Market Review – 2nd Quarter 2022

It has been another difficult quarter for markets after what had already been a tough start to the year. This is the worst first half of the year for developed market equities in over 50 years. To make matters worse, government bonds have also been hit so far this year, failing to provide the protection that investors usually look to them for.

Government bonds have been hit as markets moved to price in significant further increases in interest rates on top of what has already been announced. Markets now expect interest rates to rise to 3.4%, 3%, and 1.6% in the US, UK, and Europe, respectively, by next year. That increase in expectations for the path of interest rates has also contributed to a decline in equity valuations, along with concerns about the growth outlook. Recession fears have risen, due to the squeeze on consumers from higher prices and higher borrowing costs as the central banks seek to fight inflation. 

The good news is that valuations are now well below their average since 1990 in every major region other than the US. In the US, the cheaper parts of the market now trade at relatively low valuations compared with history, with the Russell 1000 Value Index trading on a price-to-earnings (P/E) multiple of 13, whereas the Russell 1000 Growth Index still trades on a P/E of 21. That’s despite growth stocks having already significantly underperformed value stocks so far this year. The Russell 1000 Growth Index is down 28% year to date, whereas the Russell 1000 value index is 14% lower.

The US economy has been the Fed’s indication that it is determined to get inflation under control, with the median Fed member now expecting to have to raise interest rates to 3.8% by next year to combat inflation. The Fed forecasts that unemployment will need to rise to just above 4% to get inflation down. However, the market is clearly worried that getting inflation under control could require unemployment to rise much higher, as has historically been the case.

There are already some signs that expectations for higher interest rates are starting to weigh on economic activity. With house prices almost 40% higher than at the start of 2020, and 30-year fixed mortgage rates have risen from below 3% to nearly 6%, housing has become much less affordable. That development is starting to be seen in the economic data, with the number of home sales declining.

On the plus side, while the number of housing transactions, and the associated economic activity, could continue to slow, it appears unlikely that we will see a repeat of the 2008 housing-led financial crisis. That’s because 95% of Americans today are on long-term fixed-rate mortgages, compared with only 80% in 2007. So, there should be far fewer forced sellers. There has also been much less sub-prime lending, and the banks are now better capitalized, which means they can withstand any loan losses that might be seen in a recession.

In Europe, consumer confidence has also fallen dramatically. The biggest risk to the European economy is the reduction in gas supplies coming from Russia, which has driven prices up significantly, and is raising fears of outright shortages and rationing if it continues. Gas shortages could have grave consequences for the European economy. Even without gas rationing, the business surveys have started to weaken. 

Somewhat surprisingly, the market is pricing at significant rate rises from the ECB. At the same time, the difference between the rate at which the Italian and German governments can borrow has widened materially, as it did during the eurozone sovereign debt crisis about a decade ago.

Outlook

We made no changes during the month. We remain slightly overweight in small caps and in EM equities.

On the fixed income side, we are interest rate duration underweight and spread duration overweight. We did not add to duration given the volatility but conceded that levels are becoming attractive once again given the overall outlook. From our view, it is however still a bit too early to add duration or credit risk at this stage. 

We also have built exposure to uncorrelated fixed income strategies, such as absolute return, microfinance, and cat bonds.

The rules we have set out for this Portfolio Models are that we are always 100% invested and that the allocation between the asset classes remains unchanged over time.

Yield & Income Portfolio (in USD) -4.5% (-59bps vs. the benchmark)

Balanced portfolio (in USD) -4.5% (+58bps)

Growth portfolio (in USD) -6.1% (+13bps)

Relative performances were mixed across the three portfolios. The Yield & Income Portfolio is the most sensitive to spread duration and was harshly impacted by the spread widening we observed across all credit strategies. While floating-rate strategies funds were relatively spared so far this year, loan spreads widened by more than 200bps in June. The overweight in spread duration contributed by -80bps in relative terms for the Yield & Income portfolio.

On the other hand, the Balanced portfolio benefited from some absolute return strategies which managed to register positive performance in June such as a long/short US Equity (+3.8%) or a global market neutral which was flat during the month. 

Active management on the equity side contributed slightly positively in June (+46bps) to the Growth portfolio. Asian and secular growth strategies did relatively well and helped to protect capital in this particularly nervous market environment.