May Investment Summary
The month of May provided a brief respite from the relentless bearish sentiment and price action of 2022. In sterling terms, European, Japanese and Chinese equity markets were positive for the month. The S&P 500 was basically flat while the tech heavy NASDAQ was down just over 2% for the month. There was a small whiff of optimism that inflation was peaking in the US, as it had slid down to a mere 8.3% in April from the 8.5% recorded in March. The markets were giddy enough to suggest that the US Federal Reserve might pause hiking rates in September. US rates reflected this as the ten-year US treasury yield drifted down to 2.75% after touching 3.10% in early May. This was despite oil prices touching $125 a barrel during the month. There was almost the perverse hope that an economic slowdown would show up and stop the Fed from hiking more. How a slowdown would somehow be good for equities was never really discussed.
This optimism has been shattered by the data in early June. Headline CPI jumped to 8.6% in the US, 9% in the UK and 8.1% in the Eurozone. The ECB has shifted to a more hawkish stance promising to hike rates at their next two meetings and possibly more and stating they would end asset purchases on July 1st - can you believe with inflation over 8% they were still buying securities? European bond yields leapt higher with the ten-year German bund climbing above 1.5%. You may recall they started the year with a negative yield! Perhaps more concerning was the rise in peripheral European bond yields. Ten-year
Italian yields rose to over 3.6%. Ten-year Italian government bonds had begun the year yielding around 1.25%. The ECB promised they would not allow a fragmentation of monetary policy to occur in Europe. This is code for at some point they will step in and buy peripheral bonds to prevent a panic, but they gave no specifics on exactly how and when they would do that.
Naturally equity markets do not like this combination of higher inflation, higher yields and tougher central bank rhetoric. In the US, the Federal Open Market Committee (FOMC) meets on June 14-15 and rumours of a 75-basis point hike are circulating. This seems unlikely to us as the Federal Reserve doesn’t like to surprise the markets. A steady dose of 50 basis point hikes over the next several meetings is more likely. There are five more FOMC meetings this year (counting this one in June). It is very possible that they hike 50 bps at each meeting putting the Fed funds rate at 3.25-3.50% by December. This is much faster and higher than the markets have been pricing and would negatively impact both bonds and equities.
Unfortunately, inflation has gotten out of hand and is hurting the majority of households (voters) to such a degree that governments are pushing their central banks to act. Acting, means hiking rates until activity slows down. This can be unpleasant.
We aren’t any smarter than the Federal Reserve and we can’t tell you when inflation will peak, nor how fast it will decline to a level that makes the central banks stop raising rates. Nor can we or the central banks for that matter tell you how high interest rates need to go to bring inflation down. What we can say is that the investment environment is undergoing a huge change. After nearly a decade of zero (or negative interest rates) and massive asset purchases by central banks, monetary policy is going in reverse. Interest rates are heading up and asset purchases are stopping and, in some cases, reversing. Assets that benefitted during this environment will be hurt and many already have been. Just look at the carnage in the disruptive tech equity space.
We are playing defence, overweighting the one major market that has been positive, the UK. Its sizeable exposure to energy and commodities has helped it to outperform developed market peers and we expect this to continue. We have also reduced exposure in the more speculative tech space and have considerably reduced the duration of our fixed income holdings. Bear markets do throw out the good with the bad and we will patiently look to add quality assets at distressed prices.
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