MarketMinder Europe provides our perspective on current issues in financial markets, investing and economics. Our goal is to analyse key topics in an entertaining and easy to understand manner, helping you see the news of the day in a unique perspective.
Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.
Contagion. That is the word many commentators we follow latched onto Monday, when the Bank of England (BoE) announced new support measures for pensions forced to sell Gilts to meet sudden margin calls (lenders’ demands to raise account funds to cover possible losses on positions bought with borrowed money).[i] When trouble seemingly erupted in late September, a vicious circle of rising interest rates and margin call-driven forced selling prompted the BoE to offer to step in as Gilt buyer of last resort for pensions to stop this technical issue from roiling broader markets.[ii] That appeared to stem the tide for a while, but another 10-year yield spike Monday to a fresh closing high of 4.55% accompanied more intervention to “reduce risks from contagion,” in the BoE’s words.[iii] There is a lot more to that sentence, as we will discuss, but much of the coverage we read buried the context, in our view, prompting hunts for looming risks. We aren’t dismissing the UK bond market ructions, but we don’t think this is likely to be a 2008-scale financial crisis in waiting.
For simplicity, we will avoid rehashing the political backdrop other than to say we think yields initially spiked when the market overreacted to the new government’s mini-budget that attempted to offset a stealth tax increase with tiny tax rate cuts. For our purposes today, it simply matters that when long rates jumped, it triggered some problems in a corner of the UK pensions market called Liability-Driven Investing (LDI), which is a tactic pensions will use to match their investments with their future liabilities.[iv] In practice, this is easier said than done, in our view, as some active pensions have unfunded liabilities, meaning they are still accepting new participants, don’t know what their actual benefits payments will be and must earn a long-term return to fund final-salary payments to all participants. As a result, many funds will invest in stocks and other securities as well as bonds, which can earn the needed return over time but also subjects the pension’s total value to market volatility in the interim. Enter LDI, which uses interest rate swaps (contracts to exchange pay outs depending on interest rate shifts) and other derivatives (financial contracts deriving their value from other assets) to hedge against market movement in order to keep a portfolio’s market value (and funding ratio) more stable when volatility strikes.[v]
We won’t get into the technicalities of all these contracts, as we think that too is beside the general point. In our view, all most investors need to know is that a lot of funds used LDI to get exposure using borrowed money to fixed income, aiming to increase returns when yields were low. The derivative contracts were designed to rise in value when interest rates fall. But when rates rise and values fall, it requires pensions to post more collateral to back the loan.[vi]
Throughout financial commentary lately, we have seen many economists warn major economies risk entering recession (broad decline in economic activity) soon—if they aren’t already in one. Against that backdrop, America, China and Japan released some widely followed economic data at the end of Q3. Whilst the figures are backward-looking, we think they show ongoing resilience in the world’s three largest economies—evidence, in our view, of an economic reality that is better than many market observers anticipated based on financial publications we follow.[i]
Resilient US Consumer Spending
First up: US personal consumption expenditures (PCE), courtesy of the Bureau of Economic Analysis (BEA). This inflation-adjusted consumer spending measure includes goods and services—a contrast to the retail sales report, produced by the US Census Bureau, which isn’t inflation-adjusted and omits most services spending.
Amongst the many alleged negatives that financial news we cover attributes recent volatility to, one has seemingly gained primacy of late globally: the strong dollar.[i] Some experts warn it is a negative for the US itself. As the dollar appreciates against overseas currencies, commentators suggest it hits US-based multinationals’ overseas revenues once they are converted back to dollars (never mind that as other currencies decrease in value compared to the dollar, any parts and labour American multinationals source in those currencies become relatively less expensive, and most international earnings don’t get repatriated and converted to dollars). Other observers focus on non-US stocks, warning their weaker currencies are a headwind. Commentators suggest, for example, as the pound depreciates against the dollar it is causing the UK to import even faster inflation (broadly rising prices across the economy) because imported goods will cost more. Add in actual currency market intervention in Japan plus talk of the same in South Korea and China, and currency chaos seems to be top of investors’ minds.[ii] In our view, this is more a sign of sentiment than an actual negative for stocks, as we will show.
If you re-read the prior paragraph carefully, you may notice a weird inconsistency: financial commentators’ warnings about the US directly contradict their warnings about the UK, Europe and Asia. If the strong dollar is supposedly bad for the US, then that implies a weaker dollar would be better for UK and others. Yet we are also told a weaker currency is a massive headwind in the UK, Europe and Asia, implying they would benefit from the stronger currency that is supposedly a massive risk for the US. Absent some mythically perfect exchange rate, which we have never seen theorised ever, we see no way to make it make sense.
If theoretical arguments aren’t your thing, then consider Exhibit 1. It shows a smattering of major developed and Emerging Markets’ currency moves year to date, along with their year-to-date stock returns in their home currencies, US dollars and British pounds, their highest inflation rate in 2022 thus far and their most recent inflation reading. As you will see, there isn’t much data to support today’s prevailing currency-swing warnings from commentators we follow. The US, which has the largest currency appreciation, is in a bear market (typically defined as a prolonged downturn due to fundamental causes) in dollars. Brazil, which has the second-best currency of this bunch, has positive year-to-date returns in its home currency. Yet Mexico, whose currency is also up this year, is down double digits in pesos. As for the eurozone’s four largest economies, Germany is down over twice as much as Spain in euros, and the corresponding inflation rates are all over the map. The UK has the second-weakest currency but its stocks are down just single-digits in pounds, albeit with double-digit inflation. Yet Japan, where the yen is down more than -20% on the dollar, has the second-lowest inflation rate.
Crude oil prices jumped on Wednesday, closing at $94.68 after the Organization of the Oil Exporting Countries (OPEC) and its partners reduced their production target by two million barrels per day (bpd) at this week’s meeting.[i] Financial commentators we follow warn production cuts will drive global oil prices higher and exacerbate this year’s inflation (broadly rising prices across the economy), compounding extant economic headwinds. Whilst we think this conforms to standard economic logic, considering prices move on supply and demand, we also think it is quite out of step with how oil supply and demand—and oil prices—have behaved since Russian President Vladimir Putin’s troops invaded Ukraine.
Exhibit 1 shows global oil prices this year to date. As you will see, crude rose in the run-up to the invasion and spiked just afterward, reaching its year-to-date high on 8 March.[ii] That, you might recall, is the day the UK announced its decision to ban Russian oil imports, heightening warnings of a sudden supply crunch. But since summer, oil has declined steadily as it became apparent that Russian oil was finding buyers and global supply was resilient. Oil prices now sit right around pre-Ukraine war levels.[iii]
Exhibit 1: Brent Crude Oil in 2022
With Q3 in the books, the year hasn’t been smooth for global stocks, which are down -9.2% year to date in Sterling and much more in dollars.[i] UK stocks, which have been in a correction (sharp, sentiment-fuelled decline of -10% or worse) since April, are also having a rough ride.[ii] In our experience, frustration can often motivate investors to act as doing something, anything, can feel like taking back some control in an uncomfortable situation. However, we think such urges can easily be counterproductive. As challenging as this year has been, reacting to the past is one of the biggest risks investors can take, in our view.
Global stocks’ path has been bumpy and included some steep pullbacks and rebounds. A volatile winter—world stocks fell -11.2% from early January through early March before rebounding 11.1% to close out Q1—gave way to a springtime correction of -13.7%.[iii] Stocks then rallied through the summer to mid-August before sliding anew in September.[iv]
During bouts of volatility, we think investors seeking long-term growth benefit from going back to the basics. Yes, we know popular investing adages that preach patience or sticking with it may sound obvious and tired to many, but we don’t think that makes them unwise. In our view, the things one doesn’t want to hear can still be right, important and smart. Here are a few such concepts, based on our experience: One, don’t exit stocks because of what has already happened. Selling during downturns locks in losses, and if you are out of the market when a recovery begins, we think it becomes much harder to recoup those losses. You could then be fighting equal and opposite emotions that want to keep you sidelined to mitigate additional potential declines. It is a recipe for potentially missing a recovery, in our view. Our research also shows avoiding negativity isn’t essential to earn markets’ long-term returns. For example, the US-orientated S&P 500, which we cite here for its long historical data set, has an average annualised return of 10.3%—and that includes all the bear markets (typically prolonged downturns due to fundamental causes) from 1926 – 2021.[v] In our view, if you seek growth commensurate with stocks’ long-term results, earning market-like returns is a critical component in reaching your long-term investing goals.
Days after the Bank of England (BoE) and US Federal Reserve (Fed) ratcheted their policy rates higher again last week, commentators we follow are still chattering over monetary policy moves. But most talk we hear now isn’t about those rate hikes—they weren’t exactly a shock based on reactions we witnessed and changes in bond yields ahead of the meeting, which implied investors anticipated the move.[i] Rather, consternation from outlets we read concentrated on where policy—especially Fed policy—is heading. We see many warning much more tightening is likely to come, roiling sentiment. As evidence, they point to the Federal Open Market Committee (FOMC)—the Fed’s monetary policy decision-making body—boosting its dot-plot projections for rates’ “appropriate policy path” this year and next.[ii] But, in our view, whilst future policy moves could spur volatility, they don’t dictate market direction—and today’s dot plot doesn’t determine tomorrow’s hikes.
As expected, the Fed raised its fed-funds rate target range 0.75 percentage point for the third straight time to 3.0% – 3.25%.[iii] But most observers we follow expected such a move, so they instead focussed on an unanswerable question: How high does the Fed think rates need to go to break inflation’s (rising prices economy-wide) back? To suss that out, interested parties we saw pored over reams of Fed prognostications released with its rate announcement—the quarterly Summary of Economic Projections (SEP). Bundled within it: a dot plot showing what FOMC participants think rates’ path should look like over the coming years. The midpoint of members’ latest estimates for this year jumped to 4.4% from the prior SEP’s 3.4% in June.[iv] Next year, supposedly, the fed-funds rate will hit 4.6%, up from June’s thinking it would be 3.8%.[v] So it might seem at least another percentage point of rate hikes are baked in.
But slow down. We think the dot plot’s evolution over the past year proves these forecasts aren’t ironclad. In December 2021, the SEP’s dot-plot midpoint had rates ending 2022 at 0.9%.[vi] They were collectively expecting to barely lift rates at all this year. Three months later, March’s dot plot put the fed-funds rate’s 2022 close at 1.9%.[vii] Now it has more than doubled.[viii] We don’t see these projections as forward guidance in any useful sense. All they do is show the FOMC members’ evolving opinions, in our view. We think they underscore that even Fed officials can’t forecast what policy they think will be appropriate—and they decide the rates. If they can’t foretell future policy decisions, what chance do outsiders have?
Editors’ Note: MarketMinder Europe favours no party nor any politician and doesn’t advocate policy proposals. We review political developments solely for their potential market impact.
Global stocks fell again Monday, extending another trying week for investors.[i] Many financial commentators we follow attributed the drop to the Truss government’s “Growth Plan” announcement, which includes tax cuts, the reversal of planned tax hikes, select deregulatory moves and relatively large subsidies designed to offset rising energy prices. UK stocks sold off, Gilt yields rose and the pound fell sharply, briefly touching record lows against the US dollar before rebounding on Tuesday.[ii] Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng argue this plan, which we will highlight below, will boost long-term UK GDP growth to 2.5% annually, up from the 1.8% average in the 20 years before the pandemic.[iii] Yet commentators we follow fear the plan will fail to spur growth, risk stoking further inflation and, worse still, put British public finances on an unsustainable path.[iv] Theatrically, some claimed it puts the UK on a path to become an unstable Emerging Market, with wild policymaking risking economic institutions and financial health.[v] Whilst the plan may not deliver the faster growth targeted—if it becomes law as-is later this autumn—fears tied to it are far overstated, in our view.
We think the motivation for the plan is straightforward enough, and at root, it seems largely like a traditional economic proposal from Truss’s Conservatives. It lays much of the blame for the growth slowdown in the 20 years pre-pandemic on lower private investment than many peer nations.[vi] In our experience, these factoids are nothing new, having circulated in many discussions of “structural challenges” facing the UK economy for years and years.
Based on our review of the latest sentiment surveys, many people are feeling dour both here and globally. Considering financial publications we monitor have continually warned about economic developments ranging from rising prices to monetary policy institutions’ actions, we think the bleakness is understandable. Along with the discussion about today’s prospects, we have observed economists argue more challenges loom ahead, including the prospect of a global recession (a prolonged economic downturn). That is possible. But a roundup of the latest data out of the world’s largest economies continue showing a mixed picture, in our view—and for investors, that is worth keeping in mind when comparing reality to such dark expectations and sentiment.
Reviewing the Latest Out of China
China’s National Bureau of Statistics released several data series for August last Friday, and they beat analysts’ expectations tallied by data provider FactSet. Industrial production rose 4.2% y/y, ahead of expectations of 3.9%, whilst retail sales were up 5.4%, 2 percentage points better than consensus estimates.[i] Fixed asset investment (things like infrastructure projects), grew 5.8% on a year-to-date, year-over-year basis—which the National Bureau of Statistics produces to eliminate skew caused by shifting holidays like the Lunar New Year—which was also a few ticks higher than expectations of 5.5%.[ii]
Unquestionably, 2022 has been a trying year, with headlines in financial publications we follow touting everything from inflation to energy prices, potentially looming rate hikes, the Ukraine war and more. Worldwide, stocks have been weak.[i] In US dollars, global stocks are in a bear market—a typically long decline exceeding -20% from a high.[ii] Given that backdrop, we think a fair amount of investor disappointment and frustration is understandable. But, although it can be hard to appreciate in the moment, our historical research shows bull markets (broadly rising stocks) are born on pessimism—and, as we will show, recent surveys suggest bearishness is at an extreme. This doesn’t pinpoint when an upturn will begin or whether it is already underway—nothing does—but we see widespread pessimism as a reason for optimism.
Bank of America’s (BofA) global fund manager survey, widely watched amongst commentators we follow, showed broad bearishness in September.[iii] The latest reading indicated a record share of respondents have cut equity holdings.[iv] Now, records start in 2002, so it isn’t an especially long history, in our view, but it does include 2007 – 2009’s bear market and early-2020’s brief downturn for comparison. Similarly, 62% of managers have raised cash holdings—a reading that has never been above 60% in two decades.[v] Also notable: 72% expect the global economy to weaken in the next year, with 68% seeing recession—broadly weak economic conditions—likely.[vi] Both rates are near all-time highs, exceeded by only March 2009 and April 2020.[vii] The earnings outlook is even glummer with 92% expecting declining profits.[viii]
BofA’s survey reflects professional investors’ attitudes—what large money managers are thinking and (presumably) doing. But the American Association of Individual Investors’ (AAII) polling suggests to us individual investor sentiment is similar, at least in the US.[ix] AAII surveys its members weekly about their outlook: positive (bullish), negative (bearish) or neutral. Combining them, AAII subtracts the bearish from the bullish, resulting in its net bull-bear percentage. This can be very noisy week to week, so to smooth it out a bit, Exhibit 1 shows the rolling four-week average. Although off its summer trough that coincided with the S&P 500’s 16 June year-to-date low in US dollars, it remains below nearly all points in its 35-year history.[x] Whilst it isn’t so surprising individual investors are feeling dour, we think the extent is rather remarkable.
UK bonds have entered a bear market (typically a prolonged fundamentally driven decline exceeding -20%) this year, whilst stocks haven’t.[i] In blended portfolios of equity and fixed-interest securities, we think bonds’ purpose generally is to provide asset-class diversification, cushioning against stock volatility for those whose goals, needs and risk tolerance make that desirable. But given this year’s environment, an investor might ask: If bonds don’t mitigate portfolio swings, why own them at all? In our view, although bonds may disappoint temporarily, they can still provide adequate cushion over investors’ required time horizons (the period investors need their money to work to reach their financial goals).
The UK’s ICE BofA Sterling Broad Market Bond Index, a gauge of investment-grade government and corporate fixed-interest securities denominated in pounds, has fallen -24.6% from its 11 December 2020 peak.[ii] Double-digit bond declines aren’t ideal, but by the same token, bonds were never riskless to begin with—like stocks, they are subject to occasional volatility. We think what matters for investors with blended allocations is that bonds are less volatile—overall and on average—than stocks.[iii]
Although it may not always feel great, a look at recent history over the last five years shows that has still been the case. When stocks fell -10.0% from 11 January 2018 through 23 March 2018, the ICE BofA Sterling Broad Market Bond Index ticked down -0.1%.[iv] (Exhibit 1) Later in 2018, stocks hit new highs 28 August, but then tumbled -15.9% to Christmas Eve.[v] The Sterling Bond Index rose 0.5% in that time.[vi] Then came pandemic lockdowns. As stocks plunged -26.1% from late-February 2020 to their mid-March low, Sterling Bonds declined -0.7%.[vii] During these times, we think bonds’ smoother path would have likely helped investors taking cash flows from their portfolios, as it makes the precise timing of security sales and distributions less impactful to overall returns, theoretically, than it would be for someone with an all-stock portfolio.
Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.
This article reflects the opinions, viewpoints and commentary of Fisher Investments MarketMinder editorial staff, which is subject to change at any time without notice. Market Information is provided for illustrative and informational purposes only. Nothing in this article constitutes investment advice or any recommendation to buy or sell any particular security or that a particular transaction or investment strategy is suitable for any specific person.
Fisher Investments Europe Limited, trading as Fisher Investments UK, is authorised and regulated by the UK Financial Conduct Authority (FCA Number 191609) and is registered in England (Company Number 3850593). Fisher Investments Europe Limited has its registered office at: Level 18, One Canada Square, Canary Wharf, London, E14 5AX, United Kingdom. Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission.
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