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CURRENCIES
The current environment with its ongoing recovery is tough for bonds. Especially the UK Gilt market, which was shook by the Chancellor of the Exchequer’s surprise “mini budget” in September, has suffered extreme levels of volatility amidst soaring yields. We are Underweight.
United States. With more monetary policy tightening in the pipeline, US sovereign yields continued their rise. August's inflation figures of 8.2% headline and 6.3% underlying confirmed that inflationary trends remain significant and that convergence toward the 2% target will be a gradual process, all else being equal. Given these figures and the still hawkish tone being struck by Fed members, markets continued to adjust and now see rates peaking at 4.5% in Q1 2023 before starting to come down in 2024. Similarly, the yield curve continued its inversion as the risk of a sharper economic slowdown was seen to have grown. Nonetheless, major uncertainties still remain around the Fed’s actual future tightening path, and we are Underweight.
The bulk of the adjustment now seems to have happened and the Bank of England seems willing to continue acting as lender of last resort in the event of further strong rises.
United Kingdom. Gilts suffered a surge of volatility, including record jumps in yields, following the monetary and budget announcements of late September. Statements by the government, setting out an economic stimulus package that would massively drive-up public-sector debt, and by the Bank of England announcing a rise in its base rate and sharp reduction in its balance sheet triggered a bond market crash. Yields on the 10-year Gilt rose from 3.20% to 4.60% the next day, before steadying at 4% after urgent intervention by the Bank of England to forestall a wave of pension fund defaults. The bulk of the adjustment now seems to have happened and the Bank of England seems willing to continue acting as lender of last resort in the event of further strong rises. However, the risk of new policies perceived as inconsistent and the continuing pressures on sterling are negative factors for UK sovereign indices and yields have crept up to 4.5% in early October as a result. We are Underweight.
Eurozone. Sovereign yields in Europe also rose as inflation accelerated and the pace of monetary policy tightening quickened. Eurozone inflation topped 10% in September, still being driven by energy and food prices. Meanwhile, the price of services began to show symptoms of second-round effects. Several governments announced various fiscal measures to mitigate energy inflation. While such measures may bring down the overall rise in prices, as in France, they also run the risk of stoking underlying inflation. In these circumstances, the ECB is likely to accelerate its monetary tightening, opting for a second 75 bp hike at its end-October meeting, while markets foresee a terminal rate of 2.75%. As inflation does not yet seem to have peaked, we remain Underweight Euro-denominated sovereign debt.
Developed Markets. We maintain our Underweight to Neutral on US and European investment-grade and high-yield debt. The still resilient nominal growth outlook and resilient balance sheets support IG debt, although default rates have begun rising as a tighter financial environment and price pressures undermine the real economy. Emerging markets. We remain Underweight emerging market debt. Monetary tightening in developed economies is generally bad news for emerging market assets and risks to growth remain high.
Real rates have adjusted markedly
Source: SGPB, Bloomberg, 03/10/2022
Past performance should not be seen as an indication of future performance. Investments may be subject to market fluctuations, and the price and value of investments and the income derived from them can go down as well as up. Your capital may be at risk, and you may not get back the amount you invest.
The rise in interest rates adds to recessionary risks and financial pressures. While these risk now seem to be partly priced in, we think equity markets will remain vulnerable. We remain prudent with regards to equity markets by maintaining an overall underweight with a bias to cheaper, more defensive regions.
United States. The market had a generally good summer, boosted by strong corporate earnings and expectations of an upcoming pivot by the Federal Reserve. But hopes were quickly dashed by Fed Chairman Jerome Powell. The dominant sentiment is now fear of a global recession while inflation remains stubbornly higher than forecast. Mr Powell made it clear that monetary tightening would continue until inflation was brought back down to its 2% target, while also stressing that the Fed was looking to have positive real rates across all maturities. All of which strengthened the hand of market bears. The S&P 500 recently hit levels unseen since December 2020. Accordingly, with a shift in real yields and worsening prospects for global growth, we remain Underweight on this market.
United Kingdom. The composition of the UK equity market gives it a structural bias toward “international value”: commodities, pharma and consumer goods. This distribution has made it pretty resilient since the start of the year. So, despite the recent turbulence, we remain fairly upbeat on the UK market compared to other regions. Sterling remains cheap, and compared to other developed markets, much economic pain has already been priced into UK equities. We are Overweight.
Eurozone. Driven by the same winds as US markets, eurozone markets have now completely wiped out the summer's gains, which had in any case been more modest than those across the Atlantic. Fears of recession loom larger in Europe because of the energy crisis, currency pressures and the risks of second round inflation brought on by persistent energy price pressures and the zone's economic support plans. Geopolitical risks remain high and are affecting household and business sentiment as well as the growth outlook. All of which suggests the European Central Bank is likely to stick with its cycle of monetary tightening for several months yet against a backdrop of an already lacklustre economy. We remain Neutral.
Fears of recession loom larger in Europe.
Japan. The Japanese market also corrected on the back of deterioration in global growth prospects. Furthermore, the weakness of the Yen makes returns in Euros or Dollars less attractive. We therefore remain Underweight on the Japanese equity market.
Emerging markets. Emerging markets corrected sharply against a background of tightening global financing conditions and still disappointing growth in China, hampered by Covid restrictions and trouble in the property market. Nonetheless, some markets have held up better than others since the start of the year, notably in Latin America, benefitting from strong Commodity returns. We are Neutral.
Global Equity Markets corrected in September
Sources: SGPB, Macrobond, MSCI 30/09/2022
Emerging markets corrected sharply against a background of tightening global financing conditions and still disappointing growth in China, hampered by Covid restrictions and trouble in the property market.
In the wake of the Gilts crash, GBP slumped on announcement of the UK’s new fiscal and monetary policy mix. It continues to trade in a volatile nature but has marginally bounced off its low’s not seen since 1985. Across the Atlantic, a better-than-expected labour market in the US will likely require the path for monetary tightening to be more aggressive, therefore strengthening the dollar.
Dollar index (DXY). The dollar was weakening early in the month but has since tested recent highs against nearly all other floating currencies. A better-than-expected nonfarm payrolls figure, which in usual times would be a good signal for a strengthening economy, right now means that the Fed will have to be even more aggressive at tightening to fight the inflationary impacts, leading to a stronger Dollar.
EUR/USD. The euro continued its slide over recent weeks, stabilising below dollar parity. Primarily, the euro's weakening reflects the yawning gap between European and American real short rates, at its widest since 2012. Second, the sharp rise in energy prices has worsened the balance of payments, pushing the euro down further. Finally, fears that winter could bring an energy crisis and sharp contraction in the European economy have also hurt the euro's cause. However, the ECB has stepped up the pace of its rate-tightening and raised its terminal rate. This, coupled with more similar real rates should support the European currency. In addition, economic slowdown should have the side-effect of improving the balance of payments, also helping the euro.
GBP/USD. In the wake of the Gilts crash GBP slumped on announcement of the UK’s new fiscal and monetary policy mix. The BoE has stepped in to increase its bond buying programme - despite its plan to do the opposite – hoping to calm the market. The pound has recovered some losses since, but the British currency remains fragile. With no sign that the government will back down on its budget, downward pressure on Sterling will continue to build. What is more, the United Kingdom’s current account balance remains deep in the red and high energy prices will add to pressure on the trade balance.
GBP/EUR. Sterling has remained on the back foot in recent weeks after UK Prime Minister Liz Truss disrupted markets with a plan to cut taxes and increase government spending, which sent the currency into a tailspin. On the other hand, Europe’s sensitivity to higher energy prices are weighing heavier on their economy. It is likely that the currency pair will trade range bound.
Emerging market currencies. Emerging currencies remain on a downward trend. The faster-than-expected Fed tightening cycle continues to increase the downward pressure on major floating currencies.
The pound has recovered some losses since, but the British currency remains fragile.
Dollar Continues to Strengthen
Sources: Bloomberg, 11/10/2022
The current climate of persistent inflation and uncertainties surrounding the economy is helpful for alternative assets. We recently sold our commodities position following favourable currency movements and impending recession risks. The proceeds of the sale were allocated to our real assets allocation, which offers additional diversification from other risk assets such as equities, as well as an attractive income stream and reasonable sensitivity to inflation.
Oil. The price of Brent continues to fall from its first-half highs as recession fears build. A barrel of Brent is now trading at around $93, losing about 26% in the last 4 months. OPEC+ want to keep the price above $90 and have taken output cuts to achieve this. US President Joe Biden has openly criticised this strategy and the effect it could have on inflation.
Oil has Fallen 26% Over the Last 4 Months
Gold. We maintain our overweight position in gold. With recession fears, investors continue to favour the dollar, explaining the decline in price since the highs of the first half. In addition, central banks in developed economies continue their rate-hike cycle, increasing the opportunity cost of holding gold. However, in the context of a general economic slowdown, we are encouraged to remain overweight, with gold remaining a source of diversification should risks materialize.
Hedge Funds. In unstable market conditions hedge funds can help a portfolio, but selectivity is key. We prefer strategies which hold their own in bear markets, such as Merger Arbitrage, trend followers and Equity long/short. These strategies provide relatively safe, uncorrelated sources of returns from equities, our most significant allocation across balanced and growth multi-asset strategies and provide positive contributions to returns – and lowered risk – especially during periods of volatility. It is important to remember that our hedge fund allocation is flat this year while the equity market is down, this has been a great diversifier for strategies.
Real Assets. We continue to allocate to a diversified portfolio of infrastructure (such as energy storage and efficiency, smart grids, waste-to-energy, air treatment and digital infrastructure) and specialist property assets (including affordable housing, care homes and e-commerce and logistics warehouses). These real assets offer additional diversification from other risk assets such as equities, as well as an attractive income stream and reasonable sensitivity to inflation.
Tail Risk Protection Note. Tail risks are typically understood as unlikely but severe crisis events which shock markets and dramatically impact the value of risk assets negatively. The dot-com bust at the turn of the century and the Great Financial Crisis in 2008 and 2009 are examples of such events. We believe the Tail Risk Protection Note offers our portfolios yet another critical source of safety and complements the existing diversifiers.
