This September/October 2022 market update is brought to you by LGT Wealth Management

Markets remained volatile over the last month, with many indexes returning to their lows for the year. The Federal Reserve (Fed) opted for its third consecutive rate rise of 0.75% at the September meeting. In the commentary around the meeting, their aggressive tone continued, and markets expect a further 1.25% of tightening between now and the end of the year.

There had been some talk that they would slow the pace of tightening, but this now seems unlikely until the new year. The Fed is becoming more open about a potential hard landing, not only becoming the more likely scenario, but ultimately being required to cool the labour market and bring the economy back into balance.

Thirty-year US mortgage rates have shot up to 6.7%, the highest since 2007. This is having a material impact on the US housing market and house building, but also across the wider manufacturing sector. Whether the Fed can proceed along its prescribed path, and tolerate the potential economic damage, will be something that investors will watch closely.

The European Central Bank (ECB) decided to follow the Fed with a 0.75% increase in September. Christine Lagarde struck a hawkish tone in the press conference stressing that inflation has been rising consistently every month.

These words have proved pertinent as the September reading for the Euro Area inflation rate came out at 10.0%, considerably higher than the 9.1% recorded in August. This increase was largely driven by spiralling costs of energy. The ECB is expected to continue its hiking path with another 0.75% increase in October and 0.5% in December.

On top of this, there is a potential start of quantitative tightening (QT) which was alluded to during September’s press conference. This would result in three major central banks embarking on QT, only a few months after the final asset purchases have been completed under their respective quantitative easing (QE) programmes.

The UK faced a unique set of circumstances over September. Newly appointed prime minister, Liz Truss, and her chancellor, Kwasi Kwarteng, delivered a ‘mini budget’ in an effort to boost the economy.

These so far unfunded tax cuts were seen as boosting inflation at a time when the Bank of England (BoE) is raising rates to fight inflation. This was not received favourably by markets, causing historic moves in the gilt market with the 10-year gilt yield reaching 4.5%, as markets priced in more rate hikes to reflect looser fiscal policy and a substantial increase in borrowing.

Leverage in the liability driven investment approach by pension funds drove collateral calls, exacerbating the sell-off in the gilt market. The BoE was forced to intervene, buying up gilts to restore liquidity and ‘orderly market conditions’ to the collapsing market.

The BoE extended this programme in October to include index linked gilts, with the plan to cease all bond purchases on Friday 14th October. During this episode, Sterling tumbled to below 1.04 against the US dollar, mostly a function of US dollar strength, but after the BoE acted, Sterling recovered some of the losses.

The big question remains whether the UK government or other Conservative party members force a further policy U-turn following the bond market reaction and the consequent rise in borrowing costs. Rising mortgage costs are already impacting the property market, which will put further pressure on the government.

While central banks are trying to quell inflation, they risk a more pronounced downturn. Reassuringly, government bond yields have already priced in considerable further tightening and corporate spreads now reflect the heightened credit risk.

After a challenging start to the year, bonds are starting to look more attractive. Equity markets will remain volatile until it is clear how corporate earnings will be impacted by interest rate rises. As such, we recommend a selective approach to equity markets, favouring companies which have strong pricing power and robust balance sheets.

Market View Changes

• No changes

Currencies

The US Dollar remains the reserve currency of the world and has benefited from its safe-haven status. With the Fed set on an aggressive tightening path relative to other developed markets, we have seen the dollar remain strong relative to most other currencies.

The pound has swung because of the ‘mini budget’ and the subsequent BoE action and remains depressed relative to the Dollar. However, we need to remember that this is as much a story of Dollar strength as it is Sterling weakness.

The Bank of Japan has stubbornly refused to raise rates, causing the Yen to also weaken substantially as well.

The Euro has also suffered relative to the Dollar and is trading below parity.

Fixed Income

The unwind of pension fund leveraged exposure to the Sterling bond market, particularly the long end caused significant damage. The BoE has looked to stabilise the situation but yields across the board remain substantially higher than a month ago.

At the time of writing, the Bank plans to end support on Friday 14th October and we will have to see how the market reacts when that prop is removed.

The inflation linked market, with its long duration, was particularly hard hit until the BoE expanded its purchase programme to include the sector.

The long-dated index linked market is heavily dependent on pension fund demand and as a result, remains vulnerable.

When the dust has settled, we may find attractive opportunities in the Sterling bond market following the sell-off.

The Federal Reserve and The European Central Bank continue to fight inflation, with yields moving higher. However, as the higher yields bite and consequently inflationary pressures ease, we may see opportunities within this space.

As central banks are now looking to normalise at a brisk pace, we have seen both government bond yields and credit spreads move higher. Despite the recent moves in bond markets, the BoE and the Fed are still looking to unwind their balance sheets.

However, given the elevated yields on offer, this is likely to bring support to this market where we are seeing selective opportunities.

As central banks continue a tightening path, the risk of recession is growing. While default rates have been benign, there is some fear that this may change as the economy slows. This may continue to weigh on high yield bonds for some time, but we are now starting to see better opportunities. We retain our neutral stance for the time being and continue to stress selectivity.

Emerging Market Debt

With developed market central banks set to tighten policy, this generally weighs on emerging markets. Though, many emerging market central banks have already raised rates substantially, which is likely to result in a much smaller impact than previous hiking cycles. Should China continue its easing trajectory, this could provide further support to these economies.

Furthermore, recent upheavals in Peru, Pakistan and Sri Lanka demonstrate the political risks from rising food and energy costs. Sri Lanka defaulted on its debt payments having been hit by a lack of tourist income during the pandemic and now high prices and political unrest.

Therefore, we emphasise that selectivity remains as important as ever, and we retain our neutral stance across this diverse asset class.

Equities

Earlier in the year, the FTSE 100 index had been buoyed by its exposure to energy, materials, and a weaker pound. However, the UK market cannot be immune from world events and the uncertain political landscape may discourage overseas interest.

Nevertheless, the market continues to trade at valuations that look cheap compared to markets elsewhere in the world. This, combined with the lower Pound, should spur takeover interest by overseas buyers, given the opportunity to pick-up companies at discounted prices.

That said, the UK domestic economy faces significant headwinds from higher energy costs and interest rate rises. The rise in mortgage costs may further constrain domestic consumer spending.

However, the UK index is mostly made up of international companies that are less dependent on UK specific factors. Considering the mix of factors, we recommend a selective approach in this market.

The European equity market has been particularly vulnerable to the impact of the war in Ukraine and has seen large moves in both directions driven by the news flow.

On the grounds of valuation, the European market looks relatively attractive, but the risk of higher energy costs, or even rationing are significant headwinds.

The Italian election result, with a right-wing coalition, may prove challenging for the rest of Europe and The Euro.

Europe’s ability to cushion the impact of the acute energy crisis is limited by higher interest rates and rising input costs.

The ongoing volatility surrounding inflation and its impact on the long-term discount rate has continued to cause gyrations between cyclical and less-cyclical companies.

The upcoming earnings season will be a test of how companies are coping with higher input costs and a tight labour market. While these factors are pushing the Fed further, the US consumer so far continues to be resilient.

The mid-term elections will deliver a verdict on the first two years of the Biden administration and may limit the President’s ability to act in the second half of his term.

The US market remains a source of attractive companies with good long-term prospects, with relatively high self-reliance in terms of energy and food supply.

Unlike other central banks, the Bank of Japan has maintained its easy policy stance, despite it having the worst performing currency in the G10.

Inflation, while above its target, remains well below the levels seen in other developed markets and as such the need to pivot monetary policy has remained less pressing.

While in local terms, its equity performance remains relatively muted, it has underperformed many peers on a Dollar basis. Given moderate valuations and many export-focused companies, Japan could have room to perform should the global economic situation improve.

While many countries are emerging from the pandemic, China continues to pursue its zero COVID-19 policy which has seen further lockdowns imposed in major economic centres. To counter the economic effects of continued shutdowns, China has announced several initiatives to loosen monetary and fiscal policy.

While the property market remains a source of concern in China, given its ability to control its domestic affairs, the long-term growth opportunities in China remain.

Although the risks of political business interference in China remains high, the valuations look cheap relative to other markets and the lack of sanctions on Russia confirm that energy headwinds are less of an issue for some countries in the region.

As such, we think the potential for long-term growth is higher than elsewhere.

Though the rise in commodity prices has a natural benefit for resource rich countries like Brazil, the war in Ukraine has highlighted how extreme the geopolitical risks may be.

Food shortages and higher prices threaten political stability; we have already seen this in Peru, Pakistan, and Sri Lanka. Developing countries need continued foreign investment, but events like this deter investors, compounding these risks.

Despite this, long-term growth prospects for many emerging markets remain high. Hence, we continue to stress a highly selective approach in this diverse universe, emphasise its volatile nature and maintain our neutral stance.

Alternative Investments

Hedge Funds/Targeted Absolute Return

Given pronounced movements across interest rate expectations, this will undoubtedly weigh on financing costs which may temper some merger and acquisition (M&A) activity.

Conversely, the elevated levels of interest rate volatility may present opportunities elsewhere.

On the regulatory side, geopolitical fronts mean that regulatory intervention has become more commonplace. This has tempered our enthusiasm for event-driven strategies.

More broadly, when allocating to this space, we look for funds that could diversify returns away from the directionality of conventional bonds and equity markets.

Nevertheless, we continue to stress the importance of finding the right vehicle and investment manager, which requires extensive due diligence on the strategy and fund.

Property

Rising borrowing costs may come to weigh on property markets globally. In the UK, the unwind of pension fund leveraged positions saw some open-ended property funds restrict redemptions.

We continue to suggest that any exposure to property should be selective and closed-ended over open-ended vehicles are preferred, due to the liquidity mismatch.

However, as pension funds have looked to access liquidity, closed-ended property funds (REITS) have suffered.