After a period of decent growth in the summer, September was another difficult month for financial markets. In particular, the situation was rocked by growing inflationary fears and the continuing conflict in Ukraine.
Perhaps counterintuitively, one positive from the month was the downward revision of company profits, which made valuations look slightly more attractive, particularly in the US.
Let’s take a look at the figures. Performance for the key equity markets was negative at the end of the month – the US lost about 9% while Europe was down around 6%. Bonds also suffered. The bulk of the issues stem from the rate hikes seen across the world, as Central Banks try to fight rising inflation. For the first time in history, we’ve seen three consecutive negative quarters for equities and bonds at the same time.
The key concern for markets continues to be inflation and its impact on the actions of Central Banks. In the US, inflation is being driven in large part by strong demand and a relatively stable labour market. In the Eurozone, the key problem is weak economic growth and the spike in energy prices caused by the war in Ukraine.
Inflation: what happens now?
We believe that inflation will begin to decelerate in the coming months, which may provide a platform for recovery in the markets. The US is probably the best positioned to take advantage of this, with fewer energy concerns and less immediately complex geopolitics.
Given the volatility and short-term uncertainty, we maintain a cautious positioning in terms of equity weight and risky assets. The trade-off between cheaper valuations and bearish earnings expectations remains key, but from a longer-term perspective it could offer more attractive expected returns than in recent years.
Compared to the past decade, government bonds offer high yields to maturity. We’re currently maintaining a conservative duration, both due to the high volatility of interest rates, and due to the flattening of the curves, which offer more attractive short-term risk-adjusted returns. However, if inflation stabilises and recession becomes more likely, the argument in favour of an extension of the maturities gains momentum.
War in Ukraine: some potential scenarios
The crisis in Ukraine is seemingly no closer to an end. After a period of relative calm, the war returned to the front pages in September as a result of serious political and military escalation.
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Firstly, Ukraine continued its counter-offensive, forcing President Putin to call reservists to arms and to hold pseudo-referendums to increase Russia’s alleged claim on the disputed eastern regions. Given the success of these Ukrainian operations, Putin’s tone has turned more extreme, with the threat of nuclear conflict being deliberately peddled.
Finally, Russia finally cut off its supply of gas and oil to Europe. Although this move was fundamentally priced into markets already, it further increased the risk of a tail event. In our opinion, the nuclear threat still seems implausible, though Putin may test American tolerance with tests in Crimea. From a markets perspective, things seem to be (relatively) calm for the moment – the hope is that the West and Russia start re-building some kind of constructive diplomatic relations and that the heightened tone will subside.
Euro/dollar parity: where are we?
The strengthening of the dollar relative to both the Euro and the Pound had already begun in mid-2021. It’s important to remember that the dollar is a safe haven asset and has benefited from the strong volatility and geopolitical upheaval of the last nine months.
Another factor is the monetary cycle of the Fed, which has already made 12 rate hikes since last March and is far further down the line than the ECB or the Bank of England. Finally, the US economy is simply exposed to fewer risk factors. All of these elements have combined to create a strong appreciation of the US currency relative to its key competitors.
Forecasts for the euro/dollar and GBP/dollar exchange rates are uncertain and have been revised downwards given the risks faced by the European economy and the difficult position of the ECB – weak growth and high inflation.
One potential positive scenario would be the Fed embarking on a path of expansive monetary policy while the ECB insists on monetary tightening. This seems unlikely over the short term, given the economic and geopolitical context of the Eurozone, and the US inflation target which is still a long way off.
As always, if you want to discuss anything related to financial markets or talk about your portfolio in more detail, please feel free to get in touch with our advisory team. We will be back in a month with the next market update.
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