Rocktober to Shocktobering Markets
A year of poor returns so far this year has left investors with few places to hide across global financial markets, but while portfolios may be down, investors should heed the lessons of the past when thinking about their longer-term financial goals. So far 2022 continues to be a tough environment for investors globally. As of the end of September, global equity markets had declined around -25% YTD, with Brazil standing alone in the global marketplace as the only major market delivering positive returns.
During the same period, the world’s largest stock market, the SPX delivered losses close to -24%, while the tech-heavy Nasdaq index, home to some of the world’s most recognizable growth companies such as Microsoft, Amazon, and Tesla – lost over -30% of its value. While some markets such as the FTSE and Japan’s TSE held up better than peers, this in part can be traced to losses in their domestic currencies and their effect. The Sterling and JPY weakened against the greenback by -17.5%, and the Japanese Yen by -25.8% respectively in the first nine months of this year. For currency investors outside of the dollar, it has been a difficult year.
Investors turning to traditional ‘safe havens’ will have also found little in the way of respite. Government bonds have suffered steep losses as central banks across developed markets have raised interest rates in response to inflation. As of the end of September, UK government bonds had lost just over -25% of their value at the main index level (see Chart 2), while their US counterparts have also seen significant double-digit losses. Even assets typically thought of as inflation hedges have performed poorly, with the price of gold declining over -9% through to the 30th of September.
Against this backdrop, broad commodities markets have fared relatively well, yet the complexity of these assets means they typically form only a small proportion of an investor’s portfolio. Crude oil, for example, remains in positive territory yet that performance should not disguise the volatility seen in oil prices in the first nine months of 2022, as prices have oscillated between approximately $80 and $125 per barrel.
Overall, this means that 2022 has been one of the poorest years in the past three decades for investment returns across a broad range of risk levels. How investors react to these market losses will be critical in defining their success in meeting future investment goals, but history can serve as a useful guide as to how we should approach a challenging investment landscape.
A year detrimental to bond markets
While equity volatility is a key feature of financial markets, government bonds markets have historically been more stable sources of investment returns with lower volatility characteristics. Interest rates in developed markets have been anchored near record lows for much of the past decade. This has provided little in the way of income returns to investors, but has offered stability for diversified portfolios given the typically negative correlation with equity markets: that is, when equities have fallen, bond prices have tended to rise.
This year has seen a shift in correlations, and government bonds have offered little in the way of compensation for diversified investors as correlations have shifted positively: that is, bonds and equities have tended to move together. This has been a significant change in the investment landscape and helps explain why 2022 has been a challenging year for investment returns, no matter how diversified your investment portfolio is.
The magnitude of negative returns in government bonds so far in 2022 is also difficult to sugar-coat. After years of stability, underpinned by vast quantitative easing programs that made developed market governments large owners of their own debt, the core investment assets have seen a sharp reversal in fortune as interest rates have been raised to combat inflation. In the case of UK government bonds, this has meant the worst annual return since 1998 and the largest drawdown (peak-to-trough decline in value) on record.
The need for portfolio diversification
Asset allocation refers to the mix of different investment assets in a portfolio and relies on the notion that not all investment assets perform in the same way at the same time. It is closely related to the concept of diversification – the spreading of risk across a broad range of investment assets.
Global diversification is a feature that underpins all Nutmeg investment portfolios, and in today’s market environment it continues to prove its worth, despite the recent falls in portfolios. By investing in a broad range of equity markets, as well as a diversified range of bond assets, our portfolios have still protected investors from the full extent of market losses year to date. Recognizing the value of diversification can be difficult when portfolios have delivered losses, yet this core pillar of our investment approach ensures that portfolios are not overly exposed to any one risk factor and offers some stability in a time of broad-based market volatility.
The long-term journey in investing
While this year has been a poor one so far in terms of returns, how investors react to market downturns is critical to their long-term investment success. Experiencing negative returns is an unpleasant experience – even as professional investors facing losses it is an uncomfortable experience. Investing in financial markets requires a long-term perspective and the exercise of patience, but it may also require us to reassess our investment timeframes in light of market movements, given no investment journey is linear in terms of returns.
History informs us however that there are brighter days ahead, even as the global economic picture remains mixed. In the history of financial markets, investors who held steady through periods of turmoil have never failed to recover their capital in a typical diversified, balanced-risk investment portfolio. However, please remember that past performance is not a reliable indicator of future performance.
Economic policy, beginning with the tax cuts first announced in the mini-budget at the end of September, unsettled markets, most notably UK government bonds and pound sterling. The U-turn on many of these policies doubled down with the appointment of new chancellor Jeremy Hunt, which has been seen as an attempt to appease markets and institutions such as the International Monetary Fund (IMF) which was highly critical of the previous policy. On Thursday, Liz Truss resigned as prime minister – after only 44 days in office, the latest development in a tumultuous few weeks for British politics.
A further rise in UK inflation in September to 10.1% has not helped matters, with more pressure now on the Treasury and the Bank of England to act in easing Britain’s cost-of-living crisis.
September’s disappointing inflation report mark could be a turning point for markets
The last print of CPI data came in higher than Wall Street forecasts, with the overall index up by 0.4% for the month and 8.2% higher than a year earlier. The “core” figure, which strips out the more volatile food and energy prices, climbed 0.6% for the month and is up 6.6% for the year, the biggest year-over-year increase since 1982. This follows year-over-year rises in core prices of 6.3% in August and 5.9% in July.
For the last few months, Morgan Stanley’s Global Investment Committee has consistently flagged the potential staying power of inflation, particularly due to the “stickiness” of higher wages and housing costs, as well as a resurgence in demand for services such as airfares and health care.
By contrast, many investors have been slow to embrace the reality of persistent inflation and the Federal Reserve’s resolve to fight it with aggressive monetary tightening. For months, they have instead undercut Fed guidance, hoping for policymakers to ease off on rate hikes and for inflation to quickly revert to the sub-2% levels last seen during the extended period of slow economic growth, or “secular stagnation,” for the U.S. prior to the pandemic. But the latest CPI report finally appears to have dented such hopes, based on the aggressive response across fixed-income markets last week: Treasury yields surged to multi-year highs, with the key 2-year yield approaching 4.5% and the 10-year topping 4%. Market expectations rose for this cycle’s terminal rate or the point at which the Fed will stop raising rates, to nearly 5.0%. The Fed Funds rate is now estimated to reach 4.5% by January 2024, a full percentage point above our forecast for core CPI—a stark potential reversal from recent dynamics in which the interest rate has remained well below core inflation.
These moves suggest the bond market is resigning itself to a “new normal” of higher interest rates and longer-run inflation. What are the investment implications? At current prices, short-duration Treasuries are looking attractive, as they offer yields that are more than 2.5 times the dividend yield on the S&P 500 Index. They can provide investors with decent relative income over the next year when economic growth is likely to slow.
As for stocks, however, the immediate path ahead is not as straightforward. Prices still need to adjust to reflect a more realistic earnings outlook: In our view, the strong demand and pricing power that companies have enjoyed in recent years, and the resulting record operating margins, are simply not sustainable—which is something that stock investors have been slow to admit. If earnings growth were to return to its long-run average, even without an economic recession, we could be seeing a 10%-15% decline from current estimates for 2023 earnings. Although many sectors have factored this in, mega-cap secular growth stocks are likely to still hold risk.
As the third-quarter earnings season begins, we encourage investors to pay attention to companies’ guidance for 2023, particularly to see if there’s an acknowledgment of the potential for a “profits recession,” or negative year-over-year change in profit growth. Meanwhile, consider locking in solid yields in short-duration bonds and shoring up positions in dividend-paying stocks as we wait out equity-market volatility.
Risk warning – As with all investing, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.
Geoffrey Muns is an Independent Financial Advisor and Planner certified from the UK, US, and UAE based out of Dubai for the past 20 years. He also works in the PE/VC space and is a seasoned investment banker having worked with international banks and investment firms in the region. You may contact him at firstname.lastname@example.org