Viewpoint

Risk assets performed well in July, continuing the pattern of recent months, while safe-haven government bonds generally produced negative returns as yields ticked higher.

A month which began with the collapse of another large bank in the US, First Republic, and dramatic falls in the share prices of several other regional banks, ended with the euphoria of the rapidly unfolding AI boom reflected in extraordinary share price gains for the major beneficiaries, most notably Nvidia, whose share price gained 36% in May, taking its return YTD to 160% and a market cap of $1trn.

After a benign three months, February proved to be altogether more challenging. Bond markets suffered a big sell-off as the market substantially repriced interest rate expectations in line with the Fed’s view. At the beginning of the month the Fed raised the Fed Funds rate by 25bps as expected, to 4.5-4.75%, and, while signalling further rises ahead, the accompanying statement was interpreted as somewhat dovish.

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.