Economic Performance & Outlook
It is extraordinary how quickly we adjust to new circumstances. The issues which affect us today are quite different from those of most of the last thirty years. We had become accustomed to a world where wars were far away and where central banks were able to manage to keep inflation and interest rates low – and asset values correspondingly high.
Now, as we look forward, we are trying to figure out if the current chaotic situation will persist for many years or whether we will see some sort of stability return in a shorter time period.
The major events affecting developed economies at present are the continuing impact of Covid-19 and the war in Ukraine. When Covid struck in early 2020, it was first thought that it would have a very serious effect on economies in both short and medium term. However, the major fall in stockmarkets was quickly reversed as it seemed as if the problems were largely short term. As the course of the pandemic has evolved, it is clear that, whatever about the medium term, there are long term effects of Covid. The disruption of supply chains and of labour markets looks like lasting for some time. These are having a compounding influence on the anti-globalisation mood which has seized much of the world in recent years.
The period between about 1990 to 2015 was one in which a coincidence of events created a world where economic growth was very healthy. Important elements were the success of China – and other Asian countries – as a cheap manufacturer, the availability of both food and energy and the generally benevolent political situation following the ending of the USSR as an entity. As perhaps was inevitable, these factors created their own tensions – notably the rise of populism and nationalism. These were driven by those who felt they had lost out, whether they be Russian empire builders, US manufacturing workers, Brexiteers in the UK or the far right in countries like France. The financial crisis of 2008 was effectively resolved by central banks, but at the expense of creating an asset bubble based on cheap interest rates and considerable asset price inflation – notably in housing.
It does seem that we are entering a different era from that of the last 30 or more years. What we don’t know is how different? For instance, is China going to turn into an aggressive, nationalistic country or will it realise that its economy is inextricably tied to the rest of the world, accepting the constraints that entails?
The outcome of the war in Ukraine is difficult to predict. We can imagine various scenarios, from a negotiated peace, to one where the frustrated Russians use chemical weapons or even nuclear bombs. It is very important that the Russians are not seen to ‘win’ for the simple reason that their winning would encourage other nationalist empire builders to try something similar. The likelihood is a war that drags on for a considerable time with neither side ‘winning’.
We will be left with a world which will have suffered another blow to globalisation, following the effects of the Trump presidency and Covid. This is a world of warring camps, not one of general cooperation to make the world a better place to live in. One unknown is where China will position itself – as Russia’s protector or in a less partisan role. So far China has supported Russia albeit in lukewarm fashion.
Which brings us back to inflation. Already of concern to us before the war, our focus of uncertainty remains how much and for how long.
The reasons for the commodity shortages driving the recent sharp rise in inflation have been documented in our earlier investment strategy papers. Now we are faced with greater and broader shortages as the problems spread to products such as wheat and other basic foodstuffs. The war means that these shortages will last longer and will affect our behaviour and that of our economies for some time to come.
In short, the fall-out from this awful war in economic terms seems to be a broadening and deepening of the post-Covid issues, particularly those of commodity shortages and rapid price inflation. We may be entering a period of stagflation in economies which are not major commodity producers. In this matter, the US is better placed than Europe, China or Japan as it is more self-sufficient in basic commodities such as food and energy. Management of these economic factors presents a huge challenge to governments and central banks – very different from those deriving from the crash of 2008.
Bonds
Bond performance over past year
All bonds 10+ years, 27/07/2021 – 27/07/2022, local pricing
The key factors affecting bond valuations are the inflationary outlook along with government spending and borrowing plans, so there’s plenty of information to consider when examining the fixed income market.
Two factors have been at work in 2022. The increasing outlook for inflation and interest rates drove a steady increase in bond yields over 2022 until mid-June. At this point, concerns about the odds of a global recession took over and investors moved en masse to the safety of government debt, driving prices up and yields sharply lower.
To illustrate, the German 10-year yield, the European bond standard, began the year at close to -0.2 per cent, rose to a high of 1.7 per cent in June but is now back under 1 per cent.
Equities
Equity performance over past year
27/07/2021 – 27/07/2022, local pricing
Markets have been in sell off in 2022. The mood generally is very bearish and that may be the background for the next 18 months – with likely heavy volatility to boot.
What will be fascinating is the long-term effect of the heightened intervention by governments and central banks. Governments are now having to reduce fiscal stimulus and raise interest rates in the face of inflation and product/commodity shortages. It does seem likely that we have seen the end of the 2010 – 2021 period of benign markets driven by accommodating central banks. At the same time, democratic governments are under extra pressure to spend. Markets are likely to have a much bumpier ride in the next ten years than in the last.
As regards our position, we recommend a core holding of equities with other assets judged against them in valuation terms and remain “neutral” on equities at this time.
European Property
There is a sound long-term outlook as markets recover from a period of rental weakness. We may experience a short-term correction in value as interest rates rise, especially if we enter a recessionary environment, but property has the capacity to deliver reasonable protection against inflation over the medium term.
Commodities
Commodity performance over past year against equities
27/07/2021 – 27/07/2022, US dollars
After a long period of weak commodity prices – culminating in the very low oil prices of 2020 – we have seen huge gains in price in the last year. This began with energy and has spread into many commodities including staple foods.
In the medium to long term, these prices are probably unsustainable and indeed the summer has seen a sharp sell-off; the volatility of these markets make them attractive only to serious risk takers.
Hedge Funds
Hedge fund performance over past year against equities
27/07/2021 – 27/07/2022, US dollars, hedge funds priced monthly
Absolute performance over time has been disappointing. The defensive qualities of hedge funds are being shown to be more evident in a market reverse.
Currency Funds
Sharp movements in currencies in recent months have given some opportunities for gains (and losses). These funds continue to be a useful diversifier.
Global Tactical Asset Allocation Funds
These funds provide better diversification benefits because of their broader investment universe. Recent experience has been quite good; however, performance can vary considerably between those performing well, and those that are struggling to deliver. For this reason, many have still to really prove their worth and having a good understanding of what you expect to get for the fee you are paying is key to investing in this asset class.
Senior Loans
Another diversifier, these loans are illiquid and have some credit risk, which is the basis of the return over cash that investors receive. While the risk of default on the underlying investments increases during a downturn, their floating rate nature is an attractive characteristic in times of rising interest rates like now.
