14 Jul 2022
For investors today the oft used words ‘living in unprecedented times’ ring truer than for many years. The world has suffered its first pandemic in 100 years, the first invasion in Europe in 75 years and the first serious bout of inflation in 40 years. In practical terms, are we seeing the end of the ‘Age of Speculation’?
2022 has been the year when markets and central bankers realised current inflationary pressures were likely to persist for longer periods, with labour markets in developed economies tight post the Covid-19 pandemic. Supply chain issues not fully resolved during the pandemic have been exacerbated by the conflict in Ukraine. This has resulted in a difficult start to the year for owners of most financial assets with equities, government bonds and corporate credit all declining in value.
60/40 portfolios have clearly not worked, US Treasuries fell 10% in the first six months of the year with investment grade corporate bonds and high yield corporate debt both showing 14% declines. Gold fell marginally in US$ terms with the only winner being commodities, although these have seen a pull-back in recent weeks. Did THE end of the ‘Age of Speculation’ really come when bitcoin fell 56% in the first half of the year and stocks perceived as being more speculative such as SPACs (Special Purpose Acquisition Companies) and unprofitable technology companies lost investor confidence?
At RSMR, we are forward looking and, when we look at the key drivers of global markets, we try to look unemotionally at economic fundamentals, market valuations and sentiment.
During the second half of this year, we think the global economy is certain to see economic slowdown - something the Federal Reserve (Fed) strongly desires. We could now be in an environment where, for markets, bad news is in fact good news! Central banks have been spooked by the ease with which companies have been able to raise prices which, together with the current level of wage increases, is not compatible with 2% inflation rates.
The Fed’s belief is that labour market strength will ensure any downturn is relatively shallow compared to history. Markets have also been encouraged by the Fed’s acceptance that tough medicine is needed in the short-term, with the lesson from the 70s that ‘gradualism’ in interest rate rises does not work, now being accepted. Evidence of slowdown in the labour market is obvious in the technology sector where hiring plans at larger companies have been put on hold. Smaller, embryonic technology businesses have in many cases been forced to reduce staff numbers with a new focus on controlling costs.
Compared to April, investor sentiment has deteriorated significantly. This is often a good contrarian indicator. At RSMR, we believe investors who were smart enough to have kept some levels of cash reserve in the first half of the year should not try to be too clever as markets may well respond quickly to signs of an improvement in the inflation picture, and they could miss out on any initial recovery. We have already seen in many recent market cycles, and strongly during the pandemic, how markets front run anticipated changes in economic fundamentals at an ever earlier stage. In other words, bad news is good news.
However, we feel there are still too many imponderables to be confident in short-term outcomes and forecasting in the next few months is unlikely to be useful. Equity market valuations have certainly pulled back, and financial advisers have been having some very difficult conversations at client reviews, but any level of cheapness depends on profits being delivered. Volatility will persist and a strong rally in risk assets looks unlikely over the summer unless there are clear signs of falling inflationary pressures.
Central banks will clearly focus on inflation primarily and growth at a later stage and in this cycle, with elevated levels of inflation, any monetary and fiscal response will occur later than in previous economic downturns and may make the recovery more sluggish.
For longer term investors, especially those who have built up cash, some modest selective buying on weakness would be a prudent course of action, although over the next six months a wide range of outcomes is still possible. We suggest that investors focus on quality equities with sound fundamentals as the ‘Age of Speculation’ gradually retreats in the rear-view mirror.
Graham O’Neill, Senior Investment Consultant, RSMR
This information is for UK Professional Advisers only and should not be given to retail clients.
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