Halfway through 2022

Although the most shocking development so far in 2022 has been Russia’s invasion of Ukraine, the seeds of the current turmoil had been sown even before the war started to unfold in February. During the latter part of 2021, it had become clear to central bankers around the world that consumer price inflation was proving to be more persistent than they had anticipated and that interest rates were going to have to rise to suppress prices and prevent expectations of future levels of inflation from rising too high. Indeed, the Bank of England was among the earliest central banks to have already initiated its policy-tightening cycle in December.

The second quarter saw the highest annual inflation pressures in a generation, with UK and US annual consumer price inflation both up at 40 year highs. Unprecedented monetary policy support over the past two years has clearly led a rapid recovery back to pre-pandemic levels for many economies. However, stoked by post-pandemic supply chain disruption, the ongoing war in Ukraine, and Chinese adherence to its zero-COVID-19 policy, these additional inflationary headwinds have collectively served to test the global economic and market outlook

The beginning of 2022 therefore started with a ‘rates shock’. Investors rapidly reassessed the level to which central banks would find it necessary to raise short-term interest rates and this set off some large movements in investments that we discuss in more detail below.

Bond yields across the range of maturities rose sharply leading to capital losses.

Over the course of this year, the yield on the ten-year US Treasury bond rose from 1.51% to a peak of 3.47%, while the UK Gilt yield rose from 0.97% to 2.65%. Even German bonds finally got back to offering a positive yield, rising from -0.18% to 1.76%. Capital values fall as yields rise.

We have seen the impact of this keenly this year with falls in the value of defensive assets although this has been limited by our use of Global Short Dated bonds. Larger falls have been seen in UK Index Linked Gilts.

These rising interest rates have also undermined the valuation of equities, especially many of the ‘growth’ companies that had been considered winners from the pandemic. US large companies experienced their worst first half of a single year since 1970, while smaller companies also had their worst first half since records began.

We have covered before in Insight that while some industries have done well; energy companies, miners and banks spring immediately to mind, there have been some significant falls elsewhere. Big names were affected, such as Netflix (down over 60% over the year) and Meta (Facebook: down 50% this year). In particular this has affected a new wave of largely technology-based ‘disruptive’ companies in areas such as Energy Storage, Artificial intelligence and blockchain. With rapidly rising share prices these had become firm favourites with retail investors.

The investment bank Goldman Sachs has a number of investment categories which help to illustrate the scale of the falls. For example, its ‘Non-Profitable US Tech’ basket fell 52% in the first six months of this year and ended 70% below its all-time high reached in February 2021. It’s ‘Retail Favourites’ basket fell 41% and 47% over the same respective periods. Losses were not confined to amateur traders. Goldman’s ‘Hedge Fund VIP’ basket, which tracks the favoured holdings of hedge funds, has fallen 32% this year.

In your portfolio there have been some sharp falls in the International Index Fund and the Global Smaller Companies Fund.

You will have been sheltered from the worst of these falls as Sterling has fallen through the year, especially against the dollar. So, although share prices have fallen, this has been offset by the dollar value of those assets strengthening. As we diversify across currencies this can add to performance, and so lessen the impact of falling markets at times.

For much of the year, the strongest part of your portfolio has been the UK Index Fund and the Global Value Fund. 2022 has seen a big shift in market sentiment towards ‘value’ stocks which both of these funds have exposure to and away from “growth” stocks such as the technology companies mentioned above. Value stocks are stocks in undervalued companies or industries and over the last few years, these have been characterised by energy and resource companies as well as banks. It has also included a number of well-known companies such as Cisco systems, who provide IT infrastructure and whilst making good profits are actually regarded as a more mature company and are not seen to be growing as fast as the new technology companies mentioned earlier.

Rising discount rates on growth stocks have made value stocks more attractive as they are often highly profitable companies and investors are deciding those income streams now are more valuable to them.

As you know, we do not try and predict the direction of the markets from here. While there are significant headwinds, the prospect of recession, inflation being higher for longer than expected and geopolitical issues with aggression from Russia and the chance of a Chinese conflict with Taiwan leading to further pressures on the world’s resources. The markets as we look at them today will have all these future events priced in.

The surge in global prices presents an unenviable dilemma for central bankers. If central banks tighten policy to restrain inflation, they risk a decline in confidence, spending and credit availability. If they resist raising interest rates to avoid recession, they also risk a repeat of the 1970s stagflation environment of low growth and high inflation and a wage-price spiral developing where workers need higher wages to pay for higher costs, but this then leads to higher prices.

So far, consumers remain worried about inflation, but optimistic about their job prospects. Consumer spending is therefore holding up, but we are getting fewer goods and services for our cash, as prices have surged.

Political landscape

As well as the imminent change in UK Prime Minister, there will also be other potential changes during the year.

Mid-term elections in the US are widely predicted at present for President Biden to lose overall control of congress which will make passing legislation more difficult.

China is seeing a new five year plan put in place which may point in the direction they are taking, and the implications for global politics.

Covid

Finally, while Covid has become less of an issue there is a chance that this could bring further disruption, perhaps less from a health point of view and more from an economic one as large numbers of people are getting the virus as protection from vaccines wanes.