The Holden & Partners’ investment team Q3 round up
With the mini budget, ensuing financial turmoil and subsequent U-turn dominating the headlines you would be forgiven for thinking all was quiet in the rest of the financial world, but Q3 has seen a lot of movement across the globe. Our investment team have compiled a round-up of key developments not getting airtime right now to keep you in the know.
Included in this update
US – The Federal Reserve continues to tackle inflation and the US attempts to close the clean energy gap with European counterparts
Europe – still in the grip of the energy crisis and the war in Ukraine, the EU is facing inflation and rising interest rates.
APAC and Japan – China’s growth forecast was slashed as energy and the government’s zero-Covid policy collapsed consumer confidence. Inflation abounds in Japan and the Bank of Japan had to intervene to prop up the yen against the dollar.
UK – a turbulent Q3 was spectacularly seen out by the already infamous mini-budget.
Alternatives – due to the US Inflation Reduction Act, infrastructure proved to be one of the few sectors to buck the downward trend.
Portfolios – daily monitoring of the economic landscape and our portfolio performance.
US – Fed/ Inflation Reduction Act – Treasuries
The Federal Reserve continued with its strong stance on tackling inflation, raising the policy interest rate by 0.75% in September. While the rate rise did little to move markets initially, it was the accompanying comments that were cause for concern. Aggressive hikes in the coming months were signalled along with further reductions in the balance sheet, making prospects of a ‘soft landing’ less likely. While labour markets remain tight, “Reducing inflation is likely to require a sustained period of below-trend growth, and there will very likely be some softening of labour market conditions” Chair Powell said in the following press conference. Unemployment forecasts were increased to 4.4% by the end of 2023 – up from June’s projection of 3.9%.1
The market rally seen over the summer was short-lived as recession fears intensified. Yields on various dated Treasuries reached levels not seen in over a decade. The 2-year yield – often used to track interest rate expectations – pushed above 4% for the first time since 2007.2
Inflation Reduction Act
The ambitious Inflation Reduction Act was passed this summer, and while being inflation-reducing in name, brings a broad range of implications for various areas of the economy, through lowering costs for families, tackling the climate crisis, and lowering the deficit.3
Some highlights:
- A Fairer Tax Code
– Instituting a minimum corporate tax of 15%.
– A 1% fee on corporate stock buybacks, encouraging businesses to invest instead of enriching CEOs, or funnelling profits tax-free to shareholders. - Creation of Clean Energy Jobs
– Tax breaks/credits for domestic production in clean energy technologies such as solar and wind. - Lowering Health Care Costs
– Increasing access to prescription drugs.
– Extending premium subsidies for the Affordable Care Act.
So, what does this mean for investors? Despite the misleading name (and being unlikely to reduce inflation in the short-term) the largest component ($391 billion) of the Act is dedicated to clean energy investments over the next decade.4 Policy of this size is a clear signal that the US government is confident that cleaner sources of energy are the future and is likely to bolster investment in the renewables sector by bringing forward the energy transition. Historically, we often looked towards Europe for industry leaders in clean energy – due to the US’s more conservative stance on the issue, however, this should go a long way in closing the gap.
Europe
Europe’s energy crisis continued to dominate the front pages in Europe over the third quarter, as a record drought and the continuing war in Ukraine caused energy prices to soar. During the heatwaves across Europe over the summer electricity demand and wholesale power prices surged as European’s tried to keep cool. Drought conditions exacerbated by the heat waves had serious consequences for hydropower generation and nuclear power plants that rely on rivers for cooling. Moreover, the low water levels on the Rhine, one of the most important shipping routes in Germany, hampered coal-fired power stations which rely on the river to supply their fuel via barges. With hydropower, nuclear and coal production distributed, Europe had to place more reliance on wind, solar and natural gas for electricity production.
However, with consequential sanctions on Russia forcing President Putin to reduce gas flows to Europe including the indefinite shut down of Nord Stream 1, a pipeline that supplies Europe with Russian natural gas, electricity prices across most of Western Europe surged above €600 per megawatt-hour 5 while natural gas futures topped €340 megawatt-hour before the EU Commission intervened with a proposal for a regulation of the energy markets.6
The European Central Bank (ECB) raised the three key interest rates by an unprecedented 0.75% in its September 2022 meeting. The main refinancing rate is now 1.25%, the marginal lending facility is 1.5% and the deposit facility rate is 0.75% having a knock-on effect to almost everyone. Current inflation in Europe is mostly driven by a strong increase in energy prices where the ECB’s monetary policy has little impact. Despite this, the ECB doesn’t want inflation expectations to rise outside their mandate and with European core services inflation surprising to the upside 7 it was important that the ECB were seen to be doing something.
The atrocities in Ukraine continue and following a pushback by the Ukrainian forces. As the war persists there will be continued volatility in the commodity markets leading to the potential for more EU intervention. This has been particularly apparent with the newfound gas leaks in the Nord Stream 1 and 2 pipelines earlier this week. The cause is still unknown, but it highlights the current fragility of the European energy market.
In Italy, the right-wing coalition led by Giorgia Meloni won last week’s general election, winning more than 44% of the votes. Meloni is known for being very outspoken regarding Italy’s relationship with the EU and although Italy leaving the EU is unlikely, her government will cause headaches for Brussels.
APAC & Japan
Heatwaves and the subsequent droughts were not only a problem in Europe over the summer. A long-running heat wave pushed electricity usage to record levels and led to blackouts across China, too. Chinese factories received power rationing notices restricting China’s major manufacturing hubs’ capacity. Furthermore, the Chinese Communist Party’s (CCP) continued support for zero-covid policy and mass testing severely restricted mobility and collapsed consumer confidence.8
To add to the problems, the housing sector, which accounts for 30% of GDP, is suffering a historic collapse as household debt levels rise and a funding crisis has seen development projects paused and led to buyers refusing to pay their mortgages.9 This, among other things like higher commodity prices, has prompted the World Bank to slash its China growth forecast to just 2.8% from 4.5% in April and announce they believe China’s economic output will lag the rest of Asia for the first time in 30 years.10 Since China is the second largest economy in the world, any crisis will reverberate across the globe. Our portfolios have an underweight to China compared to the benchmark, something we will look to keep.
Tensions rose between the United States and China as US House Speaker Nancy Pelosi visited Taiwan. The visit, seen as provocative by Beijing, prompted the second largest economy to conduct live-fire military exercises around Taiwan and halt some trade with the island nation. Although not a certainty we do think the probability of China carrying out its own ‘special military operation’ in Taiwan is increasing and have been considering the impact that this could have on portfolios.
In Japan, the annual inflation rate rose to 3.0% in August 2022, the highest level since September 2014, on the back of rising prices of food and raw materials as well as yen weakness. The Japanese yen became so weak against the US Dollar that the Bank of Japan (BoJ) had to intervene in the foreign exchange market to buy yen for the first time since 1998 in a bid to prop up the currency. Part of the reason the Japanese yen has been so weak against the US Dollar is due to the Bank of Japan’s ultra-loose monetary policy stance compared to the United States.
UK
After providing a port in the storm for the beginning half of the year, a multitude of economic and political risks forced UK equity and fixed income markets into negative territory after a bear market rally in the first half of the quarter. Despite the uncertain political backdrop at the beginning of July, UK equities bounced back from a torrid June. The recovery was brought to a halt initially by a decline in global sentiment, after the Federal Reserve’s chairman Jerome Powell reiterated the Central Bank’s willingness to impede growth in their efforts to tame inflation. The resulting fall in commodity prices and global growth forecasts hailed the end of yet another bear market rally. The Bank of England raised rates by 50 basis points twice in the quarter, however the latter rise fell short of expectations given the unfunded stimulus plan laid out by new Prime Minister Liz Truss in her leadership campaign.
The mini-budget presented by Chancellor Kwarteng drew fierce criticism from economists, politicians and even global supranational bodies charged with discouraging harmful economic policies (IMF).11 The fiscal irresponsibility of directly opposing the Bank of England in their efforts to tame inflation instigated a steep decline in the value of Sterling, taking the pound to a 37-year low against the dollar whilst UK credit and equity prices tumbled.12 The Bank of England was forced to intervene as government borrowing costs skyrocketed, unveiling a £65bn bond-buying programme to avert “material risk to UK financial stability”.13 This resulted in bond prices recovering from Global Financial Crisis levels, and a recouping of some of the $500bn lost in value to UK stock and bond markets under Truss’ leadership.14
The economic outlook for the UK deteriorated throughout the quarter, with inflation and GDP growth estimates travelling in opposite, and unsought directions.15 The end of the quarter saw greater strain on fixed income and sterling markets as Prime Minister Truss defended her parties’ planned policies. The FTSE finished the quarter down -2.71% with sectors considered as bond proxies (predictable returns, high yields) suffering as competing and lower risk yields in the bond market rose.
Much of the government’s plans have a wide-ranging impact on both investors and society. We are concerned about their approach and will be monitoring closely. We have always taken a more global approach to investing so have been underweight the U.K. for some time which provides an element of protection.
Alternatives
European property equities underperformed broader equity markets, owing to rising bond yields that subsequently drove up the required return from the bond proxy sectors. Property leases are often linked to inflation indices, which is beneficial to earnings when inflation rises, however the accompanying rising interest rates are detrimental to earnings due to the leveraged nature of property companies, and the sensitivity of property pricing to mortgage costs. UK lenders were briefly forced to withdraw mortgage offers as they struggled to price in increasing interest rate forecasts, and for consumers rising mortgage and energy costs outweighed the fiscal support offered by the stamp duty 0% threshold increase.16
The Inflation Reduction Act buoyed global infrastructure equities with exposure to US assets, the package is the largest investment to accelerate action on climate and energy in American history. Renewable energy companies operating in the US will directly benefit from the large tax incentives tied to clean electricity production and additional funding support. Global infrastructure indices recorded positive returns over the quarter, whilst the UK based TRIG posted a quarterly loss as soaring UK bond yields in the last week September wiped out earlier gains.
The deteriorating macroeconomic background and strong US dollar inflicted pain across the broad commodity sector, with the Bloomberg Spot Commodity Index falling to its lowest level since the Russian invasion of Ukraine. Excluding natural gas, many commodities essential to industrial production and economic growth fell as markets reacted to declining global growth forecasts. Gold fell to a two-year low, as rising interest rates increased the opportunity cost of holding a non-yielding asset.
How the portfolios have fared:
As we have mentioned previously there has been little place to hide and this quarter has been no difference except, infrastructure one of the few areas of positive returns also began to struggle as bond yields started to move higher. Despite this it has still acted as an important diversifier with some inherent inflation hedging.
The decision to move bond exposure to shorter duration (the sensitivity of an asset to interest rates) and introduce more value like holdings into the portfolio has provided some ballast, albeit on a relative performance basis.
Daily we discuss the portfolios, holdings and the economic landscape that is affecting them. Although it may seem like now is the time to be making changes these changes need to be made after careful research and consideration leaving emotion out of the equation entirely.
1 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220921.pdf
4 https://www.crfb.org/blogs/cbo-scores-ira-238-billion-deficit-reduction
5 EU promises ‘emergency intervention’ to rein in energy prices pro– POLITICO
6 https://ec.europa.eu/commission/presscorner/detail/en/QANDA_22_5490
8 https://tradingeconomics.com/china/consumer-confidence
11 https://www.ft.com/content/06962055-6b3d-4712-814f-acea3cb9e082
13 https://www.bankofengland.co.uk/news/2022/september/bank-of-england-announces-gilt-market-operation