Soon after COVID-19 brought the global economy to a standstill, the year-on-year inflation rate in the US plunged to almost 0%. As the economy started to re-open, challenges surrounding supply chains across the world, plus the more recent invasion of Ukraine, generated an upward pressure on prices, supply chains, inflation and interest rates.
This has created sporadic volatility for all asset classes and pricing pullbacks along the way. Uncertainties about how long elevated inflation will last and, importantly, how the central banks will handle it, will have implications for the equity markets which should be considered for portfolio positioning.
Last week it was reported that the US consumer price index (CPI) rose by 8.5% in July, a slower increase than expected which was, in part, due to lower petrol prices. The effect was that hopes were raised that the pace of price increases in the world’s largest economy had peaked and have started to decelerate. In July, the average US gas prices fell by around 8% and WTI crude oil down by 11% over the month of June.
Even so, with inflation in the US at a near 40-year high, consumers and investors are keeping a close eye on the Federal Reserve (Fed) in terms of near-term outlook for interest rates. However, the recent slowdown in inflation is unlikely to deter the Fed from tightening its monetary policy in order to get closer to its 2% target.
Equity markets have taken the slowdown in US inflation data as a positive and have started to price in smaller increases in interest rates. The Fed is expected to raise rates to 3.5-3.75% by the end of the year according to the US futures market, and as a result US stocks have responded positively.
Since the beginning of the third quarter (30 June), equity markets have looked strong and moved higher. The S&P 500 is up over 12%, cutting its losses for the year by nearly 50%. The tech-heavy Nasdaq is up circa 17%, reducing its losses for the year to around -17% net. It is now very clear that the July inflation reading has helped add to the positive momentum that we have seen over the past six weeks or so.
But we cannot lose sight of the fact that markets never move in a straight line and are likely to continue to experience some volatility, which is likely to be driven, in part, by the Fed’s continued interest rate rising policy as we move through Q3 into Q4. In addition, the Fed’s withdrawal of economic stimulus by shrinking its balance sheet will start to ramp up in the second half of the year. This is likely to add upward pressure to bond yields and continue to remove excess liquidity from the system.
The Fed officials agreed last month on the need to eventually dial back the pace of interest-rate hikes, but also wanted to gauge how their monetary tightening was working towards curbing US inflation. As stated in the minutes of the Federal Open Market Committee’s July 26-27 meeting, “As the stance of monetary policy tightened further, it is likely that it would become appropriate at some point to slow the pace of policy rate increases”. It has become apparent that market participants can see not only the risk of over-tightening policy, but also of entrenched inflation.
From October, we head into Q3 earnings season, which are historically seen as volatile months in markets, and economic and earnings estimates may continue to soften, which could also have an effect on market volatility.
However, the US no longer has stretched valuations and would be a strong focus for us at present. We also believe now is the right time to lock in the relative gains from our value tilt and pivot towards quality.
While there are glimmers of hope over US data, things are less clear in the UK. This week’s inflation data showed that CPI rose from 9.4% in June to 10.1% in July, the highest since February 1982 (over 40 years) meaning that the UK is now the first major economy to see price inflation reach double digits.
Core inflation, which excludes energy, food, alcohol and tobacco, came in at 6.2% in the year to July 2022. Rising from 5.8% in June and ahead of projections of 5.9%. Despite warning this month that a recession was likely, the Bank of England raised its key rate by 0.5% (its first half-percent rise since 1995), to 1.75%. The central bank sees inflation peaking at 13.3% in October, when regulated household energy prices are next set to rise.
Higher inflation data has sparked a sell-off in UK short-dated gilts which pushed yields higher. The 2-year yield surged 0.28% to 2.43% and the closely watched 10-year yield rose by 0.17% to 2.29%.
The UK hasn’t been helped by a so-called summer of discontent, with rail strikes in London in mid-June, which are yet to be resolved, followed by nationwide industrial action on public transport as well as the start of an eight-day strike by dockers at Felixstowe (the UK’s biggest container port) from Sunday, which threatens to create shortages of everything from toys and consumer electronics to clothes and furniture. Companies across Britain are suffering a surge in industrial action as soaring inflation stokes pay claims against a background of labour shortages.
In light of this industrial unrest, opportunities could be sought from companies which generate the majority of revenue abroad rather than domestically.
Inflation across the EU has also reached a new all-time high of 8.9% in July, up from 8.6% in June. The data is yet another indication that the European economy, which is gradually slowing down, faces the possibility of another recession.
Prices in July continued to climb in most countries, pushed by the worsening disruption in global energy markets fuelled by Russia’s invasion of Ukraine. Natural gas prices surged to more the €200 per megawatt-hour at the end of July – twice the average price during the first half of 2022. The upward trend in gas prices has also spilled over to other products, including fresh fruit and vegetables. The additional energy cost could represent as much as 3% of the bloc’s 2021 gross domestic product.
Even though Europe is the most exposed to the fallout from the Russian-Ukraine war, the European stock markets have performed broadly in line with the S&P 500 this year. We should also focus on opportunities linked to decarbonisation and the green economy, where the EU is and remains the leader.
It could be said that the economic outlook is currently bleak, with inflation causing issue for our policy makers as they navigate between a 40-year inflation high, shrinking balances left over from the pandemic, energy shortages forecast as we head into the winter months, and the prospect of energy disruption.
But don’t despair, history has taught us that out of the ashes of a crisis grows opportunity and by positioning our portfolios correctly, we will be well placed to take advantage of cheaper, high value assets. However, the most important factor is timing.
This is why portfolio construction is so important as we look to construct our portfolios defensively going forward. This will help us to wade through the choppy waters ahead, leaving us in good stead to take advantage of any pockets of opportunity as they arise.
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