Quarterly Investment Update

One of the largest fiscal and monetary experiments ended in tears in 2022. It was nice while it lasted, indeed, but investors now face new realities and challenges and as a result a completely different investment landscape. The extreme set of policies – zero interest rates and deficits of unprecedented magnitude – invited a new guest to the party who was thought to be dead : inflation. It looks like market participants treat inflation and interest rates as a straight line, i.e. hike rates, solve the problem, back to basics – calm and predictable markets. This framework however is only one possible scenario out of many, as the many twists and turns – geopolitics, quantitative tightening, energy transition, government/corporate/private obligations – are making possible a set of outcomes that are thought to be beyond any boundary, as investors assume that they have ‘’seen everything’’.

Bond losses exceeded 10% in 2022 and this drove up the yield on all assets – financial and real. The S&P 500 declined 18.1% in 2022, with value and defensive sectors like energy, utilities and consumer staples outperforming growth and long duration sectors like information technology, consumer discretionary and real estate. The Federal Reserve raised interest rates by 4.25% in 2022 and communicated in multiple press conferences its intention to slow down the economy and wages in order to restore price stability. While the Fed and many investors are focused on the rapid increase in the price of money, another important variable, the quantity of money has fallen this year as the world’s central bank has engaged in so called ‘’quantitative tightening’’ and as a result the liquidity in the financial system has fallen dramatically. As dollars became more scarce, the demand for dollar financing spiked and the greenback rose to a multi-decade high, creating a vicious cycle of increased financing needs, illiquidity and dollar appreciation.

The last ECB meeting in 2022 was probably the most iconic one since the Mario Draghi era. Just as Draghi committed to save the euro in 2013, Christine Lagarde committed to kill inflation by raising rates “significantly” and by showing “determination and resilience” and not “slowing down”. Moreover, the ECB announced EUR 15bn/month of quantitative tightening starting in Q12023. Given that the central bank was buying all of the government bond issuance for almost 10 years, the need for private investors to absorb these amounts going forward is something unprecedented but the ECB looks determined to try it. The European economy has held up well in 2022 given the massive challenges it faces as unemployment reached an all-time low and economic activity held up relatively well.

Similar to 1992, UK financial markets had a black September in 2022. The UK learned that the era of cheap money and complacency is over the hard way, as the market dumped the pound and UK government bonds following Liz Truss’ government attempt to subsidize energy bills and provide unfunded tax cuts at a time of high inflation and high budged and trade deficits. The intensity of the selling caused chaos and the BoE had to intervene as financial stability was at stake. The pound reached an intraday low of 1.03$ while the yield on long term bonds exceeded 5%. The BoE restored the stability in the system and UK assets rebounded but the slowing economy, falling housing prices, and large financing needs are massive challenges for the policy makers in 2023.

The Swedish housing market is in the spotlight as the 17% decline from the March peak combined with the high share of household debt with variable interest rate and the high debt to income ratio suggest that the economy may be heading for more trouble. 64% of Swedes don’t have long-term fixed-rate mortgages and so the pass-through of the Riksbank’s rate hikes is fast and painful. Although 3rd quarter GDP figures were surprisingly strong, going forward it is likely that rising rates and high energy prices will ultimately translate to a weaker labour market and squeeze household purchasing power.

China’s economy and markets suffered in 2022 from the double whammy of the zero-Covid policy and the property crisis. CSI 300 fell 19.8% in 2022 as the country’s economic and financial problems together with a push to redistribute income and wealth undermine long term productivity growth, while the decoupling from the US and the associated disentangling of supply chains and investment flows is only making things worse. Investors hope that the government and importantly the PBoC will support the economy in which case, given China’s huge economic footprint, it will have an impact over the world economy’s business cycle.