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Please see below the Tatton Monday Digest article received this morning – 04/07/2022

Overview: Energy price shock turns into central bank focal point

As we start the second half of 2022, the pressure is clearly building. The excess monetary liquidity – the unavoidable consequence of central banks’ pandemic-fighting measures – is now draining from markets and hitting the global real economy. Markets already sense that growth is slowing, and it is being reflected in government bond yields. The ten-year US Treasury yield has moved back down to 2.90%, having traded briefly at 3.50% about two weeks ago. The move was matched by the fall in the German ten-year Bund from 1.90% to below 1.30%, and the UK ten-year Gilt from 2.73% to 2.13%. Although 0.6% may not sound a big number, in the context of last Friday’s bond markets, it constitutes a substantial move. And, as we noted last week, markets have shifted inflation expectations lower by about 0.3-0.4% – rising energy costs would usually be associated with rises in inflation expectations. However, we are now observing a big shift – energy cost rises are having the same impact on markets as rising taxes. Russia’s grip on the price of energy appears significant and while those effects can be mitigated in the long-term, they are difficult to avoid in the near or even medium-term. This places considerable pressure on businesses and their profit margins. It also means that sales revenues are likely to suffer as consumers fret over their household budgets as the extra expenses diminish their savings. US businesses and households are also under price pressures, as demonstrated by the latest personal consumption expenditure data. US consumers increased dollar spending in May versus April by just 0.2% and inflation adjusted (real) expenditure dropped by about 0.4%.

Markets are already sensing that inflation-boosting growth is in the process of slowing quickly enough now to warrant a softening in central bank guidance towards the autumn. Nevertheless, the rhetoric coming from last week’s big central bank get-together in Portugal remained resolutely hawkish. We expect the European Central Bank (ECB) will still want to raise rates this month – there were several speakers at the Portugal meeting suggesting a 0.5% repo rate rise – and they may keep going from there. Interestingly, however, these rate increases will happen while the ECB continues to purchase assets. What it takes with one hand, it gives with the other, and that rather incongruous policy is helping to hold back rising credit spreads in the weaker nations.
Still, the negative effects of the energy war being waged on Europe may be softened somewhat for the weakest nations by such monetary policy moves. However, while European governments may want to turn on the fiscal taps to help households and businesses, the policy effectively channels money into Russia’s war-chest, unless there is also an increase in energy supply from elsewhere. This places the onus on fast expansion of tanker capacity to the US and others, and on building better political relationships the Middle East and North Africa. Across the globe, there are major initiatives to secure new partnerships, coalitions, alliances, call them what you will. Maybe, for the UK and the EU, it will also provide an incentive to bury the hatchet and return to a more pragmatic relationship model.

Challenges usually drive change, and greater risk tends to mean greater potential returns. As we enter the second half of 2022, market participants are certainly downbeat, reflected in lower price-to-earnings multiples and higher credit spreads. A resolution of the conflict with Russia is very unlikely anytime soon, but securing other energy supplies is possible. If and when that happens, the headwinds blowing against the global economy should slacken considerably.

Credit crunch begins to bite

Stocks and sovereign bonds regularly make the headlines, the travails of corporate credit markets often have a much more direct impact on companies and, by extension, the economy. Things are not looking good in that regard – with the cost of financing increasing dramatically for many businesses. The hard times in corporate credit are exemplified by investment flows. Despite sinking stock markets this year, the amount of money invested in equities has increased, albeit very slightly. Credit markets, though, have haemorrhaged capital. According to Bank of America, $200 billion has flowed out of corporate bonds in 2022. The squeeze looks widespread, affecting most sectors. Moreover, the longer-term impact of the pandemic is also being felt broadly across sectors because of extra debt taken on during lockdowns. Given the interplay between debt, default and growth, credit stress is often a clear sign of looming recession.

This makes sense given the relative risks in each region. US consumers are being hit by inflation and companies are facing higher debt payments, but neither of these are yet at breaking point. In Europe, energy prices are much higher, and show little sign of coming down. Natural gas prices are nearly six times higher in Europe than they are across the Atlantic. And the squeeze is widespread across the continent, putting serious pressure on growth prospects.

Here and across the channel, the sirens of negative economic growth that define recessions are growing louder (indeed, we may already be at the beginning of one). Strangely enough, that may mean credit stress is approaching its peak, after which bonds should be due a better performance as spreads reduce again when actual default levels become fact-based rather than fear-based. That is the view of some distressed debt investors, who suspect this could be a good low point to buy in. A contrarian view perhaps, but, with any luck, enough investors will believe it enough to turn the market around.

Investors learn to shrug off China’s Covid fears

China’s zero-Covid policy, an extreme outlier among nations’ late-stage pandemic strategies, is not changing anytime soon. This is despite its damaging effects on the economy and its unpopularity with the growing Chinese middle class. In a speech delivered at Wuhan last Tuesday, China’s President Xi declared he would rather “temporarily sacrifice a little economic growth” than “harm people’s health”. Given how long his ‘Zero-Covid’ policy has been in place, one might wonder how temporary that sacrifice will be.

It is curious, then, that Chinese equities are faring so well. The CSI 300 index has been on an upward trajectory for the last two months, and June looks set to deliver the best monthly returns in two years. Xi’s speech coincided with a slight pullback midweek, but even that had recovered by the end of Thursday’s trading. If Chinese citizens are concerned with the zero-Covid policies, investors seem unphased. Some have suggested this may be down to a softer Covid policy than meets the eye. Despite the President reiterating the party line, China’s State Council announced last week that the quarantine for international arrivals would be cut in half – down to seven days in a government facility, followed by three days at home. This comes a few weeks after the President himself declared that Covid containment must be balanced against economic growth – a sign of shifting priorities in Beijing.

We suspect other reasons for China’s stock market strength, and that investor optimism is down to policy changes in other areas, and early signs of returning domestic growth. Beijing recently signalled it would also take a less severe approach to the tech sector, which suffered from crackdowns over the last two years. This is a positive turn, and indicates a general easing up of the Party’s interventionism. Last week, the People’s Bank of China (PBoC) pledged to keep monetary policy accommodative as the economy recovers from its slowdown. It follows on the heels of earlier measures to loosen policy, such as the PBoC’s reserve ratio cuts, which have been an important factor in boosting China’s credit impulse (the contribution of credit to GDP).
More generally, economic readings are improving. Recent surveys of business sentiment show a rebound from lockdown malaise, with the manufacturing purchasing manager’s index (PMI) jumping to 50.2 in June, from 49.6 in May (a level of 50 or above indicates expansion). This move is broad-based too, with all major sub-components increasing. The non-manufacturing PMI (comprising services and construction) jumped to an even greater 54.7, up from 47.8 last month.

These signs all point to an improvement in the world’s second-largest economy. And with a supportive policy backdrop (for investment at least) we should expect the rebound to go further. We should not underestimate the headwinds that zero-Covid brings, but with virus cases decreasing through the summer months, short-term growth is likely to improve.

Please continue to check back for our latest blog posts and updates.

Charlotte Clarke

04/07/2022

Please see the latest Investment bulletin from Brooks Macdonald received today – 30/06/2022

What has happened

US equity markets ended broadly flat yesterday as the positive effects of quarter-end rebalancing were offset by further concerns over the aggressive zeal of central banks to tame inflation.

Central bank panel

Fed Chair Powell, ECB President Lagarde and BoE Governor Bailey all stressed their commitment to tackle inflation and acknowledged that there will likely be economic pain in order to achieve that goal. In terms of particular takeaways, Lagarde said that she didn’t think ‘we are going back to that environment of low inflation’, suggesting that post pandemic ECB policy may be structurally tighter than we have seen in the last decade. Powell interestingly still described the US economy as strong despite the more mixed incoming data, suggesting that he still believes the economy has sufficient momentum to absorb further tightening.

European inflation

Tomorrow we will see the release of Euro Area CPI data which will be an essential input into whether the ECB starts the cycle with a 25bp hike, as expected, or opts for a larger hike. Yesterday saw Spanish CPI come in far higher than markets were expecting, rising to 10% versus expectations of 8.7%. By contrast the German CPI figures came in at 8.2%, far below the 8.8% expected by the market. Forecasting inflation at this time is particularly difficult given it takes time for pressures to filter through to the end basket but should a genuine divergence be occurring this makes setting ECB wide policy even trickier.

What does Brooks Macdonald think

As we reach the last day in Q2, it is important to recognise how much the market view has shifted since the first quarter. In Q1 inflation fears grew and central bank rhetoric toughened but there was still significant hope that the Fed, and other central banks, could engineer a soft landing with interest rates cooling excess pandemic demand but avoiding a recession. In that context value equities strongly outperformed growth equities and the rotation created huge volatility within equity markets. Q2 saw less of a rotation, with investors now questioning the ability to avoid a recession and equities selling off in a more uniform fashion. The key question over the coming quarter will be whether the Fed, in particular, starts to take the poorer incoming data into account when setting policy.

Bloomberg as at 30/06/2022. TR denotes Net Total Return

Please check in again with us shortly for further relevant investment content.

Cyran Dorman

30/06/2022

Please see the latest Weekly Market Commentary from Brooks Macdonald received yesterday evening:

• The market focused on recession risks last week as economic data disappointed and European energy security came in focus
• With European and US inflation data in focus, bond markets will be looking for signs of peaking price pressure
• Wednesday sees the Federal Reserve (Fed), European Central Bank (ECB) and Bank of England (BoE) heads discuss the need to navigate economic growth fears and inflation risks

The market focused on recession risks last week as economic data disappointed and European energy security came in focus

Recession fears raised their heads again last week with bond markets pricing in a more dovish global central bank backdrop as a result. After one of the worst weeks for equity market performance the week prior, equities recovered significant ground, particularly in the US which was insulated from the energy security risks in continental Europe.

With European and US inflation data in focus, bond markets will be looking for signs of peaking price pressure

This week we see a series of inflation releases from Europe and the US. On Wednesday the German Consumer Price Index (CPI) data will be released, followed by the wider Euro Area on Friday. There is some debate as to whether we are at peak inflation yet in the Eurozone with consensus expectations pointing to a small tick up in the year-on-year rate compared to last month. With commodity prices having fallen significantly in June however, this may mean we are a month or so away from that peak. Thursday sees the release of the US’s core Personal Consumption Expenditures (PCE) inflation alongside a series of personal income and spending data. This Core PCE release is the Fed’s preferred inflation measure so will be closely watched as investors debate whether a 50 or 75bp rate hike is most likely for the July meeting.

10 year yields fell in both Europe and the US last week as economic data continued to paint a weaker picture and fears over a Russian gas cut-off played through European markets. Central banks remained hawkish however with San Francisco Fed President Daly backing another 75bp rate hike at the July meeting, joining other governors who are considering another outsized move. One of the focuses of the market will be this disconnect between the market’s focus on economic growth risks and the Fed’s focus on inflation risks. With a tight US labour market, economic growth fears have been relegated by the US central bank but given that is now a real concern in the bond market, the Fed will come under pressure to consider both factors at upcoming meetings.

Wednesday sees the Fed, ECB and BoE heads discuss the need to navigate economic growth fears and inflation risks

One of the highlights of this week will be the ECB’s Forum on Central Banking which sees Fed Chair Powell, ECB President Lagarde and Bank of England Governor Bailey join a policy panel on Wednesday. Given the range of views on the relative importance of economic risks between those three central banks, this is likely to be an interesting conversation and may encourage all participants to adopt a more balanced tone.

Please continue to check our Blog content for advice and planning issues and the latest investment, markets and economic updates from leading investment houses.

Andrew Lloyd DipPFS

28/06/2022

Please see below Tatton’s update on recent market events which was received this morning:

Overview: Public sentiment wrestles with economic realities

Inflation continues to dominate the financial market narrative. Last week the Office for National Statistics (ONS) announced that inflation, as measured by the Consumer Price Index (CPI), rose from 9% in April to 9.1% in May, while the Retail Price Index (RPI) reading increased to 11.7% compared to May 2021. And yet, believe it or not, inflation pressures are receding. Signs suggest the global supply-chain squeeze is easing, and the cost-push is passing by. While energy prices have been stickier (especially in Europe) crude oil prices came down sharply last week. Perhaps most hearteningly, there has also been a broad-based decline in agriculture prices since peaking around mid-May. However, the good news is being accompanied by more negative growth signals and ramping up recession talk. Last Thursday’s flash Purchasing Manager Indices (PMIs) for major areas added to the gloom – showing a greater decline in optimism among businesses than economists forecasted one week ago. The lack of enthusiasm is not surprising. The follow-though of inflation sees people deciding they don’t want to pay the price for goods, thereby reducing demand, which means less activity and therefore less growth. The phrase “demand destruction” means exactly that.

There is undoubtedly a slowdown underway. Business confidence has deteriorated from very positive levels, but is still at neutral rather than negative. While employment may worsen (it does lag confidence measures), it is unlikely to contract massively unless there is another shock to the global economy. There has been a slowing in hiring but jobs cuts are few and far between just now, and employers will be reluctant to lose workers again, given how difficult it has been to recruit in the past two years. Therefore, the sequencing of the slowdown is important. The fallback in input cost-price pressures is welcome and, clearly, it’s a good thing that this is happening before firms have to set about cutting labour costs. This must lessen the chance that the slowdown will be prolonged. What’s more, central banks are only partially through their rate cycle, and they still have some degree of flexibility. They don’t have to tighten if they believe cost pressures are abating enough – they just have to convince markets that they will do what is necessary. Markets are – once again – climbing the wall of worry and that is likely to persist through the summer. We cannot expect a meaningful equity market recovery until the soft patch is likely to end but, equally, the likely payoff is high enough to stay invested. We will be watching and assessing changes as intently as ever over the summer months.

Emerging market resilience is encouraging

It has been a tough year for investors so far and riskier assets have been hit particularly hard. So far, emerging market (EM) bonds have suffered their worst losses since 1994 – with JPMorgan’s dollar-denominated bond index falling 15% year-to-date. EMs characteristically have plenty of their own problems – and this year has been no different, with idiosyncratic issues across China, Turkey and Latin America, as well as Russia’s invasion of Ukraine providing a major roadblock for growth. Investors have paid attention, and as of last month, $36 billion had flowed out of EM mutual and exchange-traded funds this year, according to research provider EPFR. This has had a negative impact on some EM currencies – none more so than the Turkish lira. Turkey’s currency has lost more than 23% of its dollar value this year, amid further political controversy for its authoritarian president Erdogan. Earlier this month, Erdogan vowed to cut interest rates again, despite inflation surging to more than 70%. The Turkish treasury responded with a new bond plan to ensure stability for the lira, but investors are yet to be convinced. Erdogan’s policies are a major barrier to foreign capital, making it hard to see an upside.

Elsewhere, Argentina continues to be on the edge of default and disaster, its currency falling nearly 17% this year. Argentina’s government negotiated a $44 billion debt refinancing plan with the International Monetary Fund (IMF) in March, but its central bank is still failing to get short-term interest rates high enough to stop the ongoing devaluation. However, apart from these two, EM currencies have fared reasonably well. The most shockingly ‘good’ performance is perhaps the Russian rouble, which has managed a near-unbelievable turnaround over the last three months. Despite war and isolation from the west, the rouble has gained 96% against the dollar since March, making for more than a 40% gain year-to-date. While not as dramatic, Brazil, Mexico, Colombia and Peru have all seen their currencies gain since the start of 2022. Asia has been a different story, as lockdowns in China have curtailed demand. Asian currencies have generally struggled, with all of them falling against the dollar year-to-date. Interestingly, the weakest currency in the region is not an EM, but the Japanese yen – falling more than 15% year-to-date. Divergent monetary policy – with the Bank of Japan keeping rates low while the rest of the world tightens – is the main cause. Tellingly though, the next weakest Asian currencies are the South Korean won and the Taiwanese dollar. These are both classed as EMs, but in reality, are much more similar to Japan in terms of development.

China’s drastic economic slowdown weighs heavily on Asia’s prospects. But like Japan, China has nothing like the inflation pressures we see in the west. This has allowed China’s government to keep monetary and fiscal policy broadly supportive. The zero-COVID policy is clearly a negative, but with Li Keqiang recently suggesting a change of tack, the outlook for the world’s second-largest economy could improve. Bond yields are currently lower in China than in the US, providing a decent foundation for risk assets.

Overall, EMs have outperformed major developed markets this year. This is impressive considering the headwinds many countries have faced and shows a level of resilience that will no doubt continue to be important. Moreover, many analysts suggest that with EMs much more oriented towards technology and services than in the past they are well-positioned over the medium and long-term. The early inflation fighting in some EMs is certainly paying off, despite hiccups here and there. While EMs could be in for more pain should commodities worsen, the outlook is relatively positive, considering the difficult global backdrop.

Has the music stopped for private equity?

The recent SuperReturn International private equity conference, held in Berlin, shone the spotlight at the rapidly changing fortunes of the private equity industry. In 2021, historically low-interest rates and abundant liquidity ensured a frenzy of dealmaking – leading to record profits at the largest industry names. But this year’s gathering was full of dire warnings: spiking inflation, a looming recession and a slowdown in fundraising. One executive called it “a time of reckoning for our industry”.

Private equity has enjoyed a ‘gilded age’ since the global financial crisis in 2008 introduced an era of cheap financing, which is a boon for this type of investment. As well as increasing the amount of capital available for buyouts (taking stock market quoted companies private), loose monetary policy also pushes up equity valuations (by decreasing the ‘risk-free’ rate of government bond yields, thereby making stocks more attractive). By the same token, the tighter monetary policy makes life difficult for private equity firms. When financing costs go up, valuations go down and buyers become scarce, leaving the owners of leveraged assets potentially exposed. Industry executives were fearful of this in early 2020, but lockdowns brought an unprecedented surge of monetary and fiscal support – increasing savings and generating impressive equity returns. Now though, the world’s major central banks are in full tightening mode as they battle surging inflation. Even as the cost-of-living crisis eats into consumer and business demand, there is no suggestion central banks will ease up – meaning financial conditions are likely to only get tougher.

There is no immediate threat of distress for funds run by private equity firms – and certainly not for the larger players. But if financing costs for private equity target companies become overstretched for a more extended period, the sector could become more stressed, with a potential impact on the wider financial system, given pension funds and other long-term investors are the major holders of these assets (both the equity and the loan capital). For private equity firms themselves, the reputation risk is big. If the ‘low volatility, high returns’ model is damaged, funding will be much harder to come by in the future. Most holders of private equity assets are not overly concerned right now. Our portfolios do not hold them directly and we believe any indirect exposure is insignificant. Nevertheless, the potential impacts are significant, so we will be vigilant in the months ahead.

Please continue to check our Blog content for advice and planning issues and the latest investment, markets and economic updates from leading investment houses.

Please keep safe and healthy.

Carl Mitchell – Dip PFS

Independent Financial Adviser

27/06/2022

Please see investment bulletin below from Brooks Macdonald received this morning – 24/06/2022.

What has happened

Recession fears continue to be the major story in markets with bonds rallying significantly in response to market downgrades to future economic growth. Despite these growth concerns, the fall in bond yields helped equity markets, with the US technology index posting outperformance as lower discount rates supported growth equities.

Economic growth fears

Flash PMI surveys of economic activity suggested a poor outlook for the US and European economies with the Euro Area composite reading missing expectations quite significantly. The US weekly initial jobless claims also show signs of ticking up, suggesting that some of the tightness in the labour market may be easing. Whilst that may be good news for inflation pressures it paints a far less constructive economic picture. Bond yields fell in response to this data and that is despite a continued hawkish narrative from the US Federal Reserve. Governor Bowman endorsed ‘increases of at least 50 basis points in the next few subsequent meetings’ and Fed Chair Powell said that the Fed’s commitment to deal with inflation was ‘unconditional’. Despite these strong words, the market simply doesn’t believe that the Fed, or indeed other central banks, will be able to continue to aggressively tighten monetary policy throughout 2023 as recession risks will provide central banks with other problems to deal with.

UK Politics

The UK awoke to the news that the Conservative party had lost both parliamentary seats in yesterday’s by-elections. Both seats are symbolic with Wakefield a traditional Labour seat won by the Conservatives at the last election and Tiverton & Honiton representing a safe Conservative seat. Conservative MPs will now be considering their future ability to win a general election (and retain their own seats) if both traditional Tories and ‘new’ Tories have decided to either not turn out or change allegiances.

What does Brooks Macdonald think

Of course, few governments are popular at the ‘mid-term’ stage however the dual electoral defeats will undoubtedly lead the Conservative party to reassess their confidence in Boris Johnson. For the 1922 Committee to change their rules, and allow a further vote of no confidence, the clamour would need to be overwhelming. Whilst it hasn’t been too long since the vote, there has been a deafening silence from most Cabinet members who are keeping their cards close to their chest. Sterling is largely unmoved by the results, however any second order consequences will quickly feed into the currency market.

Please continue to check back for our latest blog posts and updates.

Charlotte Clarke

24/06/2022