As we move into the third quarter of the year, Chief Investment Officer Jonathan Marriott takes the opportunity to reflect on the macroeconomic environment, market moves and central bank announcements of the last quarter.
The last quarter saw both equity and bond markets challenged as central banks moved to tighten monetary conditions to fight persistently high levels of inflation. The continued war in Ukraine has seen further sanctions on Russia, supporting already high energy prices. With grain supplies from Ukraine cut off and higher input costs, food prices are also sharply rising. As household incomes fail to keep pace, a cost-of-living crisis is at the core of concerns around waning consumer demand. This, combined with a higher interest rate environment, is already beginning to have an impact, fuelling fears of a recession. While interest rates are expected to rise further, bonds rallied off their lows at the end of the quarter, reflecting this reduction in demand.
Throughout the pandemic, China has maintained its "zero tolerance" COVID policy and has seen repeated shutdowns while other countries are easing, or entirely abandoning, previous restrictions. However, towards the end of the quarter there were signs that China may finally emerge from the shadow of COVID and the days of city-wide lockdowns. At least on that front, supply chain constraints may be reduced, easing some inflationary pressures. Over the quarter, the Chinese equity market was one of the few to deliver a positive return.
While the direction of travel is similar, the pace of central bank tightening has varied. The Bank of England began raising rates in December last year with a 0.15% move. Since then, they have raised rates four times by 0.25%. The Federal Reserve was slower to get going but has accelerated its incremental moves, raising its target rate by 0.75% at the June meeting. The European Central Bank has only just suspended its bond buying programme and is expected to make its first rate rise at the July meeting. The real outlier here is the Bank of Japan, which has held steadfast with loose monetary conditions. This has resulted in a sharp fall in the Yen, which is down 15% this year. As we have noted, higher prices alone can slow the economy, so decisions are not straightforward. The ECB has a particular problem in that it must ensure smooth transmission of its policy stance across the Eurozone. While ten-year Bund yields have risen from 0.17% at the end of the year to 1.33% as at the end of June, Italian government bond yields have moved from 1.17% to 4.18% before the ECB signalled that they would take action to counter this spread widening, pushing yields back down to 3.26%. Credit spreads have sold off sharply and, while default rates may rise, opportunities remain and the rise in bond yields means sovereign debt is likely to balance risk in portfolios once again.
As we enter the third quarter, central banks will continue to balance the risk of recession with the need to fight inflation. The impact of the war in Ukraine may mean food and energy prices remain high due to supply-side factors beyond their control. Elsewhere, falling demand and normalising supply chains in China may ease inflationary pressures, potentially negating the need for further aggressive tightening. With higher interest rates and input costs, investing in companies with strong balance sheets and the ability to pass on price increases will be paramount.
We have never advocated for cryptocurrencies and the recent sell off has at least, in our mind, debunked the myth that they were a store of value. With inflation nearing double digits, cash is providing negative real returns. We continue to prefer to look for a stream of long-term cashflows in both bond and equity markets. Sharp downturns often lead to indiscriminate selling, which provides opportunities for active management. Financial markets typically overcorrect in response to news flow. Bonds have generally priced in more rate rises than occur during any cycle. While we remain alert to the risks in markets, we continue to see opportunities for those prepared to look through the noise.
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