The third quarter was characterised by rising inflation expectations and tighter monetary policy (i.e., higher interest rates across major central economies with few exceptions. The US continued to tighten policy driving the US dollar to extreme levels against most currencies including the pound. The focus on weakening growth and a rising probability of a recession across major economies has knocked investor confidence and inflicted further losses across most asset classes.
The bear market rally we witnessed during July and the early phase of August now seems a distant memory. This was amid growing hopes that central banks would soon start to reduce the pace of higher interest rates to tackle inflation. However, the rally ended abruptly following hawkish comments from the US Federal Reserve (Fed), that they would continue to raise rates until inflation fell back regardless of its impact on the global economy. The language served as a stark reminder that while US inflation may have peaked, it is not falling away quickly and has broadened out across the wider economy.
Ultimately, the resulting reappraisal of the path for interest rates weighed heavily on US assets, both stocks and bonds, and the impact was felt globally with equities across developed and emerging markets losing ground. The US saw its worst day of losses since June 2020. The US has now seen nine equity market sessions this year when the market has been down by over 3%, this has only been beaten three times in the past 70 years, 2008, 2009 and 2020.
In the UK, Liz Truss was appointed Prime Minister and made clear her immediate focus was on the cost-of-living crisis. It was not long before the fiscal loosening started as the Prime Minister announced an energy price guarantee for the next two years for households, limiting the average household bill to £2500. By capping energy prices, it was designed to lower the peak of inflation, but the anticipated stronger growth may actually force the Bank of England to raise rates faster to keep inflation in check.
Away from the core story of inflation and central banks, the focus also remained on developments around the Ukraine-Russia conflict and its immediate impact on global energy supplies. A series of explosions ruptured parts of both Nord Stream 1 and 2 on September 26 in what seems to have been an act of coordinated sabotage. The natural gas pipelines, each running from Russia into Poland with a capacity of 55 billion cubic meters per year, were a key part of Russia’s efforts to wield energy leverage over Europe and to hurt Ukraine. The damaged pipelines left massive bubbling gas leaks in the Baltic Sea.
Elsewhere, Beijing’s zero-Covid policies and its housing-market crisis have put China’s economic growth behind the rest of the Asia-Pacific region for the first time in more than 30 years. It forecast GDP growth in China of just 2.8% for 2022, while the rest of the 23-country region was expected to grow 5.3% on average. China’s divergent path put its GDP growth behind its neighbours for the first time since 1990.
UK Judgement Budget
In the UK, the Bank of England continued to raise interest rates increasing the base rate by 0.5% during September alone to 2.25%. While the new Chancellor stressed the need for co-ordination between monetary and fiscal policy these are different times for the government and the Bank. Previous crises such as Covid and the Global Financial Crisis have seen fiscal and monetary policies broadly aligned, with the Bank very willing to support the ballooning of government debt via asset purchases. Now, however, we have fiscal stimulus offset by monetary tightening, and a central bank on course to reduce their balance sheet by £80 billion over the next 12 months at a time when the government appears set to need to borrow a huge amount to fund the energy price guarantee and additional fiscal stimulus. No wonder sterling continues to hit record lows.
During late September we witnessed the fallout from the new UK government’s mini budget. Chancellor Kwasi Kwarteng £45bn tax cut package initially sparked fears that government borrowing would surge along with interest rates. UK 10-year gilt yields rose to over 4.1%, while sterling continued to fall. The BoE was forced to act to calm markets and announced that it would buy £65bn of government bonds over the next fortnight to try and restore market stability. This was an emergency intervention to prevent the forced selling of gilts and liquid assets by pension funds to meet margin calls. The rapid move higher in bond yields has caused significant stresses in parts of the pension fund market where gilts had to be sold to meet demand for more collateral. This had the potential to cause significant contagion across financial markets hence the Bank of England stepping in as lender of last resort to stabilise markets.
The continued selloff in government bonds over recent weeks has been global, but the severe selloff in UK government bonds highlights increasing concern over the direction of UK government policy. Reputations are extremely hard to rebuild, and the loss of financial markets’ confidence in the government’s competence will take time to reverse. To communicate their tax and growth plans with so little detail at the time when there are already clear stresses in financial markets represents a very poor start for this new government. The recent opinion polls published, giving Labour their biggest lead since the late 1990s, shows that public confidence in the government has also deteriorated sharply.
Ultimately fiscal easing through tax cuts generally supports positive economic growth. However, there is some concern that the fiscal stimulus could add to inflationary pressure and cause further interest rate hikes which to some degree would cancel out the benefit of lower taxation.
A Mild Recession?
The macroeconomic outlook is challenged by a combination of factors such as persistent inflation, energy price shock, rising recession fears and geopolitical conflicts. Most of these uncertainties dominate the near-term outlook. All central banks, including the Fed, are increasing their restrictive measures and rhetoric in the face of persistent inflationary pressures leading to rising rates around the world increasing the chances of a global recession.
Whilst the economic backdrop may deteriorate further, equity markets have tended to move in advance of the real economy. With the exception of the Global Financial Crisis, bursting of the dot-com bubble and deep mid-seventies recession, more normal recessionary bear markets tend to cause US stocks to fall somewhere between 20 – 35% in dollar terms. Given the S&P 500 is now down about 23% in dollar terms, it suggests a moderate recession is already largely priced in. As such, the risk-reward for equities is starting to improve.
In the midst of stock market turbulence, high inflation and slower economic growth, there will be productive areas that continue to thrive and much of this will stem from the disruption and innovation needed to combat the world’s current economic challenges. Given the falls already endured by markets this year, valuations are becoming more attractive for those with a long-term investment horizon. When the dust settles it will likely be disruptive technology innovations that will make a lasting impact on the world by transforming old industries and building real assets.
Fundamentally the base case for the global economy is continued lower growth with some economies entering a recession and experiencing a fall in goods markets, inventories, and company earnings. Inflation will likely peak and start to slowly fall in the months ahead as central banks tighten policy through higher interest rates. However, a lot of bad news has been priced in and labour markets remain relatively robust. Ultimately, we must also remind ourselves of the forward-looking nature of markets, right now bond markets feel closer to capitulation than equities but while the short-term outlook looks tough, history shows the other side of bear markets deliver extremely strong returns.