The second quarter of 2022 proved a truly brutal one for equity investors. If anything, the inflation problem is getting worse, with the U.S. and the euro area both running in excess of 8% and central bankers reacting accordingly. The ECB expects inflation to remain “undesirably high” for the next two years and has signaled a rise in rates, the first in eleven years, in July. The Fed has been more aggressive, with a 50-bp hike in May followed by a 75-bp rise in June. Fed Chair Powell said the U.S. is in “strong shape” and “well positioned to withstand tighter monetary policy," while reiterating a commitment to bringing inflation down. There is inevitably a worry that, if rates do climb to something like 3.5% by year end, the U.S. will be pushed firmly into a recession.
There is no end in sight for the war in Ukraine. This has undoubtedly been a key factor in the persistence of inflation as it has had a severe direct impact on, for example, the supply of energy and wheat. The “cost of living crisis” has been a permanent fixture in headlines so it is no surprise that workers have been pushing for a rise in pay. Indeed, they are having some success and there have been increasing signs of wage inflation, with perhaps the highest profile signal to date being an announcement from PWC that they are increasing pay by at least 5%, with the majority of staff getting a greater than 7% rise. Several commentators, not least of which the Chief Secretary to the UK Treasury, have urged caution, citing the possibility of a 1970s-like expanding wage-price spiral.
The wider geopolitical backdrop also remains fraught as President Biden re-iterated that the U.S. would support Taiwan in the event of a Chinese invasion, though officials were once again clear that this does not signify a change in policy and that the U.S. does not support Taiwan independence. On a more conciliatory note, the President also indicated that he may relax some of the tariffs the Trump administration had imposed on China.
The most entertaining goings-on in the market was perhaps the Elon Musk/Twitter circus. An agreement by Musk to buy Twitter and unlock its “extraordinary potential” has apparently stalled, primarily due to increasingly bitter wrangling over the number of fake accounts. The acquisition price was set at $54.20 per share and Twitter ended the quarter at a little over $37.
World equities plummeted and returned -15.7% for the quarter, as measured by MSCI ACWI. The U.S. was the laggard, delivering -16.1% which meant that the S&P 500 suffered its worst first half for more than 50 years. Other regions held up somewhat better in local currency terms, but a surging U.S. dollar ensured far less differentiation for a USD investor. MSCI EAFE posted -14.5% in USD while MSCI Emerging Markets posted a modestly better -11.5%. Value had a relatively better quarter, particularly in the U.S., where the Growthy NASDAQ index plunged an ugly -22.4%.
Meanwhile, the U.S. yield curve continued its march upward in response to increasingly hawkish Fed policy. The 2-year yield rose 64 bps to finish the quarter at 2.92%, while the 10-year yield rose a similar 66 bps to finish at 2.98%. This does not tell the full story, however, as 10-year yields had gone as high as 3.49% on the fourteenth of June, before the massive 75 bps rate hike by the Fed. The subsequent rally in bonds seems to indicate that the market believes this early aggression will either give flexibility to ease later on, or alternatively, prove to be a policy misstep that leads to a period of low growth and/or recession. In any event, the curve is worryingly flat all the way out, with the 30-year yield only very modestly higher at 3.14%.
TIPS fared significantly worse and the 10-year real yield rose by an incredible 117 bps to 0.65%, leaving the 10-year break-even inflation measure down 51 bps at 2.33%. Against this backdrop, bond investors fared poorly for the quarter. The Bloomberg U.S. Aggregate Index returned -4.7%, while high yield suffered more with the ICE BofAML U.S. High Yield Index posting -10.0%. Again, it was emerging markets that did the worst for the quarter, with the JP Morgan EMBIG Diversified down a pretty horrible -11.4%.
You have heard us beat this drum before, but we are happy to repeat ad infinitum that valuation-driven investing works in the long term. Inflation, and policymakers’ responses, will undoubtedly be at the forefront of investors’ minds for the remainder of the year. Higher rates typically cause people to reassess the fundamental value of investments, and this should be relatively good for Value, relatively good for non-U.S. equities, and particularly bad for anything more speculative in nature. (And speaking of speculative investments, Bitcoin, for example, has sunk below $20k leading to the liquidation of the leading crypto hedge fund Three Arrows.)
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 resource equities.
- 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 selloff, the opportunity for an absolute or total return approach in emerging market debt is also intriguing.