Quarterly Investment Update

The market has spent much of the second quarter worrying about inflation and what Central Banks’ terminal rates will be. As a result the relatively expensive and most “growthy” corners of the market have really felt the heat. The SP 500 fell 16% during the quarter with technology stocks selling-off sharply. The Eurostoxx 50 returned -9.4% while Emerging Market Equities posted a decline in excess of 11%. The hawkish stance of Central Banks led to a historic bond market sell-off, as yields on the US 10 year government debt rose to 3.2% vs 2.3% at the beginning of the quarter, while the most dramatic moves took place in Europe’s debt markets with German 10 year yields spiking to 1.5% from 0.55% in the first quarter. Worryingly, borrowing costs of periphery countries like Italy, Greece and Spain rose more than 1.1% in just 3 months, essentially entering a “danger zone” given how heavily indebted these countries are. The only bright spot in financial markets in Q2 was the CSI 300, rising 7.3% during the quarter, as Chinese officials signalled their determination to support the economy.

The Federal Reserve hiked interest rates twice during the quarter, including a 0.75% rate rise in early June. With inflation running at 8.6% as of May, the highest in 40 years, the Fed has no choice but to hike aggressively. The interest rate outlook is already starting to affect consumers, with retail sales falling 0.3% in May, the first month-on-month decline this year. Moreover, existing home sales dropped in May, marking the fourth consecutive month of declines as high prices and sharply higher borrowing costs are pushing buyers out of the market. Investors are divided on whether this is the start of a stagflationary environment for the US economy or whether the Federal Reserve will manage to engineer a soft landing. On the one hand, some investors believe that inflation expectations are well anchored and that corporate and household balance sheets are strong enough to weather the storm. On the other hand, others believe that falling consumer confidence and the growing refinancing needs of the government will cause a squeeze and ultimately a recession.

The European Central Bank is probably facing its biggest challenge yet as the 8.6% inflation rate recorded in June is not its only problem; the Central Bank vowed to contain the bond market “fragmentation risk”, meaning that it committed in shrinking the borrowing costs of the most vulnerable countries like Greece and Italy, while raising interest rates. Sovereign spread targeting by a Central Bank has never been done before and the possible effects of such an attempt are unknown. After the ECB signalled that it was ready to raise interest rates by 0.5% in September if needed, following a planned 0.25% rise in July, Italian, Portuguese and Spanish borrowing costs jumped to multi-year highs, prompting the ECB to signal a potential “anti-fragmentation” tool. Meanwhile, eurozone inflation expectations among consumers are rising as the war in Ukraine creates unprecedent price pressures.

The upward pressure on commodity prices and the strain in global supply chains is raising concerns that the UK economy will soon enter a recession. Retail sales contracted in May and consumer confidence fell to an all-time low. With CPI inflation at 9.1% in May, up from 9% in April, the BoE has to manage the growth-inflation trade-off. Interest rates are currently at 1.25% following the 0.25% hike in June, while many Monetary Policy Committee members and market participants are calling for a more aggressive hiking path.

The Swedish economy contracted 0.8% in Q1, more than initially reported, as export growth was sluggish. Finance Minister Mikael Damberg said "We can expect tougher times ahead" as the economy is feeling the heat from the war in Ukraine and the persistently high inflation. The Riksbank raised interest rates from 0% to 0.75% as inflation rose to the highest level since the early 1990s. The world’s oldest central bank signalled further rate hikes this year and a faster pace of balance sheet reduction.

China’s economy is slowly improving as Covid restrictions are gradually eased and activity starts to pick up. Small business confidence is rising after months of contraction, industrial production exceeded expectations in May and Xi Jinping vowed to “strengthen macro-policy adjustment and adopt more effective measures to strive to meet the social and economic development targets for 2022 and minimize the impacts of Covid-19”. There are many challenges for achieving the 5.5% full year GDP growth target, as this implies that growth will need to surpass 7% in the second half of the year. The largest problems lie in housing which continues to be a drag on the economy, while the complex international environment and geopolitical tensions create further uncertainties.