Market Update From Brooks Macdonald
Global equities remained under pressure during Q2 as the US Federal Reserve (Fed) signalled that it was likely to increase interest rates faster than previously indicated in an attempt to tackle the risk of near-term inflation pressures becoming entrenched. Continued COVID-19 curbs in China, despite relatively low rates in infections, were driven by the country’s continued adherence to the policy of ‘Zero-COVID’. This, and the expected impact on already strained global supply chains, unnerved investors during the last few months. Some positive corporate results, particularly in the US, provided some limited cheer to investors. Indeed, according to FactSet data, so far, US large company results are seeing the percentage of earnings ‘beats’ running above the five-year average. The Russia-Ukraine conflict continued to make headlines, although the conflict appears to have shifted towards a more regional focus in the Donbas east of Ukraine. Along with a supply disruption in Libya, this helped oil prices to remain elevated. Overall, financial markets have had to recalibrate for a more uncertain investment outlook.
UK stocks have risen slightly during the last few months. Providing some modest relief, markets continued to weigh a slightly less hawkish cadence from the Bank of England in contrast to other central banks globally, with the UK central bank appearing to strike a more balanced position between the risks of inflation vs the worries around a possible slowdown in economic growth. Elsewhere consumer confidence dropped to a near-record low and retail sales declined. The UK value/cyclical exposures, in particular those in oils and mining equities, provide valuable balance to growth/defensive exposures in other asset classes and regions globally.
US equities weaker as the Fed turned increasingly hawkish, although generally positive corporate results underpinned some gains during the month. US GDP unexpectedly shrank by an annualised 1.4% in the first quarter, following 6.9% growth in the previous quarter. That said however, the GDP number this time around probably resembles more noise than signal, driven as it was by a large trade deficit in the quarter. Imports were up +17.7% quarter-on-quarter annualised reflecting stronger US domestic demand, but in marked contrast, exports were down -5.9% reflecting relatively weaker demand in the rest of the world. Taking a step back, it’s worth remembering that quarter-on-quarter annualised data can see big swings at times - for context, US GDP is 2.8% above its level in Q4 2019 and is up 3.6% on a year-on-year basis in Q1 2022 versus Q1 2021. Inflation of 8.5% year-on-year in March marked a new forty-year high, although base effects and a relatively weaker comparative this time last year boosted the headline print. Expectations of more aggressive monetary policy helped the US dollar strengthen in April.
European markets moved downwards as increased expectations of quickening interest rate rises by major central banks intensified worries about a global economic slowdown. The continued COVID-19 curbs in China also unsettled investors, although some favourable corporate results helped to restrict the losses. The eurozone annual inflation rate edged up to 7.5% in April – a new all-time high – while GDP growth remained weak in the first quarter, at 0.2% quarter-on-quarter, following expansion of 0.3% in the previous three months. Energy prices continue to present a risk for the region, both in terms of corporate margins as well as household disposable income levels. Indeed, gas prices in Europe finished the month roughly four times higher than US gas prices. The European Central Bank appeared to open the way for an interest rate rise in 2022, although it remained wary about moving too quickly. The war in Ukraine creates worrying headwinds for the European Union (EU) at a time of post-pandemic recovery. Longer-term, tensions between Russia and the West might be permanently reset at a higher level, and a structural lack of EU security of energy supplies risks having a long-lasting impact on both corporate margins and household balance sheets. The EU member states are all net importers of energy, with Russia previously the main supplier for imported gas, oil and coal. Beyond the current geopolitical concerns however, we see the Eurozone facing other long-running and unresolved structural problems, centred around the mis-match between monetary union versus fiscal and political sovereignty.
Japanese shares declined as investors worried about the Fed’s monetary policy tightening plans. The Bank of Japan (BoJ), however, remained highly accommodative and kept interest rates unchanged, leading to a continued weakening of the Japanese yen currency, at one point falling to a twenty-year low versus the dollar, and which provided some support to the equity market and export-led companies in particular. The core inflation rate, which excludes fresh food prices, rose by 0.8% year-on-year in March – the strongest increase in more than two years. Japan remains a play on an albeit slowly evolving global economic recovery and coupled with domestic corporate and shareholder reform, over time may lead companies to improve capital allocation and return decisions. We are mindful that Japan has seen ‘false dawns’ before, but we will continue to monitor developments here and adjust our positioning if required.
Asia-Pacific equities (excluding Japan) weakened, in aggregate. Chinese stocks fell on worries about the extended COVID-19 restrictions related to the country’s ‘Zero-COVID’ policy and the impact on the economy, although first-quarter GDP growth of 4.8% year-on-year was stronger than expected. Meanwhile given China policy makers unveiling a GDP target for calendar 2022 of around 5.5% as recently as March, expectations are that authorities will continue to provide monetary and fiscal support for both the economy and its financial markets. Nonetheless, concerns about a global slowdown pressured shares in South Korea, while Taiwan’s market followed US stocks lower. In Australia, equities dropped on concerns about China’s lockdowns and commodity demand. Regarding China, we judge Beijing’s regulatory actions over the past year to have been targeted rather than anti-business. Furthermore, recent actions by China’s policy makers suggest a desire to maintain a constructive and stable risk appetite environment for both the economy and its financial markets. Given this view, we judge the region’s relative equity valuation derating in 2021 as an attractive entry-point for longer-term investors.
Emerging markets moved lower on anxiety about inflation and the stronger US dollar. Indian equities dropped as investors fretted about increased pricing pressures and monetary policy tightening. Brazilian shares fell sharply on worries about political upheaval ahead of a general election later this year and the economic impact of monetary policy tightening in the US. In Turkey, stocks made gains, although it emerged that inflation had hit a 20-year high of 61.1% year-on-year in March. South Africa’s market retreated as devastating floods in KwaZulu-Natal province – home to one of Africa’s busiest ports – hurt sentiment. While there is much focus on commodity exports currently, domestic pressures can also weigh; for some emerging markets, food and energy can make up between a quarter and half weight in inflation baskets, risking an outsized impact on domestic inflation and interest rate conditions. The pandemic in particular has undoubtably complicated what might otherwise be a more-normal recovery profile that emerging economies might hope for following a global recession.
Yields on core government bond markets generally moved sharply higher. The yield on US benchmark 10-year Treasury bonds rose (prices fell, reflecting their inverse relationship) as the Fed indicated it was likely to act more quickly to control inflation risks. There were similar upward moves in UK 10-year gilt and German 10-year bund yields. In the corporate debt market, US investment-grade and high-yield spreads widened as investors turned more cautious. The yields on government bonds (which move inversely to prices) have risen significantly in recent months, reflecting the market’s outlook for higher interest rates, especially so in the case of US Treasuries. Looking forwards, the outlook for sovereign yields is more balanced. Despite a continued constructive economic outlook in aggregate, should inflationary pressures start to ease, this might provide some support for those shorter-dated bond prices.
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