Few investors in equities or bonds will miss the third quarter, one that went from a period of merriment in early July, on hopes of an end to U.S interest rate hikes this autumn, to end late September in distress.
The change in sentiment reflected increasingly strident warnings from central banks, led by the U.S. Fed, that interest rates will have to go higher and be higher for longer than anticipated. This is to combat stubborn core inflationary pressures and tight labour markets in most developed economies.
The prospects of significant interest rate hikes continuing into next year, along with high energy prices, have increased the risk of recession in the major economies. It is likely to lead to downgrades to corporate earnings forecasts, which -some analysts argue- investors are unprepared for.
Global developed stocks fell approximately 6% in dollar terms over the quarter, and global emerging market stocks were down 16% (source: MSCI). Some of these losses reflected the continuing rise of the U.S dollar, and the same indices are down about a third less when expressed in local currency terms.
In sterling terms, developed stocks rose by 2% over the quarter…this reflects an unhappy quarter for the pound that flirted with parity against the dollar in late September as global investors sold sterling-denominated assets in large quantities.
The Barclays Global Aggregate index of investment grade bonds is down 7% in dollar terms.
The U.K. government’s contribution to instability
Bonds were already sliding in August and September on the poor inflation and interest rate outlook. The aggravating factor for the fixed income sell-off in September was a poorly thought-out budget from the U.K. government. The new chancellor of the exchequer, Kwasi Kwarteng, offered tax cuts to be paid for by borrowing to boost growth.
Critics claim this will boost inflation, given that U.K unemployment is at the lowest since 1974, and lead to higher imports that will exacerbate a large current account deficit. His refusal to allow an independent analysis of his budget by the Office of Budget Responsibility (OBR), a statutory body set up to do precisely that, added to speculation that it was a political-driven budget rather than one that would stand up economically.
The response from the gilt market was severe. The 10yr gilt yield rose from 2.9% at the start of the month to 4.5% on the 27th, before the Bank of England announced an unlimited purchase program of long-dated gilts to stabilise the yield, which ended the month at 4.1%. Sterling fell as overseas holders sold.
A part of the heavy selling on the gilt market also reflected pension funds’ hedging strategies, by which a loop-of-doom set in. Many large pension funds had taken on hedges against a fall in gilt prices. When the prices fell, the investment banks on the other side of the trade demanded more cash to make up the collateral (a ‘margin call’). Since a pension fund’s most liquid asset is often a government bond, they sold gilts to raise the cash. The selling led to weaker gilt prices, which led to fresh demands from investment banks for more margin cover, which only ended with the Bank of England intervention described above.
The volatility of the gilt market contributed to wobbles on Treasuries, German bonds and other major bond markets. The fact that these eased on news of Bank of England intervention demonstrates how fickle investor sentiment is in general towards fixed income and equities.
The U.S dollar enjoyed its fifth straight quarter of gains (on a trade-weighted basis). This reflects the aggressive stance of the Fed in raising interest rates and reducing the money supply through quantitative tightening. While helping (a little) to keep domestic inflation down, ‘King Dollar’, as it has become known, is aggravating inflation elsewhere as much of the world’s traded food and energy is priced in dollars.
The immediate outlook for global financial assets is difficult. For stock market and corporate debt investors, it is a question of how much damage to corporate earnings will come from rising interest rates and a slowdown in global GDP growth. Much will depend on how stubborn core inflation is over the coming months.
For investors in government bonds, already weary of the duration and extent of the global inflation problem, the U.K’s badly handled budget brought about a new set of fears. Are governments going to run a fiscal policy that contradicts the policies of their central banks? Is the U.S. doing so under Biden?
A ballooning supply of bonds, with a lack of coordination on policy to reduce inflation between institutions of government, would call for higher yields (and so weaker prices) to compensate investors.
A key date for investors will be October 14, when the Bank of England is due to end its gilt stability program. If the U.K. government has not shown any remorse and offered an explanation as to how it will fund the increase in public spending, gilt and global bond yields may well rise again. In a tussle between the current U.K. government and the international bond market, there can surely only be one winner.
Financial history suggests that investors in a multi-asset portfolio that is focused on quality stocks and other assets should sit still. Too often, we see markets snap back, with nervous investors who sold during bearish periods of sentiment left holding cash and missing out on the recovery.
The 60/40 model, which many multi-asset portfolios are built around, has taken a battering this year. Both equities and bonds have fallen on account of the stagflation taking place at a macroeconomic level. But unlike the 1970s, the last time we saw stagflation, this bout is likely to be shorter and less painful.
Why? Because central banks are independent of political meddling, allowing them to respond quicker to inflation. Second, labour markets are more flexible, allowing changes in interest rates to feed through faster into employment rates and household spending.
Once inflation is conquered, hopefully by mid-summer of 2023, interest rates will start falling, and a fresh economic cycle will be able to start.
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