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Market update

Market situation: background, analysis, impact on the portfolio’s

The world is under the spell of interest rates. Persistently high inflation rates make investors fear new, sharper and faster rate hikes by central banks. This is exactly what happened mid June: the US central bank (the Fed) raised its interest rate by 75 basis points. This stricter policy, in turn, stoked recessionary fears. Meanwhile, the war in Ukraine is also weighing on the economy, especially in Europe. Not surprisingly, volatility on the stock markets is reaching new heights, even though they appreciated the vigorous action of the Fed and the ECB.

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Interest rate hikes put an end to free money era

On June 15th, the Fed raised its interest rate by 75 basis points in one fell swoop. It had not been since 1994 that we had seen such a steep increase. In early May, the Fed also raised its interest rate by 0.5%, and in March by 0.25%. This brings the policy rate today to between 1.5 and 1.75%. The Fed is not ruling out a 3% level by the end of 2022, the market even anticipates a level of 3.5%. The central bank's stance is clearly becoming increasingly strict, because of the exceptionally high inflation figures. The market takes into account a further 75 basis points increase in July. Powell is determined to curb inflation by adopting a strict interest rate policy, which may last for another two years.

In the start of June,, the European Central Bank (ECB) announced a 25 basis point increase in interest rates for the month of July, and announced another 50 basis point increase for September. It will also discontinue its bond purchase programme, causing interest rates of European countries with challenging budget situations such as Italy to rise sharply. That triggered an emergency meeting of the ECB a week later, where support measures for those countries were announced

Central banks in the UK, Australia and India are also raising their interest rates. This brings the number of interest rate increases this year worldwide to more than 60. The days of free money and easy credit are definitely over.

Inflation continues to rise 

All the central banks are focusing on curbing inflation, which turns out to be higher than expected, time and time again.

  • In the US, the year-on-year inflation rate for May came out at 8.6% (8.3% expected), the highest rate in 40 years. Housing, fuel and food were the main culprits, with the price of food rising by more than 10% for the first time in 40 years. Core inflation, excluding food and energy, was 6%, also higher than expected.
  • In Europe, the inflation figure for May amounted to 8.1% year-on-year, as expected (up from 7.4% in April). The central bank now expects inflation to reach 6.8% in 2022 and 3.5% in 2023. That is higher than the March forecast and significantly above the desired 2% level.

The causes of this exceptional inflation are well known: strong post-covid demand, continuing supply problems, the unpredictable war in Ukraine and continuing lockdowns in China.

When will it peak? Probably the peak will move further towards the second half of the year. Much depends on the amplitude and pace of interest rate increases, and their impact on the economy.

A word of caution though: interest rate rises mainly affect the demand side. A higher base rate makes it more expensive for commercial banks to finance themselves. They pass on this higher cost price to the companies applying for investment loans and to the consumers looking for a mortgage or a car loan. This makes the company or the consumer hesitate to make the investment, especially if they have doubts about how the future will look. The result – weakening demand, which should lead to lower prices. At the same time, the Fed and other central banks have no impact on the level of commodity prices and the problems in the supply chains, which are fueling the inflation figures today.

 

Central banks put a break on economic growth

The economic activity is gradually weakening, partly because of the war in Ukraine and the continuing lockdowns in China . On top of that, the interventions of the central banks will start to have impact on the economy. Chairman Powell initially hoped for a soft landing, but that looks very unlikely now. A technical recession, i.e. two consecutive quarters of negative growth (however small), is becoming increasingly in the cards. This weaker economic activity will also start to seep through into corporate earnings. From mid-July onwards, when the results season gets under way, we may get a view on this.

The World Bank and the OECD, meanwhile, have lowered their forecasts for global growth across the board. They now expect the world to grow at a more moderate pace this year, at around 3.0% (previously over 4%). The World Bank also warns of stagflation, the combination of inflation and weak growth.

There is a silver lining too, though. The labour market on both sides of the ocean remains remarkably strong, supporting growth. Consumers are in good shape for the time being: they still have savings, are not over-indebted, and are strong in wage negotiations.

Equities and bonds remain volatile

Investors in shares and bonds went through a particularly difficult period in recent weeks. Rising inflation figures, sharp interest rate hikes and increasing recessionary fears caused all markets to go into the red. Since the beginning of the year, the US S&P index fell 16%, the European stock market index fell 15% (all in euro terms, closing prices on 16/06/2022). Interest rates on the bond markets soared and the credit risk increased further: lower quality bonds fell more sharply than higher quality ones.

In the short term, inflation and interest rate expectations will be all-important for the direction of the stock markets. The second-quarter results season will not be released until mid-July. The question is to what extent the weaker economic activity will be reflected in corporate profits.

 

Managing your portfolio: towards neutral equity weighting

Our fund manager, Cadelam, sticks to its long-term vision, but remains cautious. Much negative news has already been factored into prices, but due to the exceptional situation (war, post-covid, lockdowns in China), visibility is limited and markets react strongly to important news.

Equities 

The increased uncertainty recently led managers to reduce equity positions slightly, towards neutral weighting. This happened at the beginning of June, when the markets temporarily rebounded. Cadelam remains interested in equities, as the fund manager continues to believe in equities as the best defence against inflation. The sharply adjusted prices of quality companies have sometimes offers interesting buying opportunities. Since October 2021, quality stocks have been picked up at lower prices, from companies that match Cadelam's convictions on long-term themes, show healthy cash flow and earnings growth and have solid balance sheets. The purchases were highly diversified. The optimal spread of the portfolios (more than 200 companies across sectors and regions) creates greater resilience.

Bonds 

The average maturity of the bonds in the portfolio was reduced this year and amounts to 4.1, which is shorter than that of the broader market. This makes the bond slightly less sensitive to interest rate increases. Selling bonds at a loss today is not a good idea: the prices of existing bonds in the portfolios will eventually move back to 100% - unless the issuer is no longer creditworthy. The latter seems unlikely for the portfolios, since Cadelam chooses very creditworthy and liquid bonds. Furthermore, the managers ensure an optimal spread in the bond section in terms of maturity, credit risk, region and sector.

Contact your relationship manager 

When you invest in the stock market, you know that price fluctuations, upwards and downwards, are inherently linked to equities. Share prices react to the latest information, and when there is a great deal of uncertainty, this reaction can be fierce.

Inflation, interest rate hikes and the conflict in Ukraine weigh on returns in recent weeks Nevertheless, we must not lose sight of the long-term perspective. History shows that abrupt panic responses to crises usually do not pay off. Those who exited the stock market in March 2020 or in the fourth quarter of 2018 missed a fantastic stock market ride. Keeping calm and maintaining a long-term perspective is the best strategy in the long run.

On the other hand, if you are feeling anxious or uncertain about the current stock market situation, this is a good opportunity to have a word with your relationship manager. So, feel free to get in touch.