At the root of recent market optimism and pessimism are the market’s changing view on the inflationary outlook, the corresponding forecasted interest rate rises, and ultimately the perceived size of any potential recession. That a recession will occur in 2023 is now very consensual and even the central banks, who had at first suggested it wasn’t a guaranteed outcome, later softened their stance and coalesced around the market’s view, as economic indicators weakened.
When economic visibility is low and volatility is high, markets can be violently whipsawed, which is what we saw over the third quarter. Global markets rose 10% from their end-of-June lows, only to promptly sink 16% from that peak, finishing the quarter down in local currency terms. The cause of both moves was speculation over the so-called Federal Reserve Bank (Fed) “pivot”. (The Fed initially signalled a path of rising rates; a “pivot” means subsequently turning away from such a path.)
The Fed’s commentary in July caused broad market optimism and was interpreted, fairly in my view, to mean that it had moved off autopilot with regards to raising interest rates and had become more data-dependent. This caused bond yields to fall (and prices to rise); equites took heart and rallied, hopeful that the Fed wouldn’t hike rates into a recession without pause. The data that came in over the three-month period supported a weakening economy thesis: GDP fell 0.6% after a contraction of 1.6% in Q1, meaning that the US had entered a technical recession.
However, despite this development, the Fed’s preferred measure of inflation Core PCE ticked up, and the Fed thus raised rates by 0.75%, the third consecutive increase. Furthermore, the narrative that accompanied the meeting showed its resolve to get inflation under control and underlined that its members view this as mission-critical for the long-term health of the economy. All this meant that the early market optimism reversed and that both risk assets and “defensive” assets, like government bonds, fell in unison.
The positive correlation between equities and bonds is at all-time highs, continuing to call into question the assumptions on which many portfolios are constructed. It is worth remembering, of course, that duration and interest rate risk aren’t limited to just government bond portfolios; in fact, interest rates are the bedrock for all asset class risk premia. In property, for example, there are two direct implications – firstly, potential buyers are unable to use leverage, as the all-in-cost of debt has moved far above the income yield produced by most investments. And secondly, the re-pricing of other assets, such as gilts, has made property expensive by comparison. As such, property yields need to adjust to this new world and, whilst prices haven’t yet, the cheque is likely “in the post.”
Market-moving news flow deteriorated across the piste, adding to investor fears; China saw an increasing incidence of Covid, which prompted further lockdowns and, alongside a broad property slump, led China to be the weakest market over the quarter. The conflict in Ukraine continued and, despite Ukrainian forces making significant headway, added to fears that Putin could escalate matters; indeed, he called up the reservists, and spoke openly about the use of tactical nuclear weapons, leading President Biden to proclaim that the risk of nuclear “Armageddon” was at its highest since the Cuban missile crisis.
Closer to home, the Conservative government’s mini-budget was met with significant displeasure by investors: sterling and government bonds sold off precipitously. Sterling hit an all-time low of $1.03. As an aside, sterling weakness offset/masked the lion’s share of the equity market weakness for unhedged investors; it fell 18% through the first three quarters of 2022. UK gilts had already been declining, but the speed with which they did so at the end of the month was frightening. So concerning was it, that the bank of England stepped in with a £65bn bond buying programme as it feared systemic risk to pension funds, who held leveraged gilt positions via their Liability Driven Investment (LDI) programmes. This action stabilised the market, but credibility was damaged.
The credit market continued to fall, as both duration and widening credit spreads hurt performance. High yield credit spreads (the additional compensation offered for default risk) started the quarter at 6.5%, then tightened to 5.4% before succumbing to the macro trends described above; they finished at 6.7%. In a recession, default rates will clearly pick up from today’s low levels. However, with illiquidity premia repriced to sub-investment grade debt, which always happens in periods of forced selling, by quarter-end the market was pricing in close to a 10% default rate. To put that into perspective, default rates hit 9.95% in 2009 after the financial crisis. As such, it feels that this space more than others is offering long-term and patient investors good levels of compensation for the looming risks.
The fears of recession also bled through to commodity prices, with the broad index posting a negative return in USD, led down by weaker prices in the energy and industrial metals complex.
Within equities, the tug-of-war between Growth and Value stocks was a more even affair than of late. As we have communicated previously, the vicious rotation away from Growth stocks and into Value stocks looked to have largely played out, with Growth stocks having been de-rated in keeping with the higher interest rate environment. Going forward into a more persistent inflationary environment, company characteristics are likely to be more dominant than broad factor exposures.
Disruption wasn’t limited to listed investments as, in the private markets arena, there were reliable reports of forced selling of positions at heavily discounted prices. There was evidence of this in March, as funds that had over-committed were forced to rebalance. But in the UK, the large collateral calls associated with LDI exaggerated this trend. Discounts of 20-30% in private equity portfolios were mooted.
It serves as a reminder that it pays to invest cautiously over time, as this allows those with uninterruptable long-term plans and patience, to be rewarded – it is these vintages that are often the most lucrative. Another positive point of note here is that the current market dynamic is playing into the hands of our private debt mangers, who are able make loans with middle-market terms, to much larger (and more resilient companies) that would otherwise be tapping the capital markets.
The news flow into the end of the year has the potential to worsen. However, it should be remembered that the market is a forward-looking pricing mechanism, and so often leads the data; and, whilst I do not believe we have seen the bottoms in equity markets at least (as markets always overshoot), we have already experienced a significant correction across all asset classes bar the USD. This movement down, whilst temporarily painful, increases the prospective returns of investors and, as already mentioned, provides opportunities for those committing fresh capital via deployments in the private market programmes, tilting the odds in the favour of long-term investors who can take advantage of forced sellers.