Market update - July 2022
- Shunil Roy-Chaudhuri
- 27 July 2022
- 10 mins reading time
On 5th July, we hosted a webinar in which we assessed rising interest rates, high inflation, the continuing tragic conflict in Ukraine, and the outlook for the months ahead. This briefing is based on that content.
The world is having to deal with high inflation, which in May reached 7.5% across the G7 group of leading economies. Against this background, interest rates have been rising, as central banks can use these as a means to potentially control inflation. In the UK, interest rates have gone up from 0.1% in December 2021 to 1.25% today. We believe they are likely to go higher.
We are seeing significant stock market turbulence. The VIX index, often known as the fear index, attempts to measure this turbulence. There was a big upward spike in the VIX in 2008, when Lehman Brothers collapsed, and there was another big spike during the pandemic.
Today’s VIX levels, of around 30 to 35, are not as high as they were during 2008 and the pandemic, but they are still high by historic standards.* Historically, in the 12-month period following the VIX index rising above 30, the S&P500 index of the largest US companies has returned more than 20% on average. On this basis, periods of market gloom can potentially be a good time to invest for people with longer time horizons.
Asset class returns since 3 May 2022
Our last webinar was held on 3 May and, between that date and 20 June, commodities have continued to rise in value. But UK equities, which rose in the year to 3 May, have declined in the year to 20 June. Meanwhile, North American and European equities, and government and corporate bonds, have continued to decline (see chart below).
Asset class returns for the year to 3 May and 20 June
Source: FactSet 31/12/2021 to 03/05/2022 and 31/12/2021 to 20/06/2022. Past performance is not a reliable indicator of future results.
In the G7 countries, inflation had been low for a long time, but has recently picked up sharply. This is due to post-pandemic shortages of components and commodities combined with the economic impact of the tragic events in Ukraine. For example, there are long car waiting lists, as manufacturers face delays on the delivery of semi-conductors. Regarding commodities, there’s been a rise in global energy prices, with oil up more than 40% in the year to date.
Moreover, unemployment seems to be returning to pre-pandemic lows. It is currently less than 4% in the US and the UK, and some firms are struggling to attract workers. They are often offering higher wages in order to bring employees onboard and this is feeding inflation.
Central banks typically raise interest rates to try to bring inflation down. People’s mortgage payments often go up when interest rates rise, which can leave them with less disposable income. This can reduce demand for goods and services and help bring inflation under control.
Interest rate rises
In June, the Bank of England (BoE) raised rates by 0.25%, and the US Federal Reserve (Fed) raised them by 0.75%, in an effort to tame inflation. We expect interest rates to continue to rise, but to do so gradually. We think they could potentially rise to 2% to 2.25% this year in the UK. And, in the US, we think they could go up to 3% this year. The UK government has already raised national insurance rates and frozen personal allowances, which have reduced disposable income. This means the UK is less dependent on interest rate rises than the US.
We hold bonds in portfolios to provide income, reduce variability of returns and spread risk. The prices of these fixed income assets have been rising since 2008. This is due to the impact of low interest rates (bond prices often rise when interest rates fall) and central bank bond-buying programmes. But, since the start of this year, bond prices been falling as the market anticipated interest rates going up.
This has had an effect on lower risk portfolios, which typically contain a higher allocation to fixed income assets. We think interest rates are likely to rise, but not by as much or as quickly as investors seem to expect. As a result, we believe some bonds could be pessimistically priced and that these bonds have attractive values.
The tragic events in Ukraine have had a global impact. Russia is not a large economy: it’s roughly the same size as Italy. But Russia is a global producer of commodities such as natural gas, wheat, oil and timber. So sanctions against Russia, coupled with supply disruptions due to the Ukraine conflict, have led to commodity shortages and a rise in global commodity prices.
The US is the largest economy in the world. Its economy continues to grow, but has high inflation. The Fed is raising interest rates in order to reduce consumer disposable income, reduce demand for goods and services and bring down inflation. But there’s a danger of a US recession if interest rates are raised too quickly or too steeply.
There has been significant inflation among European Union nations, but the European Central Bank (ECB) hasn’t raised rates, which remain at zero. Even so, the ECB has announced that its bond-buying programme will likely end in July and indicated interest rates will rise by 0.25% in July and again (by an, as yet, unspecified amount) in September. Europe contains many different economies, but they all have the same interest rate. However Germany, Greece and Italy, for example, have different levels of borrowing. This means there are different yields on bonds from different governments, which means that different countries have different effective interest rates. Greece and Italy have high debts and are supported by the European emergency fund.
The UK economy contracted by 0.1% in March and by 0.3% in April but grew by 0.2% in the first quarter of the year. The second quarter of 2022 included the long Jubilee break. This included an extra day of bank holiday, could lead the UK economy to contract in the second quarter.
China is the second largest economy in the world. It currently has a zero tolerance policy towards COVID-19, which involves imposing lockdowns in cities or regions with COVID outbreaks. This can lead to shortages of goods and services in China itself and across economies worldwide. We expect Chinese economic growth to slow to 3.5% this year as a result of this policy. But we believe it will be higher in 2023 due to increased infrastructure spend and a reduction in interest rates.
We anticipate global growth of 2.7% in both 2022 and 2023. We expect China to drive global growth next year as interest rates come down. This expected global growth is not too far below historical levels of global growth.
Summary of portfolio changes
Source: Schroders Personal Wealth, June 2022
The table above shows how we are invested in our portfolios, as compared with our long-term strategic allocations to asset classes (in which every asset class would have a neutral status). These weightings show we have moved from a positive assessment of equities at the start of the year to a cautious assessment at the end of the first half of 2022. In fixed income (bonds) we have moved from a negative outlook to a neutral one. We think bond valuations in general now look more attractive, especially if interest rate rises are lower than the market expects. We remain positive on commodities, although less positive than previously.
*FactSet, CBOE Volatility Index (VIX) USD, 30 June 2006 to 22 June 2022. Past performance is not a reliable indicator of future results.
Forecasts of future performance are not a reliable guide to actual results, neither is past performance a reliable indicator of future results. The value of investments and the income from them can fall as well as rise and are not guaranteed.
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