Quarterly Investment Newsletter: Summer 2022

The dominance of the inflationary narrative and central banks’ responses of higher interest rates continued to weigh on stock markets throughout the second quarter of the year. Global equities fell a further -14%, led by US markets, and in particular sell offs in sectors that were previously deemed expensive, not least technology. The strength of the US dollar brought some respite for UK investors with global equity returns being -8% in Sterling terms, and the price of gold increasing by +2% when converted back into Pounds. As during the first quarter, the bond market continued to fall as interest rates rose, and Gilts lost a further -6%. Time to maturity on Gilts mattered enormously with longer term holdings losing around -15% of their book value, whereas shorter term debt was largely unaffected.

Having been absent for decades, the return of inflation is forcing market analysts to learn how to respond to rising interest rates and squeezes on the real purchasing power of consumers’ disposable income. For many years central banks have been able to placate the financial economy through Quantitative Easing and the maintenance of very low interest rates, but when push comes to shove and inflation becomes a very real factor, the US Federal Reserve and the Bank of England at least have made it abundantly clear that bringing inflation under control is priority number one. As interest rates rise, the notion of ‘There Is No Alternative’ is diluted, and the prospects for a slowing economy increase, leaving valuations on risk assets vulnerable despite the recent falls.

The hope of central bankers is that by raising rates ‘quickly’ now, inflation can be suppressed without choking off economic growth entirely. Markets seem to have little faith in this scenario arising, and instead are focusing on the possibilities either of inflation becoming endemic, or perhaps more likely, for the economy to fall into recession as higher debt servicing costs impact company margins and consumers are pressed by the cost of living crisis. The primary sources of current inflation may be showing signs of waning. Energy prices whilst not falling aren’t continuing their rises from the Spring, whilst the pressures on global supply chains are showing signs of easing particularly as China reopens from its latest Covid lockdowns. Though this is good news on the inflation front, it is also true that there are plenty of indications that economic growth is slowing with economists roughly evenly split on whether this will result in a global recession. Consumer confidence levels are low, and forward looking indicators for manufacturing suggest a further slowdown.

Either stubborn inflation or economic recession could cause equity markets to continue their sell off, and our analysis suggests that a significant reduction in corporate earnings is not yet priced in. That said, there are numerous factors which could help markets find a floor. China is reopening and stimulating its economy, supply chains are in better shape allowing trade to flow, and central banks could yet decide not to pursue Quantitative Tightening beyond the level already discounted by markets.

At our June meeting the Investment Committee voted to maintain our neutral position in equities, and to retain the more defensive nature of the underlying holdings. Though we recognise that the current sell off will ultimately represent a buying opportunity, we do not feel that now is that time. In bonds, where we have been very defensively positioned, we closed a significant portion of our underweight position to account for the fact that markets have already priced in a number of rate rises.

-David Baker, CIO