Within equity markets, growth companies have continued to bear the brunt of the downturn with significant valuation compression and several high-profile profit warnings. Over in the US the S&P 500, which has a bias to growth stocks, has detracted 23% year to date and the technology dominated Nasdaq index has seen a drawdown of 31% over the same period. Over a period where the price of oil has broken $120 dollars a barrel, commodities, and energy in particular have been the best performing areas. This has also been reflected in strong equity returns for Latin American markets. A larger weighting to the energy sector and exposure to ‘old economy’ sectors have continued to cushion the blow for UK equities, with the FTSE 100 down only 4% year to date. Performance across property and wider alternatives has been mixed, with assets offering superior inflation linkage holding up better. Meanwhile, bond markets have offered limited protection and have had their worst start to a year in decades.
Russia’s invasion of Ukraine in late February was an internationally condemned act of aggression and the escalation of the conflict surprised many. Primarily, this is a grave humanitarian crisis, but we have also seen the conflict feed through to markets. The invasion and sanctions on Russia are hitting economies worldwide, with emerging markets and developing countries in Europe and Central Asia particularly vulnerable. Russia is a key exporter of many of the most important raw materials and the invasion has pushed energy and commodity prices to extreme levels, amplifying inflation pressures, supply chain disruption and risks to global growth.
As we have progressed through the year it has become clear that this period of inflation is not a short-term phenomenon as many investors and central banks had predicted. The Russia-Ukraine conflict undoubtedly put upward pressure on prices that was already running hot, but it is difficult to untangle and assess the more widely discussed supply side issues with other secular trends. A strong case can be made that central banks printed too much money in response to Covid-19, a large amount of which was put into consumers hands. This was then spent and to a greater extent was used to pay down credit. We have now seen credit pick back up, allowing for more demand driven inflation alongside the ongoing supply chain issues. This leaves many economies in a position where there is too much money chasing after too few goods.
The US Federal Reserve (The Fed), which tends to set the tone for global central banks, has been forced to become more proactive in trying to bring down prices. Despite an aggressive rhetoric, inflation remains at 8.6% (or 6.6% above target) and the federal funds rate at 1.75%. Further imminent hikes are expected with a forecasted terminal rate of 3.25%-3.5% by the end of the year, however there is growing scepticism on whether this will be enough to tame price levels. In summary, The Fed is aiming for a “soft landing” and is walking a tight rope between trimming demand enough to take the edge off inflation without resulting in a recession. Soft landings are historically uncommon and the fact that inflation is significantly above target combined with the large amount of debt in the system makes this task even more difficult.
Following suit, the Bank of England (BOE) and The European Central Bank (ECB) are also in the process of tightening monetary policy. Over the last few months, the BOE has increased its base interest rates from 0.25% to 1.25% after the U.K.'s annual inflation hit a 30-year high of 7% in March, prior to a new high of 9% in April. The ECB recently stated that it will raise its key interest rates for the first time in 11 years in July by 0.25%, with further increases planned for later in the year. Arguably, as a monetary union without a fiscal union, the ECB has the most difficult job of all.
A crucial factor for companies in this new environment will be the ability to keep profit margins intact or growing despite elevated inflation and slowing economic growth. Strong brands and innovative companies with few direct competitors are likely to be better placed. Furthermore, we may continue to see changes in sector leadership with further rotations from growth into value sectors which are generally deemed to be less vulnerable to rising rates. The valuation gap between growth and value stocks remains historically wide and is most pronounced within US equities. Real assets should also be well placed if current trends continue.
There are very few historical analogues that closely resemble current market conditions, and we have not seen a decoupling between inflation and interest rates on this scale since the 1940s. With this in mind, it becomes ever more important for investors to be wary of recency bias and cautious of relying too heavily on assumptions made from data over recent years. The last few decades have generally seen a backdrop of decreasing interest rates and low inflation and it would be prudent to be open to the possibility that the winners and losers of the next decade may look vastly different across asset classes and style factors. Market turbulence does have the benefit of presenting opportunities for active managers and a diversified portfolio can help to reduce the impact of volatility on long-term performance.
The value of an investment and the income from it can fall as well as rise, and investors may not receive back the amount they invest. Past performance is not a guide to the future.