Market update – June 2022
Investors face the prospect of a recession in the next couple of years - and the challenge of high inflation today.
Markets start to fear next recession
The global economy has been moving through the cycle at break-neck speed in recent years. The pace is showing no sign of easing as investors fear that the recovery from the pandemic could soon be coming to an end. The catalyst for this transition is a classic one: rising interest rates in response to inflation. The historical evidence suggests that there is good reason for concern. As Schroders’ Chief Economist Keith Wade has noted, “the recessions of the 1980s and 1990s followed a similar pick up in inflation to that being experienced today.” While the timing and extent of any recession remain very unclear, markets are starting to price in the risk. At their recent trough, global equities were very close to the 20% decline that constitutes a bear market. For the first time in many years, the UK is proving more resilient, supported by the strength of US dollar and commodity earnings.
US dollar at strongest in two decades
Jerome Powell was in crisis-fighting mode at the Federal Reserve’s latest press conference. In words addressed “directly to the American people” he acknowledged that high inflation was causing significant hardship and reiterated the Fed’s commitment to bring it under control. The dramatic shift in tone has had big repercussions in currency markets, with the US dollar now approaching its strongest level in twenty years. The Bank of England, the European Central Bank and the Bank of Japan have all sounded much less “hawkish” than the Fed – and their currencies have suffered as a result. Given the pace and extent of US dollar appreciation, we could well see sterling, the euro and other currencies enjoying a modest bounce against the greenback. However, we expect the current dynamics supporting the dollar to remain in play for some time.
Inflation’s impact on profits and politics
While recession is a concern for the next year or two, in the very near term companies are having to grapple with the challenge of inflation. This was starkly illustrated by a profit warning from Walmart, the world’s largest retailer. The company saw its shares fall by the most since 1987 after stating that higher costs and weaker-than-expected general merchandise sales would result in lower profits for the year. In the UK, the cost of living crisis has forced the government into a u-turn on a windfall tax on energy companies, which will be used to part-fund a support package for households. Economists have suggested that the £15 billion package could put pressure on the Bank of England to increase interest rates at a faster pace than currently envisaged.
The risk of stagflation, a period of high inflation and low or slowing growth, remains high. We have been making changes to our portfolios to reflect this changed environment. We have reduced our exposure to small and mid cap equities, while tilting portfolios towards higher-quality companies with stronger balance sheets and greater ability to pass on cost increases. We are also increasing the defensiveness of our fixed income allocation. This has been achieved by cutting our allocation to emerging market bonds and increasing our exposure to high-quality credit and short-dated government bonds. However, given the potential for yields to continue rising, we still prefer to diversify portfolios using alternative assets such as gold, broader commodities and absolute return funds.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.
All data contained within this document is sourced from Cazenove Capital unless otherwise stated.