CIO: Macro & markets in the second quarter

The second quarter of 2022 saw a continuation of widespread negative sentiment towards risk assets, albeit in smaller magnitude than during the prior quarter.

The primary drivers were multi-decade inflation highs, fears of a global recession and continuing geopolitical tensions. Monetary tightening by central banks has now become commonplace worldwide, with more than 60 central banks increasing interest rates this year to combat runaway inflation. In the US, the Federal Reserve (Fed) used its June meeting to increase interest rates by 75 basis points – the largest single rate hike since 1994 – bringing its policy rate range to 1.5-1.75%. The purpose of the large move was to combat increasing year-on-year headline inflation, which stood at a high of +8.6% in the quarter.

The UK was no different, with the Bank of England raising rates twice in the quarter. The base rate is now 1.25%, up from 0.75% at the end of March. Headline inflation in the UK touched 40-year highs of +9.1% at the end of the quarter. The only notable exception to this tightening trend is China, which cut interest rates by 10 basis points to 3.7% at the beginning of 2022. China has seen its economy improve over in recent weeks, following the easing of some COVID restrictions, and a more accommodating stance from the government on corporate regulations, particularly in the technology sector. Whilst this benefitted domestic markets, it did little to stimulate sentiment in other emerging market economies.

Recession risk

Recession fears began to grip the world towards the end of the quarter. Several economists slashed second quarter real GDP forecasts in the US to +2.4% after the Fed’s more aggressive stance towards rate rises became apparent; forecasts had been close to +4% in January 2022. The situation in the US was aggravated further by the release of a disappointing consumer spending report in June.

However, many market participants believe any US recession could be mild, given the low level of unemployment, and lower sensitivity to the events in Ukraine. Europe finds itself in a much tougher position, with large dependence on Russian energy adding to cost of living pressures across the continent. As a result, real incomes are falling quickly and growth in the region’s export market is slowing. Consensus among economists increasingly points to a mild recession in Europe in coming quarters.

Equity, credit & commodities

Equity, credit, currency and commodity markets experienced significant mark-to-market volatility against this backdrop of high inflation and slowing growth.

Global developed equities, proxied by MSCI World, fell by approximately 9% in GBP terms, with all but two countries registering a negative return. Emerging Markets – proxied by MSCI Emerging Markets –fared better; the index fell a modest -4% in GBP terms, although this was heavily skewed by China, which appreciated by +12% in GBP terms, following the easing of some COVID restrictions. Almost all countries in emerging markets posted negative returns over the quarter. In terms of styles, the higher interest rate environment proved supportive for Value stocks vs Growth counterparts – as had been the case in Q12022. Value stocks outperformed Growth by more than 8%. Unsurprisingly, the most successful style was Low Volatility, which can outperform during equity drawdowns.

Credit experienced one of its worst periods in recent history. A perfect storm of rising rates – driven by inflation and subsequent central bank actions – and widening credit spreads, sparked by growth and recession fears, caused major falls in most bond prices. Government bond yields continued to rise across the globe, particularly in the US, where the 2-year and 10-year yields rose to 2.93% & 2.98% respectively, a rise of over 70 basis points in each case. Government securities and investment grade corporates –proxied by two of the Bloomberg Global Aggregate indices – both fell approximately 9% in local terms in Q2 2022. Large bond duration, a measure of interest rate sensitivity, was the main driver. Sub-investment grade securities had a torrid period, with high yield corporates – proxied by the Bloomberg Global High Yield Corporates Index – falling over 11% in local terms, after recession fears sparked significant spread widening.

Many commodities finally ran out of steam, as recession worries began to trump the supply squeeze following the invasion of Ukraine. Both precious and industrial metals suffered heavy losses in Q2 2022. Notable examples included nickel and copper, which saw spot prices fall by 25% and 34% respectively (in GBP terms). Oil was a notable exception to this trend, with the WTI benchmark rising over 14% in GBP terms.

Dollar rush

Recession concerns and tight monetary policy drove more investors to the US dollar, which is typical during times of market stress. The DXY Index – a measure of US dollar strength relative to a basket of foreign currencies – rose another 6.5% over the quarter, taking its year-to-date appreciation to over 9%. This has become particularly prevalent vs the Japanese yen, which depreciated due to the Bank of Japan’s continued stance on yield curve control. The US dollar appreciated approximately 11% vs the yen in the second quarter alone.

Looking forward at quarter-end, there were still several key questions for investors to ponder. It is still very unclear how the slowing growth and high inflation themes will play out or how much is priced into markets.