A brutal second quarter in global equity markets has led to the worst first half of the year for more than a decade. This has been exacerbated by Sovereign debt (gilts in the UK) also retreating sharply rather than providing a safe haven as other risk assets sell off. An (im)perfect storm for investors.
Inflation is at the core of the problem globally. As so often, it is in the US that its persistence has challenged forecasters the most. Being largely self-sufficient for energy supply, inflation was expected to peak in the US in March, but further increases have led the Federal Reserve to accelerate interest rate rises, negatively impacting sentiment that was already fragile.
Few investments can provide absolute protection from spikes in inflation particularly when starting from relatively full valuations and this has proved to be the case. Infrastructure investments and other ‘real’ assets can provide some ballast, as can gold, but none are totally immune as interest rates rise from extraordinary low levels.
Corporate Bonds have also endured a torrid quarter. Inflation and rising interest rates have proved to be a difficult back-drop, but company defaults still remain extremely low which is positive for now. Concerns that Central Banks were behind the curve in the battle against inflation took centre-stage. Put simply, rates might have to rise further and stay elevated for longer if inflation feeds through into large wage increases.
Broadly, commodity prices have risen in the first half of the year, as global demand has outstripped supply, exacerbated by the uneven recovery from the pandemic geographically. The Russian invasion of Ukraine and subsequent prolonged hostility has added to the supply-side problems particularly in energy and food. In the cyclical nature of things, a mild recession is likely to restore the balance of supply and demand for energy.
It still remains unlikely that inflation will remain at its current elevated level over the long term. The risk of that outcome has however increased – hence market nervousness.
The transition to a more inflationary environment has been painful and more prolonged than expected by markets. Companies do adjust as was demonstrated by the reaction to the pandemic and corporate earnings are currently healthy although under pressure in many sectors. More resilient supply chains and less access to cheap goods and labour globally are challenges but will be overcome in time.
It is normal for sentiment, good or bad, to cause markets to overshoot, both up and down. We are not tempting fate and calling the bottom of markets. But, with a recession already being anticipated, we are at a level where asset prices can recover as and when the outlook becomes less gloomy. For now, a balanced approach to investment and focus on the long term remain suitable.