Viewpoint

Following a bruising year for investors in 2022, markets opened 2023 in much better spirits. Nearly all the major asset classes enjoyed strong returns, with global equities up over 7% in dollar terms in January, global bonds by close to 3%, corporate and emerging market bonds outperforming governments, and gold up almost 6%. Commodities were generally more subdued, with the oil price declining by 2%, taking it 7% lower than a year earlier, a dramatic turnaround from its steep rise in the early months of 2022.

The third quarter started with bond yields falling, equities in the midst of a sizeable rally, and a perception that increasing evidence of a slowdown in the US and Europe would lead to a relatively short tightening cycle and a more dovish Fed. It ended with an increasing probability of recession, yet the most hawkish Fed since the Volcker era, bond markets in disarray and equities at new lows for this cycle.

The third quarter started with bond yields falling, equities in the midst of a sizeable rally, and a perception that increasing evidence of a slowdown in the US and Europe would lead to a relatively short tightening cycle and a more dovish Fed. It ended with an increasing probability of recession, yet the most hawkish Fed since the Volcker era, bond markets in disarray and equities at new lows for this cycle.

The rally in equity markets that started in mid June continued into the first half of August, taking Wall Street 17% off its June low, but was ultimately overwhelmed by the global energy crisis and extraordinary falls in bond markets through the month, reversing most of the gains of the previous two months. The biggest falls came in Europe, and most extreme was the UK, where yields on 2-year government bonds rose by 130bps, taking the yield to 3.0% at month end, the highest for 15 years. The UK 10-year yield also rose dramatically, up by 94bps to 2.8%. Eurozone bond markets fared only slightly better, with the German 2-year yield up by 93bps to 1.19% and the 10-year up 73bps to 1.54% over the month.

After a torrid six months, with global equities suffering a 20% decline and most developed world sovereign bond markets producing negative returns each month in the first half of this year, there was finally relief in July. Led by Wall Street, with the S&P 500 up over 9% in the month, the MSCI World index returned 7.9%, while the JPMorgan Global Government Bond index returned 1.9%. Riskier parts of the bond market, which had sold off heavily in the first half of the year, recovered sharply, with US investment grade bonds +3.2%, high yield bonds +5.9%, and emerging market debt +4.0%.

The sharp downturn in financial markets this year broadened and deepened in the second quarter, resulting in an exceptionally difficult six months for investors. While in Q1 there were some pockets of strength – commodities, gold, UK large-cap equities, and a small number of emerging equity markets and currencies, in the second quarter the only positive returns of note came from oil and Chinese equities. With the dollar surging throughout the period, the only safe haven to preserve capital in dollar terms was US dollar cash. Developed equities returned -16% in Q2, led by the US, and are now down by over 20% YTD.

The brutal sell-off in markets this year finally stabilised Performance of major markets 2022 to date (local currency terms) during May, although the rally was by no means uniform, and investor sentiment remained nervous in the face of intense uncertainties about inflation, growth, and the unfolding impact of the war in Ukraine. No single catalyst triggered the rally, rather a combination of factors: signs of a consumer squeeze and economic slowdown ahead, leading to a sense that inflation is nearing a peak and the Fed’s hawkish policy shift could be enough to bring it under control; improved valuations leading to some dip-buying and a short squeeze in some of the big tech stocks which have been hammered this year; a weaker dollar; and China’s support for its ailing economy and loosening of covid restrictions in major cities.

The war in Ukraine, and widespread evidence of Russia’s depravity as its advance falters, continues to cast a dark shadow over the world. With Russia’s invasion now into its third month, and both sides increasingly intransigent with no signs of a negotiated end in sight, the probability of a long, attritional war is rising. The longer the war drags on, the greater the risk of longer lasting economic damage, transmitted primarily through global energy and agricultural commodity prices. Yet in April it was deepening worries about economic imbalances, which had been developing long before the invasion, that drove financial markets – ultra-loose monetary and fiscal stimulus adding fuel to the fire of post-pandemic release of pent-up demand, triggering excess demand in supply-constrained markets, in turn leading to high and persistent inflation. War in Ukraine has exacerbated these imbalances by driving commodity prices higher, and, in damaging consumer and business confidence, especially in Europe, it has created even greater challenges for central banks as they begin the process of attempting to unwind excessive policy stimulus without triggering recession

The benign conditions enjoyed by financial markets in the 18 months since the depths of the pandemic were well and truly shattered in the first quarter of 2022, driven by two powerful shocks, both largely unexpected and each with huge consequences globally: Russia’s invasion of Ukraine and the Fed’s very sharp hawkish shift in policy. The immediate consequences of the war produced surges in energy prices and further disruptions to key commodity markets and supply chains, adding to the damage inflicted by the pandemic. But away from commodities, there were few markets that could withstand the heightened risk of a significant slowdown in global growth and much higher interest rates than anticipated only a few months earlier.

“There are decades where nothing happens; and there are weeks where decades happen.” – Lenin

The quote is attributed to Lenin shortly before the Russian revolution. The week which started on February 24th, when Russia invaded Ukraine, is one of those weeks. Russia’s aggression and the unfolding humanitarian disaster have shaken the West to its core. The self-indulgent complacency spanning three decades since the fall of the Berlin Wall and the break-up of the Soviet Union has hit the brick wall of an existential threat to the liberal order of the democratic free World.