melting further?

summer edition of the PWA quarterly newsletter

Rise of the bear (and interest rates)

Review

Both shares and bonds suffered in the second quarter of the year, as concerns over inflation and an ongoing war in Ukraine dominated sentiment. Almost no major economy could escape the rising inflation rates, based on supply chain disruptions and a looming energy crisis. Covid however seemed to be a thing of the past, al-though cases were on the rise again towards the end of Q2 in many countries.

Europe and Switzerland

Most major stock markets in Europe lost in double digit territory, with even Switzerland as the traditionally stable market losing 11.5% in Q2. Only energy-laden UK lost merely 5.4%. The biggest market in the EU, Germany, even introduced an emergency energy plan, as the steps against Russia seemed to have boomeranged. Currently being at step 2 of this plan, the next step would mean rationing of energy to industrial users (and potentially households as well!). The consequences are difficult to imagine at this point in time. Eurostat showed inflation jump from an already high 8.1% in May to 8.6% in June, with energy being the main driver. Therefore, the ECB is poised to lift interest rates in July, with more to come most likely in September. Consumer confidence also fell to -23.6 in June, the lowest since April 2020, when the pandemic hit the markets. To round events off, the Euro fell to historic lows vs. the Swiss Franc and to a 20year low vs. the US Dollar as the FED hiked interest rates already by 1.5% in 2022, with the first hike in Europe yet to come.

USA

With the S&P500 losing 17.7% in Q2, investors were spooked by inflation figures and the FED’s response when Jerome Powell announced that they will “keep pushing” until inflation falls convincingly, adding this might require “more aggressive” moves. Sector performance was diverse to say the least, with energy, utilities and even financials upholding relatively well, while media, auto sectors and technology were hammered (Google -22.8%, Meta -29.2%, Apple -23.1%, Netflix -54.4% year to date). With the PMI (Purchasing Managers Index, a summary of how purchasing managers see current market conditions) just above the critical 50 at 51.2 in June, the sentiment is still seeing a (very moderate) growth of the economy, but warning flags are up everywhere. Manufacturing output fell to a two-year-low, this being only the 3rd time ever the reading fell more than 5.6 points (financial crisis 2008 and pandemic 2020).

Asia & Emerging Markets

Stock markets in Asia lost less than developed markets, with China even growing slightly as Covid lockdowns were lifted, thereby igniting higher factory activity. The hardest hit markets were South Korea and Taiwan, as they are tech-heavy, a sector which lost substantially globally. Inflation fears and soaring energy prices weakened investors sentiment everywhere and markets lost accordingly. In Japan, the Yen dropped to below 130 per USD for the first time in 20 years, triggered by the Bank of Japan’s confirmation of no change in policy, in contrast to the western central bank actions. Other emerging markets suffered from lower demand for industrial metals, a stronger USD (South & Latin America) and the war in Ukraine (Eastern Europe).

Bonds

Bonds continued to sell off sharply, as high inflation numbers persisted and various central banks raised rates. Mounting concerns over growth prospects and even recession also dampened sentiment.

Graph 1: maximal drawdown from previous highs.

The US Consumer Price Index, the most popular measure of inflation, rose to 8.6% in May. The yield of the US 10Y treasury bonds went from 2.35% to 2.97%, with the 2Y only slightly behind at 2.93%. This led to the weakest first half of a year in 200 years! In Europe, the ECB’s announcement to end their bond purchase programs created volatility. The yield of german 10Y Bunds jumped from 0.55% to 1.37%, UK Gilt yields from 1.61% to 2.24% with Italy’s bonds up from 2.04% to 3.39% after reaching a high of 4.27%. Corporate bonds suffered even more, thereby widening spreads to Govies. Particularly high yield bonds were hit hard.

Commodities & Precious Metals

The ongoing conflict in Ukraine had a big impact on the asset class, as more questions over supply issues arose globally. Strong energy prices, particularly in a volatile oil & gas market, offset a steep decline in other commodities such as metals and agricultural products. Silver was also significantly lower, while Gold declined less pronounced.

?Our Investments and Actions

Except from reducing our equity exposure in Europe, we added a Nordic High Yield bond fund to the portfolios. The attractive performance and downside protection this year (+1.5%) and the stable outlook for this niche asset class seem attractive.

Outlook for the 3rd quarter

Perfect storms ahead?

Shortages and disruptions in supply chains have been the dominant theme over the past 18 months. In May, two U.S. retail giants, Target and Walmart, sent a shock wave through Wall Street - but not because of too little inventory, but be- cause of too much inventory. Such headlines might continue (with the exception of shortages in the energy sector). And they are not only good news, as stability of the value chain is necessary for companies to rebuild capacity.

A moderate recession is probably necessary to clean out the excesses of the past decade. You can’t have such a sustained period of growth without an occasional downturn to balance things out. It’s normal and it’s healthy.

The ESG push seems to have vanished in 2022 with the world’s focus increasingly shifting to energy independency, pushing gas and coal prices to fresh highs. Weak US crop conditions mean food inflation will pick up again.

So let's not get too comfortable.

A very narrow landing field

Central Banks will have to get a lot tougher at keeping inflation under control. But can they? They have no choice than fighting inflation with higher borrowing costs. Finding a balance to slow the economy without destroying demand is becoming increasingly difficult. As rates rise, growth slows and consumer confidence de- clines, the margin for a policy error narrows. The Fed Put, the assumption by market participants that the Fed will rush to the rescue should prices collapse too sharply, has been suspended until further notice. For how long? Most likely until Powell can declare victory against inflation or until the U.S. economy is falling into recession and the unemployment rate is rising.

Bonds – Income is returning to fixed income

The painful short-term losses at the beginning of the year have at least laid the groundwork for more income. At today’s yields, history suggests higher total returns over the next few years, even if surprising rate hikes might hit prices again. The past 6 months added around 2% more yield to low investment grade US corporate bonds for example. A point of worry are de- faults, which we strive to avoid at any cost!?Selectivity remains key. That is why we primar- ily invest with proven active managers.

Equity

Rates may be on the rise, but history shows re- turns could be looking up as well. In the eight rate-hiking periods since 1977, the MSCI All World Index has posted an average annualised return of 12.1%. Nevertheless we currently suggest defensive sectors like healthcare.

United States – recession is coming

The issue of recession is key because corporate profits usually fall in a downturn. However, analysts have not even begun to lower their earnings estimates. Corporate earnings should be the driving force of equity markets going for- ward – a welcome return to fundamentals.

Europe's service sector

We have reduced our exposure to Europe further, even if the European economy held up relatively well. We worry about a war-induced re- cession. While the European manufacturing sector has been hurt by the war and fears that Russia’s natural gas supply could be disrupted, the services sector might continue to do better, driven primarily by pent-up demand.

China – the wrong interests at work

Most analysts say that China will outperform the rest of the world in the near term. The companies are very cheaply valued, especially tech companies. The last quarter already shows a re- bound. The government's unpredictability, on the other hand, make us at PWA cautious. We see Xi Jinping and the party’s interest in expand- ing power clearly has a higher priority than building a good foundation for business and the economy. The zero-covid policy shows that. Secretly, we hope to be wrong - for the sake of the global economy. We still prefer to cover our Asia exposure with a notable investment in Vietnam.

Positioning our portfolios

Faced with today’s challenging environment, we focus on quality across all asset classes. We favour investments that continue to generate strong cash flows, combined with more reason- ably valued structural growth stories like our thematic investments. Even now we have gently reduced our overall equity exposure and added more fixed income at the current, finally slightly attractive levels.

We are keeping our investments in emerging markets hard currency government debt — a corner of the bond market that has been especially volatile. Several countries have raised rates ahead of the Fed and are on good financial footing.?

Keep in touch, Philip