The quarter started well, with both equites and bonds rebounding strongly in July, but this proved something of a false dawn; by the end of September, it had proved to be another ugly quarter for traditional investments.
Inflation and consequent rises in rates remain a key issue and, despite the efforts of central bankers around the globe to act quickly and decisively, the problem is proving increasingly stubborn. As the expectation for rate rises becomes more prolonged and more pronounced, investors are worrying about the impact of a likely recession.
The war in Ukraine shows no sign of abating and the resultant energy crisis in Europe is getting worse. There are widespread reports that shortages may lead to energy rationing and mass power cuts through the winter. Perhaps even more worryingly, tensions between China and the U.S. seem to be escalating after Nancy Pelosi visited Taiwan in August, prompting China to announce missile tests, although the U.S. stated that her visit did not alter its longstanding policy in the region.
China is still pursuing a zero-Covid policy, and this is hampering economic growth in the country as well as impacting global supply chains. If we needed a reminder that we are still not finished with Covid, the megacity of Chengdu (which has a population of some 21 million people) spent much of September under strict lockdown.
We saw political change in Europe, with the exit of leaders Mario Draghi in Italy and Boris Johnson in the UK. The start of new UK Prime Minister Liz Truss’ stewardship was put on de facto hold as the nation stopped to mourn the death of Queen Elizabeth II, ending her seventy-year reign as monarch. As soon as the government did get back to business, it sent UK markets into a tailspin by announcing a swathe of tax cuts with no information as to how they will be paid for. As the pound sterling hurtled towards parity with the U.S. dollar (but did not quite get there) and following what was a catastrophic sell-off in gilts, the Bank of England stepped in with some calming measures to try and restore order.
World equities, as measured by MSCI ACWI, returned -6.8% for the quarter and an incredible -25.6% for the first nine months of the year. Developed markets outside the U.S. held up the best in local currency terms, but a surging dollar more than offset this. The S&P 500 delivered -4.9%, MSCI EAFE posted -9.4% (a far cry from the -3.6% local currency return), and MSCI EM was dragged down by China, returning -11.6% (MSCI EM ex-China did much better at -5.6%). Value did a little worse for the quarter in developed markets as investors seemed to move their focus from “rate rises are bad for Growth stocks” to “recession is worse for Value stocks.”
Meanwhile, the U.S. yield curve continued its march upward in response to the increasingly hawkish Fed policy. The 2-year yield rose a truly remarkable 130 bps to finish the quarter at 4.22%, while the 10-year yield rose 85 bps to finish at 3.83%. As the yield curve has morphed from worryingly flat to truly inverted, the pessimists are quick to point out that historically this has been a pretty reliable harbinger of doom. TIPS fared significantly worse, and the 10-year real yield rose by an incredible 103 bps to 1.68%, leaving the 10-year break-even inflation measure down 18 bps at 2.15%.
Against this backdrop, bond investors fared poorly for the quarter. The Bloomberg U.S. Aggregate Bond Index returned -4.8%, although high yield held up much better (admittedly after a horrible second quarter) with the ICE BofAML U.S. High Yield Index posting a -0.7% return. Emerging market debt also had a relatively tough time and the JP Morgan EMBIG Diversified returned -4.6%.
In these uncertain times, it is more important than ever to pay attention to valuation. The continuing selloffs make some assets look increasingly interesting, and we have been cautiously adding to risk. Higher rates typically cause people to reassess the fundamental value of investments, and this should be particularly bad for anything more speculative in nature while being relatively good for Value non-U.S. equities. Indeed, the extreme divergence in valuation between the U.S. dollar and many overseas currencies makes the case to invest outside the U.S. even more compelling.
Our views and positioning have not markedly changed, and we wholeheartedly reiterate the suggestions we offered last quarter:
- Exploit this global Growth bubble with a long cheap-value/short expensive-growth equity strategy.
- Avoid the Growth bubble by investing in liquid alternatives.
- Skirt around the Growth bubble by pivoting your equity exposure to EM value, Japan small value, quality cyclicals, quality, and resources equity.
- Keep duration short in fixed income portfolios and use active management in credit, where there remain pockets of dislocated pricing and higher yields provide reasonable protection against bad outcomes. Following the months-long sell-off, the opportunity for an absolute, or “total return,” approach in emerging market debt is also intriguing.