Monthly Market Commentary - June 2022

The US market is trying to buck a rather unwelcome trend of consecutive weeks of declines, and we might well see something of a rally over the near term. Of course, this might only be one of the bear market rallies that are common in protracted downturns, so it is perhaps best not to get too excited. Some of it may be a technical bounce, but there is a degree of hopeful positioning from investors, driven by the idea that the Federal Reserve will be forced to scale back the extent of its monetary policy tightening in the face of a weakening economy.

This is something of a gamble as bringing inflation down appears to be very much the main focus of the US central bank and Jay Powell. Also, the latest jobs data has been strong, limiting the scope for a restrained approach.

President Biden has recently made comments that he will respect the independence of the Federal Reserve in this task, meaning that a rate rise induced recession may have to be accepted as a necessary consequence. Whether this will be sufficient is a separate question of course as higher energy and food prices are not going to be curbed by demand-led measures, unless of course they are so severe that they have destructive consequences for the wider economy.

Several options for an independent monarchy were considered after the US declaration of independence in 1776, but the idea was dismissed in favour of a Republican system. The attractions of the two systems continue to be hotly debated in many countries.

Existing concerns over supply side pressures were added to by the results from Apple and others, and mid-May saw dramatic market moves in the shares of Target and Walmart after their results indicated significant pressures on the consumer. So again, these dual fears of inflation and a slowing economy are stalking the investment landscape and finding their way into pressures on corporate margins. Pressure is building and it is not remotely reassuring that the starting point in terms of valuations is so high. Yes, we have seen a shakeout in equity prices, but it could be made to look rather modest if the risks facing markets materialise in the most unhelpful way.

The US market has been underperforming many of its global peers recently, which is a significant reversal of the trend over the last decade. Perhaps this is to be expected given how expensive the market had become, but a period of further risk-off sentiment might yet attract buyers fleeing economic weakness elsewhere.

The latest European inflation figures are disturbingly high and, unlike in the US where there is a strong demand-pull component to the inflation rate, it really looks to be almost entirely supply side in origin. This would seem to leave the European Central Bank (ECB) either powerless or having to tighten much more aggressively than it would like going into a downturn. Rising food and energy costs do not look as if they are going to go away any time soon and it would seem that Europe is facing a material slowdown and that an actual recession is likely.

Of course, markets tend to ‘look ahead’ and are to a degree pricing in these potential developments, but it is difficult to believe that the current levels of the European indices are reflecting the worst possibilities. Monetary policy tightening is going to resurrect a lot of the structural concerns the continent faces and, combined with weakening growth, there could be significant challenges ahead.

To assuage concerns over the likely fallout of tightening, it looks as if the ECB is preparing plans to avert stress in the bond market by making some sort of commitment to protect vulnerable countries’ sovereign debt if a sell-off transpires. Perhaps this is wise – a re-run of the debt crisis of 2011 is hardly an exhilarating prospect, but we do wonder whether we will ever really return to any sort of normality in markets.

If you are looking for an unfortunate monarch you need look no further than King Charles II of Spain. Years of Habsburg marriage and breeding between blood relatives meant that he was ill throughout his life and passed away at the age of 38.

We retain exposure for clients at relatively modest levels – there remain some interesting opportunities, but the region as a whole looks troubled.

We have written extensively about the challenges facing emerging markets in a world of slowing growth, higher US interest rates and elevated geopolitical uncertainty. This combination of threats has proved to be highly detrimental to emerging markets so far this year, particularly emerging market debt. In fact, it is the worst start to a year for the asset class since 1994 and funds in the space have seen almost $40bn of outflows.

If rate rises are accompanied by strengthening growth, this can of course benefit emerging market equities, but this is not the environment we appear to be in. The markets are as concerned about recession and weak growth as much as they are about inflation, and this combination is extremely toxic. China has also been a drag on sentiment with its hard-line approach on Covid-19 and its range of macroeconomic problems. China’s bonds and equities have suffered considerable outflows this year and this has had a knock-on effect given the size of China in emerging market indices and the importance of the country as a barometer of risk appetite.

The positive moves in commodity prices have meant that some pockets of emerging markets – those established as commodity producers (such as Brazil) – have benefited, but this powerful combination of tightening monetary policy and lower growth could yet undo this part of the emerging markets complex as well.

Brazil’s monarchy lasted from its creation in 1815 until the republican coup in 1889. Rule was effectively Portuguese of course, with Pedro II being the last of the monarchs.

It is very difficult to make a case for the space as a whole at the moment – indeed, we have removed our emerging market debt exposure from portfolios and our equity allocations here are running at very low levels. The dramatic deterioration in sentiment will, as always, present opportunities at some point, but these are likely to be quite niche and a dramatic broadening of our emerging market allocation looks unlikely.

Is there a more divisive area of financial markets than cryptocurrencies? According to Investopedia, there were over 18,000 cryptocurrencies in existence at the end of March 2022. For some, they represent the future; a decentralised system that cannot be manipulated by governments. For others, they are a largely useless and valueless sign of the levels of excess witnessed in financial markets. The Oxford English Dictionary defines a currency as ‘a system of money in general use in a particular country’. One obvious issue with cryptocurrencies is that they are not widely used. While countries such as El Salvador, and more recently Central African Republic, have launched initiatives to start the widespread use of cryptocurrencies, the success of such schemes is questionable.

Critics often point to the volatility of some cryptocurrencies as a fundamental flaw. With wild fluctuations in the value of a number of coins, consumers are often reluctant to use them in day-to-day transactions. This has led to the invention of stablecoins, which peg their value to other currencies or instruments.

One such coin was Luna, which was effectively pegged to the US dollar. However, in May, that peg broke down, causing the value of the currency to collapse and sending shockwaves through the crypto community. The crash in Luna is yet another catastrophe in a difficult year for crypto investors. Bitcoin, which many see as the bellwether for cryptocurrency sentiment, has fallen nearly 30% since the turn of the year. Once touted as a digital asset that could threaten gold’s role as a hedge against financial risk, the currency has proved to be highly correlated with technology stocks and other areas of the market where valuations have become extended.

The Missing Cryptoqueen is a BBC podcast that tells the almost unbelievable story of Dr Ruja Ignatova and what is alleged to be one of the biggest scams in history … well worth a listen!

Cryptocurrencies appear to be an easy target for mainstream media, but the technology behind them is likely to have significant real-world applications. Whether they present an interesting investment proposition is an entirely different debate. We continue to monitor developments in the space but remain unconvinced that they have a role to play in client portfolios at this point in time.

In our May edition, we commented on the tensions that differing stances towards Russia continued to cause between EU member states. While an agreement was struck to ban 90% of Russian oil imports, negotiations were fraught. With a significant reliance on pipelines from Russia and a leader with a difficult track record with the EU, it was no surprise to see Hungary presenting significant roadblocks. Eventually, a deal was struck, whereby Hungary would be allowed to maintain its use of Russian oil, having used its veto on the EU proposal.

Closer to home, the announcement of a windfall tax sparked an outcry from a number of investors and business leaders. While many anticipated such a move in the oil and gas sector, a harsher tone towards electricity producers appeared to catch investors off guard.

Though the levy should help to ease the pain for certain households in the short term, a number of businesses have warned of the long-term consequences of the move. Indeed, the CEO of the largest North Sea producer, Harbour Energy, commented that additional taxes would be ‘detrimental’ to investment in new projects, energy security and energy transition. To try to ease the pain, the Chancellor announced that operators investing in significant new projects in the North Sea would get a material tax saving, as a result of the new levy.

In early June, the government approved plans to produce from the Jackdaw gas field, off the coast of Aberdeen. When production starts in 2025, the field could account for 6.5% of total gas output from the North Sea and is seen as a signal of the government’s intentions with regards to domestic production.

The Kingdom of Saudi Arabia first discovered oil in 1938, under the reign on Abdul-Aziz II, and it has since become the world’s second largest oil producer. Development of the newly discovered oil fields began in 1941 under the Arabian American Oil Company, which is now known as Saudi Aramco and is the world’s most valuable company.

Geopolitical tensions continue to be supportive for higher oil. Quite how long consumers can stomach the effects of this remains to be seen and demand shock remains the most pertinent threat to the downside. We retain our position in energy for our most adventurous investors.

It remains an ominous macro environment for corporate bonds with future interest rate hikes on both sides of the Atlantic now priced into credit markets. In addition, credit spreads (that is, the difference in yield between two debt securities of the same maturity but different credit quality) have already adjusted to a negative scenario. This has, however, made the risk/reward profile of some areas of the high yield market look attractive. The market has priced in a large number of defaults, using the last period of significant interest rate rises as a benchmark, but things could be quite different this time around.

The Covid-19 pandemic has reduced the likelihood of a large number of defaults – particularly in the high yield space – without necessarily removing risk from the market. The sheer size of monetary and fiscal stimulus in 2020 means that many corporates have termed out their debt, borrowing as much as they are able with longer-term payment schedules at cheap rates. In defiance of history, our base case is for default rates to increase only marginally as we enter a period of persistent inflation and a cost-of-living crisis given the current strength of company balance sheets.

A number of weaker business models have already exited markets, as they could not survive the pandemic. Therefore, we now have a better quality credit market. We should note that a fall in earnings will certainly stretch company balance sheets, but many in the space had the advantage of coming into the crisis in a robust position.

George IV of England (1762–1830) was famous for almost always owing hundreds of thousands of pounds. He left many tradespeople waiting more than a decade for payment, leading one jeweller to publish his debts in scathing newspaper advertisements.

We think that opportunities do currently exist in the corporate credit space; however, we remain very selective in terms of our exposure to the asset class.

Once the darling of the stock market, the technology sector has endured volatile price swings and a broad-based sell-off since the start of the year. During May, some high-profile earnings disappointments did little to quell investor concerns around the space. US streaming company Netflix delivered an underwhelming earnings report, with subscribers declining by 200,000 in the quarter (+500,000 excluding the suspension of service in Russia), well below the guidance for +2.5 million. Management explained that the pull forward in demand due to Covid-19 restrictions had obscured the picture until recently.

The aforementioned easing of draconian restrictions in areas of China should be helpful in alleviating some of the supply chain blockages that have plagued the technology eco-system, as well as supply/logistics generally, for months. Chinese state media announced in early June that public transport and restaurant dining would reopen in Beijing sparking hopes that Shenzhen, a city that is sometimes referred to as China’s ‘Silicon Valley’, will follow suit.

King Ludwig II of Bavaria’s ambitious feats of architecture went on to inspire the castles of Disney. One of his creations, the ‘Grotto of Venus’, was a costly wonder of the latest technology including a device that could produce a programmed sequence of five different lighting effects, each lasting for ten minutes and concluding with the appearance of a rainbow over a painted tableau.

With the prospect of a higher interest rate environment in the US, more speculative technology companies continue to look unattractive. However, we invest selectively in the theme believing that there are good companies with strong fundamentals in the space.