The bear market is back

Stock and bond markets are once again under pressure, leaving investors with few places to hide. US equities experienced their worst September in 20 years and are now 25% lower, in USD terms, than at the start of the year, -8% in GBP terms. Bonds have also performed poorly. The bond market sell-off has been particularly brutal in the UK, as investors have reacted badly to the new government's approach to spending and borrowing. For the first nine months of the year, UK government bonds have fallen -25% and UK inflation-linked government bonds -29%. However, we have seen a similar trend in many other bond markets around the world as an era of exceptionally low-interest rates comes to an end. High levels of volatility may be with us until investors have a better sense of when interest rates will stop rising – and the level at which they settle.

UK shows that debt and deficits still matter

Last month, it looked as if soaring energy prices would be the greatest near-term headwind for the UK economy. But Chancellor Kwasi Kwarteng’s “mini-budget” included a generous support package to limit the impact for households and businesses – and that on its own might have been palatable to markets. Instead, the challenge has come from Downing Street’s unexpected tax cuts and the apparent absence of any plan to bring government debt back down. Intervention by the Bank of England and a tax cut “u-turn” have undone some of the damage, but sterling and UK markets remain volatile. Investors now expect UK interest rates will need to rise further to offset the inflationary impact of the mini-budget. However, as the last two weeks have shown, rapid rises in interest rates come with significant risks to economic and financial stability. The Bank of England may have to accept higher UK inflation as the lesser evil.

Can Ukraine win the war?

Ukrainian forces have recovered significant amounts of lost territory in recent weeks and have made further advances in early October. Their success at least raises the possibility that Ukraine may be able to repel the Russian invasion, something that looked unimaginable earlier in the year. Russia has responded by calling for a partial mobilisation and reiterating its threat to use nuclear weapons. The risks of dramatic escalation cannot be ruled out. At the same time, recent developments could encourage Putin to look for a way out of a war that it appears he can no longer win. While it does not look imminent, a resolution of the conflict and the restoration of European gas supplies would be a huge shot in the arm for the global economy.

Portfolio positioning

As we move into the fourth quarter, we expect developed market central banks to maintain their hawkish stance and further raise interest rates. This is likely to lead to recessions in the UK, US and eurozone and we could see corporate earnings start to decline over the remainder of the year. In this environment, we remain underweight equity, with a clear preference for higher-quality companies. Government bond valuations now look more attractive and we are starting to gradually increase our exposure. We are also modestly increasing our allocation to alternative investments, which we continue to like as a source of diversification. We retain our significant exposure to the US dollar, which should provide some protection in more challenging environments. Recent higher levels of inflation in the UK have made meeting inflation plus return targets more challenging in the shorter term. Despite this, we remain confident in the ability to meet inflation plus targets over the longer term.