesting that recessionary fears are overtaking inflation as investors’ most pressing concern. In the US, with unemployment at near record lows and an economy still growing, the Federal Reserve has made it clear that reducing inflation is their top priority and that they are willing to tolerate a degree of economic pain to do so.
Elsewhere in the US, disappointing results recently from US consumer bellwethers Walmart and Target have added to worries that surging fuel, food, and housing costs will force lower spending elsewhere, leading to a weakening of economic growth through the rest of this year. The strong position of the US consumer was a major plank in more optimistic outlooks at the start of 2022, so signs of cracks here were punished.
Globally, nearly all asset classes, geographical regions, and sectors are down significantly since the start of the year, and with this causing a headache for investors it poses the question, where do we go from here?
We see three broad scenarios for the next six months
The immediate investment environment will remain challenging. Markets must grapple with the implications for growth of the complex interplay of inflation, interest rates and geopolitics, while the effects of the pandemic continue to reverberate. Meanwhile the Federal Reserve’s move to shrink its balance sheet will likely send further shivers through an already febrile market; lower liquidity usually means higher volatility.
The wide range of plausible scenarios for the next year is reflected in poor investor sentiment, with bearish indicators at levels associated with the depths of the financial crisis in 2008 and the start of the pandemic in March 2020. At the risk of oversimplification, we see three broad scenarios for how things may develop over the course of the year:
Scenario 1: An economic soft landing
Central bank policy and post-pandemic normalisation reduces inflation without causing a significant deterioration in growth and levels of employment. This would be a favourable result for equity markets and for consumer-facing companies; stabilising growth expectations and lower inflation would support both corporate earnings and equity market valuations.
Scenario 2: A recession with moderating inflation
Central banks reduce inflation but only by reducing demand and increasing unemployment, slowing economic growth. In this scenario, equity markets would likely remain under pressure as expectations for future earnings growth are reassessed. Companies with more resilient earnings streams or structural growth opportunities would likely return to favour. Bonds would likely regain some of their traditional safe-haven status given low growth and lower inflation.
Scenario 3: A recession with stubbornly high inflation
Central bank action reduces demand but does little to address inflation driven by supply shortages arising from residual coronavirus pressures, the war in Ukraine and China’s zero-COVID policy. Low growth, but high inflation (stagflation), would be negative for most investments, although energy and commodity companies, real assets such as property or infrastructure, and precious metals performed strongly in similar periods during the 1970s.
Whilst the first scenario looked most likely as recently as January, the ongoing war in Ukraine and economic impact of China’s lockdowns have raised the risks to both inflation and growth, and with them the odds of scenarios two or three materialising.
So, what are investment houses doing when considering these potential scenarios?
The challenge is that each scenario above could drive very different returns across asset classes and sectors, necessitating quite different portfolio positioning.
As a result, many have built further resilience into portfolios to reduce vulnerability to any single outcome. Whilst maintaining core exposure to high quality growth companies, some of more expensively valued holdings at greatest risk of devaluation have been reduced taking the overall risk in portfolios down.
For new ideas, they have focused on investments that are able to withstand slowing growth and rising prices. Defensive businesses in the healthcare, transport, consumer services and infrastructure investments can offer solid returns in more difficult environments while maintaining the qualities they look for.
No business is immune to recession, but the type of company in which many invest will be well placed to navigate any slowdown due to barriers to entry, pricing power, higher returns on capital, superior operating margins and conservative balance sheets. This means these companies tend to emerge from tough times stronger than competitors, something proven by their successful performance through the pandemic. These are better businesses than the market; higher quality, growing faster and more resilient.
The poor share price performance of these good companies this year has largely reflected a fall in valuations (they have become cheaper) not operating problems. Their fallen share prices and stable earnings mean that valuations are now much closer to long term averages associated with solid returns for investors over the medium-term, even if those returns may not accrue in a straight line.
The chances are that the earnings expected for these businesses may fall from here, something we have seen in previous periods of economic weakness. However, this is increasingly reflected in share prices. The risk is that short-term decisions can reduce immediate discomfort but often at the expense of long-term returns.
As we have said many times in the past, timing markets is notoriously difficult. What is vital is to have the right strategy to be able to stay invested through the difficult periods. The toughest conditions inevitably see not just the biggest market falls but also the biggest gains. While rallies only prove the start of a recovery, in hindsight, missing the big gains can seriously reduce long-term returns. Since 31st December 1999 to the end of 2021, the MSCI All Country World Index delivered an annualised return of nearly 6% (in local currency), despite including two of the most savage bear markets of the last fifty years. Missing just the ten best days would reduce that annualised return to only 3%, whilst missing the best thirty would reduce that to near zero!
Looking further out and reasons to be positive
The stresses in markets are likely to remain with us through the summer. The war in Ukraine shows few signs of ending and relieving the associated energy and food pressures. China’s zero-COVID policy remains in full force with cases starting to increase in Beijing just as they slowed in Shanghai. Central bankers are focused on taming inflation even if that causes short-term economic damage with little regard for financial markets. They can no longer be expected to step in to calm volatile markets.
However, there are credible catalysts that could shift the tide to alleviate these tensions as we head into the autumn.
China’s twentieth people’s party congress begins in October at which President Xi Jinping should be granted an unprecedented third term. The stage-managed nature of Chinese politics suggests that this may prove a watershed for social restrictions and should be accompanied by further fiscal and monetary stimulus for the world’s second largest economy, just as its emerging from Covid lockdowns. With valuations in these markets looking the most attractive for some years, it could be that China leads the way out of this bearish global environment.
The longer that the conflict in Ukraine persists, the more that both sides will see the benefits of an armistice, particularly as the economic toll mounts alongside the human. Any sign of de-escalation in Ukraine should be greeted by relief in commodity markets and the wider investment community.
Finally, inflation will probably peak over the summer, even if it remains high. This will allow central bankers to turn their attentions back towards economic and financial stability, especially if we see signs of economic contraction. Even if this pivot comes too late to avert a recession, any slowdown is likely to be manageable given the absence of the structural imbalances or valuation excesses associated with the financial crisis or technology crash.
Some final thoughts
It’s worth having some final thoughts from Edward Marsden, a Portfolio Manager at James Hambro, to help put it all into context:
“We are in the midst of a storm which could get worse and rage for a while longer. However, we have experienced many squalls over the years; this is not the first nor will it be the last. What we have learnt is that these are periods to stress the quality and security of investments and ensure that portfolios have the balance and resilience to withstand the turmoil of uncertain markets. We have confidence that the core holdings in portfolios can prosper in the years ahead driving growth for investors, whilst the changes undertaken this year in the face of a rapidly changing world have increased our resilience to withstand the inevitable challenges in the near term.”