A Look at Global Financial Markets 27.07.22
This Investment Strategy update aims to provide clients with a comprehensive picture of the global economy and regular updates on the current stock market and fixed income trends, to assist investors in making informed investment decisions. It is headed by Tom Elliott, deVere's International Investment Strategist, who produces regular updates on a wide range of topical investment issues. Please find below the update from 27th July 2022.
Market sentiment: Improved. Investors appear to have rediscovered their appetite for risk, with global stock markets and high yield corporate bonds both making steady gains over the month so far. And it has been the riskier parts of the stock market universe that have performed best: global small cap stocks have outperformed global large cap stocks, while in the U.S the tech-heavy NASDAQ index has outperformed the broader based S&P500 index.
The relatively defensive FTSE100 has made more modest gains, but remains one of the few major stock market indices to record overall gains since January.
The VIX index of implied volatility on the S&P500 over the coming month stands at 24, down from a recent high of 36 in mid-June. The fall in this so-called ‘fear gauge’ suggests greater investor confidence about the future, however the number continues to be well above the low to mid-teens that prevailed for most of the decade prior to the Covid pandemic.
What is behind the rally? The gains in risk assets have come despite continuing high inflation and accelerating monetary tightening from central banks. So what is behind the rally? Possibly one, or several, of the following:
First, investors believe that central banks will squeeze inflation out of the system. The higher interest rates go in the near-term, the sooner they can come down and help facilitate a new economic cycle. This is the message of the core sovereign bond markets, where long dated sovereign bond yields have fallen after recent interest rate hikes. By this thinking, stock markets will weaken if the U.S Fed falls short of the 75bp rate hike markets are pricing in for later this week.
Second, after a poor first half to the year, stock market valuations no longer look expensive. JP Morgan Asset Management calculate that, as of the end of June, forward price/earnings ratios on all the major stock markets were below their 30-year average*.
Third, the ‘there is no alternative’ (TINA) argument persists. Although central banks are raising interest rates aggressively, they remain negative in real terms (ie, below inflation). Compared to current inflation rates of 9.4% in the U.K, and 9.1% in the U.S, bank account cash rates and the yields on government bonds are underwhelming. Equities have the advantage of being linked to the real economy, with many companies able to raise their selling prices with inflation and so offer investors a level of protection from inflation that cash and bonds can’t.
Fourth, large companies are in a generally sound financial position. Big tech in the U.S is cash rich. Global energy and mining companies are enjoying windfall earnings. Rising interest rates help financials boost profits, by increasing the spread between what they pay for capital, and what they can charge their clients for the same money. Meanwhile post-financial crisis regulation have contributed to sound balance sheets amongst the leading banks, reducing the risk of a financial crisis being triggered. Meanwhile, many companies have used the rock-bottom borrowing rates of recent years to re-finance their debt at much cheaper rates. Big Business PLC is in rude health.
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Finally, stock markets are said to look six to eighteen months into the future. By this reckoning, they have already discounted the slowdown in global economic growth over the second half of 2022, that many economists are forecasting. This argument may be reinforced by the first argument, about investors believing that central banks will be successful in bearing down on inflation.
But we must not be complacent. Economic data continues to weaken. Last week, for instance, we saw expectations of a contraction in business demand from purchasing managers index (PMIs) numbers from the U.S and Eurozone economies. In the U.K, GfK reported the weakest level of consumer confidence since records began in 1974. This reflects the ravages of inflation on demand, particularly for discretionary products, as well as increased borrowing costs as central banks tighten credit conditions. As growth weakens, and corporate profit margins get pinched, volatility on stock markets is likely to increase.
Continental Europe appears particularly vulnerable to recession later this year, given its reliance on Russian gas, one of the factors behind the fall in the euro against the dollar (it briefly reached parity on 11th July).
Investors’ response should be to avoid panicking, and stick to basic investment truisms. They should look to allocate cash to risk assets (ie, ‘buy when others are fearful’), while remaining well diversified by asset type as well as sector and geography.
Italy, a crisis, and ever deeper European union. Along with last week’s 50bp rate hike from the ECB came more information about its Transmission Protection Instrument (TPI). Yet another bond purchase scheme designed to ease a crisis, yet another move towards member countries providing direct support to one another, and so deepening the monetary union. But it is also full of conditionality, that erodes national sovereignty over fiscal policy making.
The crisis has come from Italy, where a political fracas has resulted in Prime Minister Mario Draghi’s resignation. A fresh election will be held in September, at which right wing parties are expected to perform well. The spread of Italian government bonds over German bunds has ballooned, as investors fear a new government will prove less fiscally responsible, and put into jeopardy payments worth approximately Euro 200 bn from the E.U’s post-pandemic recovery fund. The result is tighter financial conditions in Italy than in Germany, the opposite of what the ECB would wish to see.
The TPI will allow the ECB to buy the bonds of selected eurozone countries, and so reduce yields and borrowing costs for those countries. But only if ‘a deterioration in financing conditions are not warranted by country-specific fundamentals’. More specifically, the supplicant country must show that it is complying with eurozone fiscal rules, have a sustainable (ie, realistic) debt reduction plan in place, and follow through on commitments made to access post-pandemic recovery funds. These commitments usually refer to the de-regulation of services and utilities, and of labour markets.
Germany and other northern European countries have always demanded closer political union as a condition for monetary union. France successfully resisted this when the euro was created, to the relief of many southern European countries. But as time goes on, and crisis come and go, the cost of bail outs and support -whether monetary of fiscal- is increasingly clear: the blessing of Berlin and other northern countries. Political union, of a sort.
deVere's International Investment Strategist