Dear Investor
General Market Overview
The macroeconomic environment and the release and analysis of various macroeconomic indicators have led equity market performance lower over the quarter. Although further short/medium-term volatility is anticipated, as long-term investors, we will not be reducing our risk exposure and therefore remain fully invested. The reason for this is that most of the best trading days occur in bear markets (down over 20%) as markets rally off lows. If you could time the market perfectly, it would make sense to sell before the bottom and buy lower, but because markets change so quickly you run an outsized risk of missing the run-up in prices and therefore having to compound off a smaller base. This highlights the importance of remaining invested in times of market volatility and infers that market timing is a fool’s errand; one in which we are not participating.
This is illustrated in the graphs below. As seen in the first graph, S&P 500 Total Return 1988 – Present vs Missing the Best Trading Days, missing the best day in the S&P 500 since January 1988 would have cost you 335%, and missing the best 3 days would have cost you 843% - just over a quarter of your entire return. It goes on further to show that if you lost the best 21 days (an average month of trading days), you would have given up 2 402% worth of return. The second graph, Share of Best Trading Days Per Period (1988 - Present)” shows that 86% of the best trading days occur in stock market crashes.
There are two critical and interlinked macroeconomic themes currently dominating market sentiment: inflation and interest rates. Market participants have been intensely focused on how the interest rate and inflationary environment will impact consumer and business sectors. Additionally, the focus on central bank action has been to understand the changing liquidity environment with the concern that the withdrawal of excess liquidity in the financial market system will see significant falls in the prices of those assets that were the recipients of the “easy money”.
The United States (US) Federal Reserve (Fed) and the Bank of England (BOE) have started the hiking or hawkish interest rate cycle. The European Central Bank (ECB) is expected to raise rates for the first time in over a decade in July. Since December last year, the ECB has started the path of policy normalisation; however, the Bank of Japan (BoJ) is still committed to an ultra-loose monetary policy to capping the 10-year JGB yield at 0.25%.
Outside of the G7, at least six central banks worldwide have raised interest rates over May 2022, including Malaysia, Argentina and, of course, South Africa. More Latin American central banks will likely follow Argentina with steep increases in food and fuel prices pushing inflation well past forecast levels. The annual inflation rate in Argentina hit 58% year-on-year in April 2022, the steepest since January of 1992. Inflation in Turkey is now 70% year-on-year, and Zimbabwe, no stranger to hyper-inflation, is running at 131.7% year-on-year!
Central bank action has been precipitated by rising inflation globally. In the US, the headline annual inflation rate slowed to 8.3% in April 2022 from a 41-year high of 8.5% in March 2022, which is well above the Fed target of 2%. While the contribution from energy costs declined in April 2022 in the US, energy costs and food costs and services (excluding food and energy) have been persistent contributors to monthly US inflation measures.
The same contributors to rising inflation are present in France (and Europe). Food and energy costs are fueling inflationary pressures. The French government pledged to increase social benefits and issue food vouchers to the poorest households as freshly re-elected President Emmanuel Macron seeks to avert panic over a cost-of-living crisis before legislative elections next month. Similar measures are being enacted in the United Kingdom, with financial measures being rolled out to assist households in the face of the rapidly increasing “cost of living”.
ECB President Christine Lagarde outlined the economic challenges facing Europe in a recent speech. She said Europe had faced a series of shocks to input prices and food prices. She blamed the failure of OPEC+ to meet production targets which resulted in rising natural gas and fertiliser prices. The war in Ukraine further impacted these price rises, and the combination of factors has led to surging energy and food prices.
Europe has also faced shocks to the demand for and supply of industrial goods, which has shown up in record-high industrial goods inflation. Demand has been encouraged by central bank stimulus policies. Simultaneously supply has been constricted by the sluggish rebound of industrial production from lockdowns, transport, and logistics bottlenecks, and now “zero-Covid” policies in China once again.
An economic shock was also experienced after reopening following lockdowns, which triggered a rapid rotation of demand back to services (tourism and hospitality). Input costs have been rising, and companies in the services sector have struggled to find staff quickly enough to meet growing demand. That has led to increasing service sector inflation.
In Europe, core inflation jumped to 3.5% in April. All sectors of the economy are being affected; 75% of items in the core inflation basket are recording inflation rates above 2%.
The same picture is presenting itself globally. Prices are rising across all sectors, particularly in the food and agricultural sectors.
Given the combination of rising inflation and rising interest rates in reaction to the price increases, the IMF now sees growth in 2022 and 2023 lower than it did in January 2022. There are concerns that the world economy will essentially flatline this year.
The world economy, both developed and emerging markets, are almost always impacted by the value of the US Dollar. US Treasury Secretary Janet Yellen has barely made any public comment on the Dollar’s exchange rate since she assumed office in January last year. However, she is to meet with G7 finance ministers and central bankers in the coming weeks amidst a challenging global economic backdrop. Measured against a basket of major currencies, the US Dollar is the strongest it’s been for 20 years.
Japanese officials have expressed discomfort with the Yen’s weakness, and now Eurozone officials are also worried about the inflationary impact of the Euro approaching parity with the US Dollar. From a US perspective, Yellen should be happy with a strong Dollar as it helps dampen the effect of import prices on inflation, which is running at its highest in 40 years. Import prices are a concern for US consumers and businesses.
The stronger US Dollar, coupled with higher US yields, feeds into the pricing of just about every asset. Looking at the long-term chart (50 years) of US 10-year yields, it could be argued that the recent increase in yields from lows of just 60bp in early 2020 to nearing 3% (300bp) now marks the end of what has been a secular bull market in fixed income.
General Conclusion
There is no doubt that the macroeconomic environment presents a problematic climate for financial markets. Rising prices, particularly in the energy and food sectors, have a material impact on households and businesses. Inflationary pressures coupled with the response from central banks in the form of rising interest rates make it difficult to justify higher growth targets for the economy and market sectors in the very short-term.
There has been a withdrawal of liquidity
from the markets as part of the central bank’s “normalisation” strategy. Together with the strong Dollar and rising US yields, these factors have fed into asset prices, particularly in more growth driven sectors like technology and those areas of the market that require a higher risk appetite like emerging markets and higher yield debt. However, we strongly reiterate our view that current market levels represent very attractive valuations on a medium/long-term basis.
08 June 2022