Your second quarter round up from the Holden & Partners’ investment team
At the half-way point of the year our investment team takes you on a tour around the globe focusing in on some of the key factors shaping financial markets right now and their impact on the performance of investments.
US interest rate increases and a painful quarter for US stocks, but the US banks passed the Federal Reserve’s annual stress test.
Asia/EM China’s zero Covid strategy continues to impact the region whilst elsewhere equity indices fell under the weight of the strengthening US dollar.
Europe the energy crisis and reliance on Russian fuel continues to loom large and the Eurozone looks set to face its first rate rise in over a decade.
UK experiencing a period of stagflation where inflation is high and economic growth is low.
Alternatives experience mixed performance across the sector.
Sustainability world leaders continue to balance climate change commitments with energy needs in the ongoing crisis.
Performance there has been virtually no asset class or type of investment that has not struggled over Q2, As always, we invest for the long term and we are continuously monitoring our portfolios and analysing whether or not changes can be made to enhance returns and reduce risk.
US
As with many Central Banks across the world, the Federal Reserve faces a difficult trade-off between growth and inflation. Their intent was made clear in Q2 as they raised the benchmark interest rate 0.75% in June – the most aggressive hike since 1994 – signalling that they are willing to dampen growth to tame inflation. Comments from members of the FOMC (Federal Open Market Committee) suggest rate hikes in the coming months will follow a similar path, with another 0.50-0.75% increase looking likely in July, and perhaps the same for subsequent meetings.1
We have seen factory orders and manufacturing fall lower than expectations for June,2 and consumer confidence hitting a 16-month low in the same month.3 With this in mind, it is becoming increasingly difficult to see how a ‘soft landing’ will be achieved.
It was a painful quarter for US stocks with the S&P 500 falling 16.49%,4 contributing to the worst first-half performance the index has seen since 1970. Big tech continues to show large levels of volatility, with earnings expectations at risk of being revised down amongst talk of a potential recession. The tech-heavy Nasdaq fell 22.5% in Q2.5
On a more positive note, US banks passed the Fed’s annual stress test; a ‘health check’ looking at their ability to withstand unfavourable market conditions, such as a market crash or a recession.6 This should help to avoid a more devastating recession, such as 2008-09.
Looking at US Treasuries, the 2-year yield briefly exceeded the 10-year yield for the first time since April – historically seen as a key predictor of a recession – as US consumer inflation reached 8.6%, its highest level in over 4 decades7 (see our Q1 update for a brief description on yield curves).
Asia/EM
Moving on to Asia, Chinese equities performed a U-turn within the quarter, initially pulling broader emerging market equity indices down as authorities locked down cities including Shanghai to curb renewed Covid virus flareups, to outperforming in the latter part of the quarter as sentiment returned to the region, overall the Shanghai Composite Index returned 4.5% over the quarter.8
Inflation figures in China are lesser than neighbouring Asian countries due to the price slumps 12 months prior, whilst elsewhere inflation figures rise. Prolonged shutdowns stoked concerns of supply chain backlogs, which have large global implications on key industries such as auto manufacturing and semiconductor chip making. Despite the optimism that caused Chinese equity indices to almost rally into bull market territory in June, mass Covid testing continues to take place, and given the strict commitment to the zero Covid political ambition, fears remain that world’s second largest economy will miss GDP growth targets if lockdowns continue throughout the year.
Elsewhere in Asia, equity indices broadly fell under the weight of a strengthening US dollar and weakening economic data. India’s trade deficit widened last month as high oil and gold prices pushed import costs higher. The depreciating Rupee and higher energy prices are stoking inflation and pushing the trade balance further into the red.
In Japan, core inflation rose above target for the first time since 2015, for two consecutive months in a row.9 Despite the figure being much lower than global peers, Governor Kuroda maintained his stance that Japan’s economy requires ultra-low interest rates, putting Japan in stark contrast to Central Banks around the word. The Yen continued to weaken against a basket of major world currencies over the quarter, causing investors to question the currency’s safe haven status, given the nation’s dependence on imported energy that is often priced in US dollars.
Europe
When wars drag on for months and years, it is easy to become desensitised to the news, or even forget that the conflict still exists. However, the atrocities in Ukraine are still all too real for its citizens.
The energy crisis continues to worsen with gas supplies falling. Russian gas giant, Gazprom, cut off supplies to several countries after payments were failed to be made in Roubles. As winter approaches, large shortages threaten Germany and their industries. Economy Minister Robert Habeck warned of a ‘Lehman-like effect’ in the energy sector, as the country raised its risk level to the second highest phase.10 To offset these shortages, a temporary reversion back to coal power – one of the largest contributors to greenhouse gas emissions – is looking increasingly likely.
From July, the European Central Bank (ECB) decided to end net asset purchases under its asset purchase programme, along with the intention to raise the key rates by 25 basis points at this month’s policy meeting. This will be the first rate rise the Eurozone has seen in over a decade. As with many other Central Banks, these increases are likely to be sustained as the year goes on.11
UK
The commodity-heavy FTSE 100 started the quarter resiliently before declining in June which was led in part due to a large fall in the price of metals and oil. Overall, the FTSE 100 fell 4.05% in Q2 bringing its year-to-date return to -4.48% as blue-chip stocks feel the pain of growing recession fears and tighter monetary policy.12
The more domestically focused FTSE 250 continues to perform badly highlighting the bleak outlook investors have for the UK economy and thus company earnings. The index fell 12.4% in the quarter bringing its year-to-date return to -21.89%. The pound continues to weaken against other developed market currencies most notably the US Dollar and the Euro.
The pound finished the quarter down 7.1% against the US Dollar to settle at $1.2132 while against the Euro it fell 2.0% to finish at €1.1610. A weak pound makes it more expensive for UK households and businesses to import goods and services and with the economy experiencing large supply shocks resulting in elevated global energy and tradeable goods prices, but it does provide the benefit of increasing foreign revenue for UK businesses with global revenue streams.
Economic data released this quarter points to a slowing growth outlook for the UK economy. The composite purchasing managers index (PMI), which is considered a leading indicator of the business conditions in an economy, has fallen from 58.2 to 53.1 where a figure below 50 represents a contraction. Moreover, consumer confidence has fallen to a level not seen before fuelling fears of a recession.13
The main driving force behind this drop in consumer confidence is the cost-of-living crisis consumers are experiencing. The consumer price index rose 9% in April on a year-over-year basis and is expected to rise to over 11% in October following an additional large increase in the Ofgem price cap.14 Coupled with the Bank of England’s prediction that UK GDP will stagnate this quarter,15 and we can see the UK economy is experiencing stagflation, a situation in which inflation is high and economic growth is low. This puts the Bank of England in a tough position as it must tackle the highest inflation we’ve seen in four decades with the very mechanism (raising interest rates) that stunts GDP growth.
The Bank of England has raised its main Bank Rate by 0.25% in both the May and June meetings this quarter, bringing the current bank rate to 1.25%. The central bank also provided forward guidance in signalling to the market projections for a Bank Rate that rises to around 2.5% by mid-2023.16 The rise in the Bank Rate has led to a rise in bond yields along the yield curve as higher inflation expectations reduce real expected future cash flows resulting in falling demand and thus price. Bond yields move inversely to price.
Finally, the shining light of the UK economy has been the labour market in the past few months where we have seen the unemployment rate in the three months to March fall to 3.7%, the lowest level since 1974. Unfortunately, the jobless rate unexpectedly edged higher to 3.8% in the three months to April with employment falling by 254,000 in April alone hinting the job market may be beginning to cool.17
Also, equally worrying for the central bank and government is the downward trend in labour productivity, as measured by output per hour, since productivity is a driver of long-term growth.18
Alternatives
Global listed property shares suffered as inflation rose and interest rate cycles hastened, which whilst often linked to rental growth also has the negative effect of reducing access to funding. Logistics, a sub-sector previously lauded for its growth potential and lucrative returns in a period of largely negative office and retail returns, underperformed as Amazon shook growth forecasts when the company stated they are no longer chasing physical capacity.
The Renewable Infrastructure Group once again finished the quarter unscathed, managing a positive 1.5% positive return over the quarter. Conventional energy sources such as natural gas and oil appreciated throughout a period of high volatility in the second quarter, led once again by a mix of supply and demand concerns as fears of an impending recession in the US grew. Oil prices remain over 40% higher than the start of the year, driven by a global risk-on environment and US dollar, which oil is most commonly priced in.
Gold prices fell in USD, but our ETF holdings (denominated in GBP) were boosted into positive territory by currency movements, due to the weakening Pound against the US Dollar. Overall the metal proved more resilient than other precious metals as investors weighed the potential reduced industrial demand for other metals such as silver, platinum and palladium in the event of a recession.
Sustainability
Germany hosted the 48th G7 summit, a summit bringing together seven of the world’s advanced economies to discuss solutions to major global issues including climate change, at the end of June. Major discussions were held on how to bring down the cost of fuel, including a suggestion to change market rules so that lower cost wind and solar power impact wholesale prices. However, Germany urged the G7 to allow increased investment in gas in a bid to move away from overreliance on volatile Russian supply. This came after a commitment was made by the G7 countries earlier this year to end international public finance for gas projects by the end of 2022 but could be deemed necessary given the current crisis.19
Greenwashing
As industry bodies attempt to crack down on greenwashing, a term used to describe unsubstantiated claims that a fund is doing more in terms of ESG and sustainability than it is, the FCA has suggested it is bringing out new regulation to implement new sustainable disclosure requirements (SDR).20 This is expected to follow the likes of the EU’s Sustainable Finance Disclosure Regulation (SFDR), which sets criteria for sustainable funds to be labelled as either Article 9, where sustainability is a main priority of the fund, or Article 8, where a fund promotes sustainable outcomes, creating more transparency in the industry. Additionally, the US’s Securities Exchange Commission (SEC) has announced the desire to bring out new regulation requiring funds to disclosure emissions related to their holdings. There has been backlash from the Investment Company Institute, claiming that this policy will be unworkable.21
Tesla
Tesla has been widely debated over whether it can be considered an ESG stock and whether it should be included in ESG indexes. It was recently removed from the S&P 500 ESG index after being sighted as falling short on the ‘S’ and ‘G’ aspects despite having a strong ‘E’ prospect as a leader in the EV market. Investors are mostly concerned with Elon Musk’s unconventional management and impulsive behaviour as CEO, as well as poor disclosure on workforce and labour conditions.22 Whilst many argue that the removal of Tesla from this index was a sound decision, some question the existence of other stocks in the index. For example, Exxon Mobil Corp., an American oil and gas company, has poor climate change outcomes but has been seen to be improving from an ESG standpoint compared to its peers and has therefore been included.23 Debates such as these highlight the nuanced nature of the industry and importance of growing industry standards.
Net zero
Finally, the industry still has a long way to go to create a net-zero investment future, with a recent report stating that 30 of the biggest asset managers have at least $550 billion invested in fossil fuel companies that have expansion plans and continue to provide money to these companies, making it difficult for them to support to a net-zero emissions target. Other concerns arose when HSBC Head of Responsible Investing, Stuart Kirk, gave a presentation earlier this quarter expressing why investors need not worry about climate risk, as he believed it was “getting a little out of hand”. HSBC were quick to suspend Kirk following his comments and launch an investigation.24
Performance and our portfolios
The situation that we have seen in both equity and bond markets has continued over the second quarter. There has been virtually no asset class or type of investment that has not struggled over Q2 but also year-to-date. The only sector that has shown positive absolute performance year to date are the hard commodities sectors such as oil, gas and mining. These are areas that we have virtually zero exposure to in our sustainable portfolios and minimal exposure to in our conventional portfolios.
In our portfolios we have seen that our weighting to infrastructure has provided some ballast albeit on a relative basis. As well as this our decision to move into shorter duration bonds (bonds less susceptible to interest rate hikes) has provided a relative pay off in the portfolio when compared to longer duration bonds.
As central banks continue to raise interest rates in order to curb rampant inflation, we find ourselves in an environment where equities, particularly those that are more ‘growthy’ and longer duration bonds (bonds more susceptible to rising interest rates) are both moving down together. This situation is very rare, but we believe that normality is likely to resume as returns and style reverts to the mean as we see from history. The big question here is when which is impossible to predict.
Whilst not a comfortable situation to be experiencing it is always worth reminding ourselves that we are long term investors and investing for the long term enables investors and portfolios to weather the type of short-term volatility that is being experienced now.
As always, we are continuously monitoring our portfolios and analysing whether or not changes can be made to enhance returns and reduce risk. We have our quarterly investment committee in the coming weeks which will bring to light any changes that we might look to make. Of course, any changes that will be made will be communicated to you with a full rationale as to why they have been changed.
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2 https://cdn.ihsmarkit.com/www/pdf/4471209_4471200_0.1.pdf
4 FE Analytics Data – S&P 500 TR (USD) from 01/04/2022 – 30/06/2022
5 FE Analytics Date – Nasdaq Composite TR (USD) from 01/04/2022 – 30/06/2022
7 https://www.wsj.com/livecoverage/stock-market-news-inflation-consumer-price-index-may-2022
8 https://www.bloomberg.com/quote/SHCOMP:IND?sref=1LVTCemH
9 https://tradingeconomics.com/japan/core-inflation-rate
11 https://www.ecb.europa.eu/press/pr/date/2022/html/ecb.mp220609~122666c272.en.html
12 https://www.investing.com/indices/investing.com-uk-100-historical-data
17 https://www.reuters.com/markets/europe/uk-unemployment-rate-rises-38-three-months-april-2022-06-14/