Market outlook - Q2 2022 update

Aside from the tragic loss of human life, the war in Ukraine has numerous and far-reaching consequences for financial markets. The major focus for us has been on grain, gas, and oil markets. Due to the severe sanctions placed on Russian resource exports, the already tight global supply of these commodities has accelerated since the start of the year.

This acceleration has driven the price of these commodities higher, which will result in increased input costs for producers over the upcoming months. In this situation, the producer can then either absorb these costs (which reduces profit margins and their ability to grow) or pass the additional cost onto the consumer which would increase inflation and reduce affordability. 

Communication from the Fed earlier this year continued with the narrative that inflation was transitory and that they expect it to pass as supply chains eased. Since then, supply chains have tightened further, and US inflation has accelerated. This has forced the Fed to pivot. It  now thinks inflation is a problem and has recognised the need to do whatever it takes to get it under control.

The Fed has often mentioned it needs to level out the supply/demand equation. Since the Fed has limited influence over the supply side of the economy, it must target demand destruction to achieve its goals. This ultimately means a reduction in asset prices (property, equities, venture capital etc.) is inevitable. 

As a result of their zero COVID policy, cities across China continue to be plunged into strict lockdowns as new COVID cases emerge. This has weakened Chinese demand for metals, energy, agriculture, and consumer products. These lockdowns will continue unless China pivots away from its zero COVID policy. This is difficult as the COVID-19 vaccine presently in use across China has low efficacy and wears off relatively quickly. 

Bonds have been selling off consistently since the start of the year. So far, the Bloomberg Global-Aggregate Total Return Index is down -12.44%*. The previous worst year was 1999, when the index declined by -5.17%. This sell-off has meant coupon rates on these bonds have appreciated swiftly. Not only are there implications for companies and their profit levels, but investor positioning is also having to unwind years of bond allocations due to this new environment. Although the move seen so far is statistically significant, the lack of capitulation or acceleration tells us it is far from over.

In our view, the Fed has started to increase rates far too slowly. It has meant that inflation has run out of control, and they are now in a pickle. In the US, affordability is one of the largest political sticking points, and (1970’s), raising interest rates is not a solution that has a short-term impact on inflation.

It took the Fed two attempts to control inflation in the 1970s. The first time between 1973 and 1975, CPI rose from 4% to 12%, while the Federal Funds rate rose from ~3% to ~13.5%. The second occasion was between 1977 and 1980 when inflation rose from 6% to 14%. This time the Fed was forced to raise rates from ~4% to ~20%.

Inflation only returned to below 6% approximately 10 years after they first started to increase rates. On both occasions, policy responses caused recessions and significant volatility in financial markets, as investors rapidly repriced growth outlooks.

Through the above assessment process, we can see that many of these events have impacted both growth and inflation negatively. One of our core themes for 2022 was ‘inflation’. We have now experienced numerous extraneous events this year that will make inflation even more difficult to control. Because of this, we have adjusted our market outlook for the next 12 months.

Previously, we were overweight equities, underweight fixed income, overweight commodities, and neutral weight to currencies.

After these events, we have now pivoted to be underweight equities, underweight fixed income, overweight commodities, and have a neutral weight to currencies.

The original version of this document can be found here.

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