Across the globe, elevated inflation, soaring interest rates and a widespread economic slowdown led to negative investment returns in Q2. Unusually, it was a volatile quarter for both equity and bond markets: many investors achieved negative returns on low-risk funds – which usually have more bonds in their portfolios – as well as high risk funds, which have more equities.
During this period, our Fund Managers chose to hold ‘shorter-dated’ bonds (those with five years or less until their maturity date) for portfolios and generally maximised equity holdings whenever possible. This is because they believe that equities will, over the long term, provide a better investment return than bonds. Our funds’ equity exposure remains biased towards UK equities, which is where our team still sees growth potential, but they are gradually increasing overseas exposure thanks to valuations falling in recent market dips.
A slight stumble
Though the UK stock market outperformed in the first three months of the year, it started to stumble slightly in Q2. Despite that, it still performed better than the US, Asia and Europe. With the conflict in Ukraine on its doorstep, and energy supply issues caused by a dependence on Russian oil and gas, European markets were hit particularly hard throughout the period, which resulted in a sharp drop in values.
An environment of negative investment returns is always frustrating for customers, but history shows us that patience and a long-term focus is required. Taking the 1970s as a comparison, UK interest rates back then peaked at around 17%, which was a bitter pill for many to swallow, especially for those with mortgages and other loans. However, even with inflation expected to keep edging higher this year, rates are not forecast to reach anywhere near the 1970s level. At the time of writing, the Bank of England (BoE) base rate is a comparatively low 1.25%.
Across the pond
In the US, meanwhile, the picture was largely drawn by the Federal Reserve’s efforts to combat the country’s worst inflation for 40 years by raising interest rates. Significant market swings were the result. To illustrate this, by the end of June the S&P 500 (an index of 500 large companies listed on exchanges in the US) was down by 20.6% – a loss of circa $8.5 trillion in market value and the steepest ‘first half’ drop for the index since 1970.
In some positive news, while lockdowns in China continued to impact global supply chains, Chinese manufacturing activity increased in June. This was a big step forward for the world’s second-largest economy and it showed a green shoot of recovery, which offered some much-needed reassurance to global stock markets.
Recent market volatility has presented numerous opportunities for our Fund Managers to buy good quality assets at attractive prices, in the firm belief that they will perform well for our funds and investment customers over time. That said, they also expect markets to display volatility for the remainder of the year, particularly in this harsh environment of rising interest and inflation rates.
Indeed, the BoE expects UK inflation to reach 11% before the end of the year, which is significantly higher than its 2% target. Double-digit inflation is never a positive sign and UK interest rates are very likely to go up in the coming months, to help rein in inflation. This is also true for the Eurozone, US and many other developed economies. It’s certainly a sign of the times that the European Union is preparing to raise its interest rate for the first time in 11 years.
Supply-chain bottlenecks are slowly unblocking, which is good news, but at the same time consumers are under a growing ‘cost of living’ strain – paying more money for energy and food, as just two key examples. This has led to lower levels of consumer confidence, with many households tightening their purse strings.
We are closely monitoring this and a range of associated data reports covering insolvencies, credit arrears, house repossessions, and unemployment, which all act as indicators of stress in an economy.
A current highlight is labour markets, which are close to full employment in developed economies and complemented by a high number of job vacancies. The US recorded 372,000 extra jobs in June – more than forecasters had expected – while its unemployment rate remained stable at 3.6%.
In the UK, the unemployment rate is only slightly higher at 3.8%, which is close to the lowest level since 1974. This positive news is one of the few rays of sunshine on a landscape of rising inflation and interest rates.
However, it’s also worth adding a note of caution: unemployment rates are likely to rise later this year. Given the current state of the global economy, businesses are expected to review their staffing levels and cut costs where possible, especially if consumer demand for their goods and services dips as the ‘cost of living’ crisis deepens.
Growth is already slowing across the industrialised world, so the key focus for our fund management team will be the scale of the downturn and whether a recession can be avoided…
A rising risk of recession?
A risk of recession is growing for countries such as the UK and US.
Recessions can quite often be traced back to one of three main sources: wars, energy price shocks, or an extended series of interest rate rises in ‘quick’ succession. 2022 is providing us with all three of these sources simultaneously.
This backdrop makes it very difficult for central banks to target inflation without also having a negative impact on economic activity. It’s a challenging tightrope for them to cross but getting inflation under control will be a key priority for them, as that is more important for long-term economic stability than trying to avoid a recession.
Markets looking forward
There is generally a fear of recession among consumers, but markets are forward-looking and have already factored it in, so the ‘good’ news to take away is that recent falls in value during Q2 can be attributed, in part, to that forward-looking stance they take.
As always, our in-house Investments team of Fund and Property Managers, Analysts and Socially Responsible Investment professionals will use their expertise to navigate a course through the short-term ‘choppy waters’ of markets, with a commitment to maximising the long-term returns for all our investment customers.