April 2022

April Investment Summary

A very toxic combination of macro factors produced a big reaction in risk markets during the month as all major equity markets fell sharply, reversing March’s gains and some. High and rising inflation, high and rising energy prices, the war in Ukraine, ongoing supply chain issues, hawkish central bank actions and the extensive Covid-19 lockdowns across much of China proved too much for risk assets. In the US, the tech heavy NASDAQ led the way falling 13% on the month, while the S&P 500 dropped 8.8%. The FTSE 100 outperformed finishing slightly positive over the month. This can be attributed to the index’s exposure to oil majors as well as the underperformance of the UK pound which fell some 4.5% against the US Dollar. That said, the weak pound – now down 7.3% YTD against the US Dollar – is not going to help the high inflationary environment in the UK.

Turning to inflation, this continues to rise to levels not seen in decades. In April, it registered 8.5% in the US, 7% in the UK and 7.5% in the Eurozone. Overnight interest rates, even after recent hikes by the US Federal Reserve (Fed) and the Bank of England (BoE), sit at 0.80%, 1.00% and -0.50% (European Central Bank – ECB) respectively. Yes, even with inflation over 7% in Europe, overnight interest rates remain negative! These rate levels are not going to reduce inflation and financial markets have only now begun to realise that there are likely many more interest hikes to come. Over the course of the month the Fed hiked rates by 50 basis points and intimated several more 50 basis point hikes are on the horizon. The BoE recently hiked by 25 basis points and also intimated there were more rate hikes to come. Even the ECB has hinted that a return to positive interest rates is coming later this year.
It’s clear that central bank balance sheets will shrink over the coming months. The Federal Reserve plans to stop reinvesting proceeds of maturing treasury bond holdings in June. Some $47.5 billion in bond proceeds will go uninvested every month starting then, with the amount increasing to $95 billion per month from September. This is a huge change from the net monthly purchases of $120 billion that had been taking place since March 2020. The BoE also expects to start selling some of its security holdings in third quarter, whilst the ECB plans to stop buying bonds around the same time.

It’s hard to overstate how big a change in the investment environment this is. We have spent much of the past decade with central banks buying trillions of dollars in securities (mostly bonds but the Swiss Central Bank has been buying equities as well) while they also reduced interest rates down to zero or below. This policy combination was incredibly supportive of both bond and stock prices. During the roughly two years of the pandemic central banks accelerated their pace of asset purchases. The Fed
alone bought over $4 trillion in bonds in just two years. During this stretch US equity prices, particularly the prices of technology related growth companies, soared. The NASDAQ index is still up 70% from the March 2020 lows, despite the 21% pullback YTD.

Rising interest rates and the absence of central bank bond buying is forcing a sharp adjustment in the valuation of risk assets. For example, we may be heading toward pre-Covid pandemic levels of equity prices. That is a long way from where some equities are currently trading despite the falls we have seen year to date.

What is driving the Federal Reserve’s hawkishness? Every economic indicator they look at in the United States is flashing red. Inflation is over 8%, the labour market is exceptionally tight, with wage growth running at 6% and 11.5 million jobs remain unfilled. House prices are climbing at an annual rate of over 20% and after two interest rate hikes the Fed funds still sits under 1%.

The UK and in particular the FTSE 100 has been an oasis in this desert of negative returns. The FTSE 100 is still up just over 2% for the year. This has been one of our larger holdings this year and we expect it to continue to outperform other developed markets. The index is heavily weighted to energy and commodities (all dollar earners so the weak pound helps earnings) and it lacks large exposure to the more speculative tech/growth types of firms. That said, domestic UK is likely in for a tough H2 with slowing growth and increasing energy costs, coupled with the weak pound, likely to weigh on more domestic focused companies’ earnings.

Will falling markets make the central banks stop? Yes, if the fall in asset prices were to significantly slow economic activity (and inflation). But given the rise in asset prices we have seen over the past two years; I suspect we are a long way from levels that would unnerve central banks. Could inflation begin to moderate and even fall and encourage the central banks to slow or perhaps halt interest rate hikes?
Perhaps, but inflation will have to fall significantly. This would probably require an end to the war in Ukraine and a sense that tightness in world energy and commodity supplies is likely to be reduced. I think it would be hard to assign a high probability to that outcome. Given this, our base case is for more market turbulence over the summer months.

We expect UK equities (FTSE 100) to continue to outperform other developed markets given the exposure to energy and commodities. Growth / tech names will likely continue to underperform in this rising yield environment - our preference within this sector is to favour companies which have strong pricing power, solid balance sheets and above average earnings growth. In fixed income, we maintain our preference for lower duration, where possible, as central banks still have a great deal of work to do and yields are just not yet attractive enough.

Jeffrey Brummette

Chief Investment Strategist


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