29th July 2022
Here in the UK the race to become the next prime minister is well on the way, with the ruling conservative party whittling down the prospective candidates to just two favourites, former Chancellor Rishi Sunak and former Foreign Secretary Liz Truss, who will now go head-to-head to gain the vote of conservative party members who will vote in the autumn. Both candidates have promised a series of tax cuts ahead of the next general election, which will be a popular headline albeit not very sensible economics given the high inflationary pressures we’re currently experiencing.
The ECB finally acted on inflation data and raised rates for the first time in over a decade and ending the era of negative interest rates, European rates remain far below their global counterparts. Annual inflation in the Euro Area hit a record high of 8.6% in June, up from 8.1% in May and just 1.9% a year earlier. The largest contributor was energy, with prices up 42% from a year earlier, but strong gains were also seen in food, alcohol and tobacco (8.9% year-on-year), services (3.4% year-on-year) and non-energy industrial goods (4.3% year-on-year), showing inflation is rooted throughout the economy and may not abate quickly.
Most recent economic data showed the US economy contracting into an official recession (two quarters of negative GDP) as the Federal Reserve continue to raise interest rates in its attempts to bring inflation under control. The Fed are also in the early stages of quantitative tightening, the opposite of quantitative easing, which means they are removing liquidity from the economy. This is the first time in recent economic history that the world’s most influential central bank has pursued contractionary monetary policy into a slowing/contracting economy. Bond markets are now pricing in rapid rate cuts from the Fed as early as next year as it anticipates the need to ease policy in response to economic stress.
The macro backdrop for risk assets has shifted this year. Equities have come under pressure from higher inflation rates and recession fears as central banks have entered into a rate hiking cycle. Some value equities offer more protection against these threats compared with their growth peers, as they tend to benefit most from strong recoveries after recession and trade on lower earnings multiples. We are taking a more cautious approach to portfolio positioning for a possible recession. We still like selective growth stocks where there remains true innovation and potential for change, especially recent trends in consumer behaviour that were accelerated by the pandemic, but prefer value equities on the whole. We have also lowered our overall equity weighting to neutral. Fixed income remains unattractive given record low (and negative) real yields and the thin spread between sovereigns and corporates offering little in the way of reward for risk. Bonds remain an important diversifier in our portfolios, but given current yields the return profile looks unappealing, with downside risk in long-dated government bonds remaining elevated given the outlook for interest rates and recent commentary from major investment banks regarding monetary tightening. Low duration bonds therefore look the more appealing investment, along with inflation-linked bonds which offer some protection to rising inflation. Duration will become appealing again as market participants shift their primary concern away from inflation and towards growth fears, however we are cautious in our positioning here. We also hold an allocation to cash to offset some of this fixed income risk. We have also been adding ‘alternative’ assets to the portfolios, which offer low-to-negative correlations to traditional asset classes (stocks and bonds) and give the potential to protect during times of significant market volatility, such as we are seeing at present.
We expect the UK to continue its outperformance in global equity markets. The UK market is very value-tilted and despite this year’s positive relative performance is still highly attractive on a valuations basis. The UK economy has also recovered well from the pandemic, though economic growth is faltering. The main driver of UK equity outperformance will be relative valuations.
There is good value to be found in European equities, however with war on the continent and the ECB lagging significantly in its inflation outlook and response, there are many headwinds on the horizon for European stocks. Many European equities are also vulnerable to rising interest rates, as debt levels are significant, and many will default if unable to restructure their payments. We remain underweight here for now.
The US represents poorer value relative to the rest of the world due to the high proportion of tech companies that still command a multiple far in excess of the broader market, however it also has the best long-term earnings growth and some of the most outstanding quality companies, as well as the most innovative. In times of global stress, the US also tends to act as a safe haven investment, which props up markets. We believe the US will remain an attractive investment option in the long-term, but with some obvious headwinds making us more cautious. President Biden has made no secret of his desire to increase tax rates, and the Federal Reserve have been clear they will not be getting any more accommodative.
We believe Japan to be an extremely poor environment for equity performance. The Japanese economy is predicted to grow at the slowest pace of all regions, in addition with a declining and ageing population, the prospect of future economic expansion looks unlikely. Thus, we expect poor relative equity performance from Japan. In the short-term, attractive valuations in the region may boost markets, but this will likely be short-lived.
Asia Pacific & Emerging Markets
Asia Pacific and Emerging Markets are predicted to see exceptionally strong GDP growth over the next year, but are struggling with the pandemic, particularly those countries who are not so able to distribute vaccinations to their populations. We remain concerned at the decreasing Chinese stimulus, together with regulatory crackdowns, investments in China require careful monitoring. However, the recent selloff in Chinese markets looks overdone given the longer-term outlook for the economy, and we remain positive on the emerging markets growth story in the long-term, and thus are comfortable maintaining an overweight position. The more recent remarks from the Chinese government have been positive, but must be taken with a pinch of salt. We currently like frontier markets as a more attractive investment option within the emerging markets universe.
The opinions expressed in this update are those of A&J Wealth Management Limited only, as at 29th July 2022, and are subject to change.
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