Strategy
Soft Landing Getting Harder
So far 2022 has not been a welcoming year for investors. Financial markets have had to contend with slowing growth, surging inflation, impending monetary tightening, lockdowns in China, a war in Europe and soaring energy prices.
Coming into the year, a number of these factors were expected: we knew growth would slow after the breakneck pace of last year, we knew inflationary pressures were becoming more broad-based and we knew that central banks would tighten monetary policy. The issue is that all of these variables have had a more negative impact than anticipated and the tricky balancing act of removing policy support to slow inflation without causing a recession became more challenging after Russia’s invasion of Ukraine and renewed lockdowns in China.
This combination of events has proved particularly difficult for financial markets, hitting both bonds and equities. For much of the past 22 years since China joined the World Trade Organization, the world has had a disinflationary bias; lots of new low-wage, productive workers meant the world could produce more and reduce costs. This backdrop was very supportive of financial markets as it meant that the correlation between bonds and equities was negative; when one asset class was performing poorly, the other asset class was usually performing well. As such, a portfolio of bonds and equities produced very strong risk adjusted returns.
The return of inflation has flipped this relationship and both asset classes have suffered this year. Commodities, on the other hand, have proven to be good diversifiers with the broad index up around 31% through the first four months of the year. However, even within commodities there has been a lot of dispersion. Commodities more exposed to disruption from the Russia-Ukraine conflict, like oil, natural gas and agricultural commodities, are rising but others more exposed to global growth are weaker. Gold performed very well as a diversifier around the time of the invasion but more recently has also struggled as real yields and the US dollar have risen.
The primary question now is whether central banks engineer a “soft landing” i.e. increase interest rates enough to bring inflation down but without causing economic growth to slow so much that the economy tips into recession. In March, Federal Reserve Chair Powell argued that the Fed had managed to achieve a soft landing in 1965, 1984 and 1994 as it was reacting to “perceived overheating”. The challenge today is not perceived overheating but actual overheating, so the Fed is playing catch up. Furthermore, in the three soft-landing cases US inflation and wage growth were not accelerating the way they are doing now. The Fed is therefore facing a more difficult challenge than those three prior cases and the risk of policy mistakes is elevated.
If the Fed is to achieve its aim then it is going to need some help from productivity growth. The good news is that the pandemic crisis forced many businesses to innovate, particularly in their use of technology, so they should see the longer-term benefits of this. Furthermore, the rise in wages provides an incentive to invest in cost saving technology, which should also bring future benefits. One major challenge is that deglobalisation means there is a risk that the supply side of the economy won’t ride to the rescue and bring down inflation. With risks mounting, we took additional steps in April to increase the defensiveness within Equity allocations, by increasing our exposure to Health Care and reducing exposure to the Financials sector.
Equities
Elusive Safe Havens
Investors struggled to find havens in April. Financial markets sold off on mounting fears of an economic slowdown and the Federal Reserve prioritised fighting inflation over supporting economic growth. The global equity market rout resumed, declining -8.3% in April, with a broad sell-off across both Developed and Emerging Markets, and across almost all sectors (the defensive Consumer Staples sector eked out a slightly positive return of <1%). US stocks, the only major market with positive returns in March, led major global equity indices lower with a -9.1% drop. Japanese stocks fell -8.8%, underperforming the global equity market and diverging from their historically inverse relationship with the yen, which depreciated in April. Emerging Markets declined -5.1%, benefiting from a relatively better -3.6% return in Chinese stocks following a rally at the end of the month.
The uptick in Chinese stocks at the end of the month came after authorities provided assurance they would support the economic recovery and boost infrastructure spending, and signalled a willingness to resolve regulatory issues in the technology sector. Fresh Covid outbreaks in China, and the stringent policies applied to contain them, had spooked investors who feared shutdowns could further disrupt global supply chains, fuelling declines in China’s markets and also those of developing nations that rely heavily on Chinese trade. These pledges were well received by the market, although authorities didn’t abandon the stern Covid Zero policy that had sparked the panic in the first place. China’s 5.5% 2022 growth target is now in question, and in turn could lower growth in countries exporting to China.
Russia’s apparent decision to engage in a war of attrition in Ukraine is another supply-chain concern as shortages of some raw materials and food will likely be more persistent. Higher inflation for a longer period of time could provide further support for the Federal Reserve’s plan for aggressive rate hikes, weighing on stocks whose valuations are seen as dependent on future growth.
Perceived as safe havens (even beneficiaries) from stay-at-home pandemic lockdowns, US megacap technology stocks appear to have lost some lustre as western societies reopen, exacerbated by supply-chain issues. US market indices have benefitted for years from these stocks’ outperformance and growing index weights have seen them become an increasing drag this year. Six tech companies, namely Apple, Amazon, Netflix, Alphabet (Google’s parent company), Microsoft and Meta (Facebook’s parent company), contributed more to the S&P 500’s returns than their weightings would imply. Notably, these six stocks pushed the market higher after markets fell in 2015 and 2018 but have contributed roughly half of the S&P500’s drop in 2022, despite making up less than a quarter of its weight.
In April, the S&P500 equal weight index declined -6.4%, in comparison to Meta’s -9.8%, Apple’s -9.7%, Microsoft’s -9.9%, Alphabet’s -17.7%, Amazon’s -23.8%, and Netflix’s -49.2%. Headwinds have been apparent in weaker-than-expected quarterly results, and downward adjustments in analysts’ forecasts. Amazon reported slowing e-commerce growth and disappointing forecasts, Alphabet’s first-quarter revenues fell short of expectations, Apple warned supply constraints would hurt sales, and Netflix had a shockingly weak subscriber outlook. Stock selection therefore remains very important in Equity markets.