Mondial Dubai - Chart Of The Week

What does the chart show? The chart shows the performance of various currencies versus the US dollar as well as the performance of the US dollar trade-weighted index (a measure of the value of the USD against a basket of other major currencies) year-to-date. All major currencies have fallen significantly this year and the USD trade-weighted index has risen as markets position for an increasing divergence in monetary policy paths between the US and other major economies. The Japanese yen has struggled so far this year as the Bank of Japan (BoJ) continue to run with ultra-loose monetary policy. The euro and sterling have also suffered as investors have started to question how far the European Central Bank (ECB) and Bank of England (BoE) will be able to raise rates this year without having severe economic ramifications. Additionally, the recent depreciation of China’s currency against the dollar comes as the country grapples with a resurgence in Coronavirus, dampening the outlook for global growth, further bolstering the dollar which is traditionally seen as a safe-haven currency when investors flee from risky assets (despite Q1 GDP in the US unexpectedly falling nearly 1.5%). Why is this important? As investors flee to the US dollar, this would hurt US multinationals who need to convert their weaker foreign currency revenues back into a stronger dollar. A stronger dollar would not be beneficial to US exporters, particularly at a time when slower global growth potentially means lower demand for their products and services. However, a stronger currency may be advantageous to the Fed who might welcome the downward pressure a stronger dollar exerts on the current multi-decade high inflation rates, which in turn may give policymakers more flexibility as they may not need to raise interest rates as high as they otherwise might have. For other economies around the world, a stronger dollar makes dollar-priced goods and services more costly to buy in their local currencies. With recessionary risks to the eurozone, the UK facing a potential economic slowdown and the BoJ committed to retaining ultra-loose monetary policy, the US dollar may not be ready to cool off just yet.

What does the chart show?The chart shows the US Treasury yield curve (red line) and the US breakeven yield curve (blue line) as at 4 May 2022. The first compares the yields available on similar US treasury bonds with different maturities. Its “normal” shape is upward sloping, with higher yields on bonds with longer maturities, reflecting investors being compensated for tying up their capital for longer and being more at risk of changes in inflation and interest rates levels. The breakeven yields, instead, indicate the maximum level to which bond yields can move to in the next year before investors start experiencing a net negative total return. The higher the breakeven yield compared to the bond yield, the more the investor can withstand a yield rally. Why is this important? With the Fed tightening monetary policy and increasing policy rates, the front end of the curve has repriced substantially, moving from a 0.2% yield on a 2-year bond only 12 months ago, to the current value of around 2.8%. The long end has also come up, though by a lesser extent, with the 10-year yield having come up from 1.6% to 3% over the same period. Bond investors have experienced very poor total returns over the period, -4.3% and -9.2% respectively for the 2-year and 10-year maturities, as rising yields (or falling bond prices) overwhelmed the lower starting yields.However today the situation is substantially different. The risk of bond yields rising is still very high, but starting yields are a lot higher than a year ago, which provides a good buffer for bond investors. For instance, an investor in the 2-year US treasury bond would need to see yields going up by about a further 1.9% over the next year before eroding all the gains made on the income and roll-down side. Long-term investors have a lower buffer, because of the longer duration (and hence interest rates sensitivity) of their income streams, but right now the longer end of the yield curve seems to be less at risk of big swings.Is it time to be interested in government bonds again?

What does the chart show? This week’s chart shows the exchange rate of the Japanese yen against the US dollar (showing JPY per 1 USD). The yen’s recent depreciation (illustrated by an upward sloping line) started in early 2021 though it has recently depreciated against the dollar every day for 13 days up to 19 April – its longest losing streak since 1971* – and now sits at its weakest level since May 2002, as divergence between monetary policy paths weighs on the Japanese currency. Yen weakness has traditionally been beneficial for Japan’s export-driven economy (as their translated earnings are worth more in yen terms), but at these levels companies are more concerned about how it will further inflate fuel and raw material imports which are already surging due to the war in Ukraine. Japan is a large importer of oil and gas, and the big price rises in those markets pushed the country’s trade deficit to its widest point in eight years in January. Why is this important? Many investors have often owned the Japanese yen as a safe haven asset during periods of financial and geopolitical stress. Yet so far this year the currency has weakened over 10% against the dollar, leading some to question its traditional diversification role. On many metrics the yen looks cheap now. However, further hawkish comments from Fed officials have continued to widen the policy divergence between the Bank of Japan (BoJ) and the Fed. The BoJ’s pledge to continue stimulus measures in order to boost Japan’s economy and maintain interest rates of -0.1% massively differs from other key central banks, particularly the Fed, where policymakers have already started raising interest rates this year to combat surging inflation. Whilst US consumer inflation sits at 8.5% today, in Japan it is just 0.9%. The BoJ has also reaffirmed its commitment to yield curve control by purchasing Japanese Government Bonds (JGBs) without limit to keep 10-year yields near 0% which has widened the gap between yields on JBGs and US Treasuries. The surge in inflation across western countries has made central banks like the Fed increasingly hawkish and determined to push ahead with their rate rises despite uncertainties of the financial ramifications from the war in Ukraine whereas Japan’s central bank remains unwaveringly dovish. *Bloomberg data only dates back to 1971

What does the chart show?The chart shows the performance of the MSCI World sector indices year-to-date, in total return dollar terms. The notable outperformers so far this year have been the energy and metal sectors supported by higher underlying commodity prices, boosted by elevated demand and tight supply. Financials began the year outperforming most other sectors as the outlook for a higher interest rate environment benefits these companies through higher net interest income, however, Russia’s invasion of Ukraine spooked investors, sending most sectors into negative territory. The worst performing sectors this year have been information technology, consumer discretionary, and communication services. The prospect of higher interest rates has a greater negative impact on growth stocks as the interest rate used to discount their higher future earnings increases, meaning the present value of those earnings decreases. Furthermore, the consumer discretionary sector is more sensitive to prospects of lower growth and slower consumer spending.Why is this important?The first quarter of 2022 was driven by two powerful shocks: Russia’s invasion of Ukraine and the Fed’s sharp hawkish shift in policy. The immediate consequences of the war produced surges in energy and other commodity prices and further disruptions to key commodity markets and supply chains, exacerbating the damage inflicted by the pandemic. It is now the indirect consequences of the war that are increasingly driving financial markets and are likely to do so in the months ahead. The focus has shifted to the inflationary implications, the surge in commodity prices, damage to supply chains, the risk of shortages, and the extent to which central banks will tighten policy to combat this more persistent inflation. The large-cap UK equity index has been a standout performer year to date, buoyed by its significant weight to energy and miners. A lot of ‘value’ managers have benefitted from long-standing overweights to these sectors. On the other hand, the technology dominant US market has endured a more challenging period, as have ‘growth-focused managers with overweights in tech and consumer discretionary stocks.  

What does the chart show? The first quarter of 2022 saw the worst quarterly performance of US Treasuries (government bonds) on record as the Fed moved to tackle soaring consumer prices by withdrawing stimulus and hiking interest rates. Markets now see a strong possibility that the Fed will increase rates by 50bps at its May meeting. The expectations for a more hawkish Fed led to a sell-off in Treasuries across all maturities. Given the inverse relationship between bond prices and yields, the first three months of 2022 has seen yields rise sharply with shorter-dated debt bearing the brunt of the Fed’s more hawkish stance.   Why is this important? Driven by fears that central banks will have to be more aggressive in suppressing multi-decade high inflation, global bond markets have experienced heightened volatility so far this year. Fed Chair Powell recently signalled his willingness to support a 50bps hike at May’s Federal Open Market Committee (FOMC), with other Fed officials also echoing his stance. Fed policymakers have expressed that combatting rising inflation is their top priority and they may be willing to risk slower growth in order to reach the Fed’s 2% target. Shorter-dated debt has especially suffered with 2-year Treasury yields rising the most in one quarter since 1984 and last week, the 2-year yield exceeded the 10-year yield for the first time since 2019 (a yield curve inversion is seen by many as an indicator of a recession), reinforcing the view that these steeper rate hikes by the Fed may cause a recession due to demand destruction. Investors have become accustomed to Treasuries playing a reliably defensive role in portfolios in recent decades, and whilst they might continue to do so at times, particularly at points of market crisis, high inflation and low bond yields pose a key risk and we anticipate more volatile periods ahead for the world’s favoured safe-haven asset class.  

What does the chart show? This chart shows the calendar year total returns for the MSCI Europe ex UK index and the maximum drawdown the index experienced over each calendar year since 2000. Maximum drawdown reflects the greatest peak-to-trough fall over the period (the worst possible loss an investor could have made if they had bought at the peak and sold at the trough in the same calendar year). European equity markets have experienced heightened volatility in the past two months and uncertainty around the ramifications of the war in Ukraine which has weakened market sentiment. In light of the rapidly evolving situation, investors are finding a level which discounts the heightened risks and the financial consequences (which will be felt more in Europe given its higher dependence on Russian gas). Despite recent volatility, this year’s maximum drawdown (so far) of -21.4% is only marginally worse than the average calendar year maximum drawdown of -20.9% since 2000. Why is this important? Even during the strongest years for markets, there are always periods where markets fall. Volatility and capital loss are part of investing in any financial market and should be anticipated. Europe is more exposed to the financial consequences of the war than other regions and some of these financial implications are yet to become apparent. There are also other factors spooking the market at the moment: most notably Eurozone inflation reaching a record high of 5.9% in February – implying that tighter monetary policy and potentially slower economic growth lie ahead. After their sizeable falls, markets are rapidly discounting these risks and are offering some longer-term buying opportunities. Times like this tend to lead to a compression of investor time horizons. Now, more than ever, is a time for longer term perspective, riding out the short-term volatility, to participate in the recovery whose timing is unpredictable, but which surely lies ahead.

What does the chart show?The chart shows the returns of various mainstream bond indices rebased to 100 from December 2019. Markets reacted as the Federal Reserve lifted interest rates by 25 basis points last week, as it faces the highest level of inflation in forty years, with a sell-off in US Treasuries (blue line) and US (inflation-linked) TIPS (red line). Rising inflation reduces the appeal of low-yielding debt where the purchasing power of principal and coupon payments are depleted as consumer prices surge. The bond sell-off (and subsequent rise in yields) has been seen worldwide as central banks wind back pandemic-era stimulus to combat rapidly elevating consumer prices and rapidly switch to monetary tightening. The steep sell-off emphasises the degree to which some investors have underestimated how far central banks are willing to go in order to tackle rising inflation (just three rate hikes of 0.25% were priced in at the start of the year in the US, a long way from current expectations, covered below). Why is this important? US consumer price inflation soared to 7.9% last month, with Russia’s invasion of Ukraine prompting sharp jumps in commodity prices, exacerbating existing inflationary pressures. Fed Chair Powell’s comments reinforced the view that the key concern from the war in Ukraine is that it will add fuel to rising inflation, leaving it more persistent in the economy, opening the door to tightening monetary policy at a faster rate than initially anticipated. Markets have priced in a further 190 basis points worth of rises at the remaining six FOMC meetings this year, effectively provisioning for at least one rise above 25 basis points. Powell’s remarks sparked a sell-off in government debt, sending yields higher with the moves particularly sharper for short-maturities. Government bonds are offering little or no downside protection amidst geopolitical turmoil. US Treasuries are currently set for one of, if not their worst, quarter ever. They are certainly not a source of risk-free return they were perhaps once perceived to be! It is also noticeable how poorly (dollar denominated) emerging market sovereign debt has performed this year. This, in part, is explained by direct Russia exposure but that was never really more than low single digits. We think there is likely an element of ‘baby out with the bathwater’ here and so it is an asset class we have spent more time on recently and have recently added to in some portfolios.

What does the chart show?The chart shows the price-to-earnings (P/E) ratio for the MSCI China index (Chinese equities) relative to the MSCI ACWI index (global equities). The P/E ratio measures the relationship between a company’s stock price and its earnings per share (EPS), giving investors a sense of the valuation of the company, or broader market, and how much investors are paying for the earnings of a business. Companies with high P/E ratios are often growth stocks and can, at times, be overvalued compared to their current fundamentals. Similarly, companies with low P/E ratios are referred to as value stocks and are sometimes considered as undervalued. Over the last twelve months, the valuation of Chinese equities relative to broader global equities has declined to sit at historic lows.Why is this important?Investors in Chinese equities — both onshore and offshore listed names — have been spooked by the long-running crackdown by President Xi’s administration on companies in the technology, property and education sectors; default concerns in the property sector; lockdowns in wealthy cities, including tech-focused Shenzhen, as the country grapples with rising Covid cases; slowing economic growth and more recently, concerns over China’s support for Russia in Ukraine, which it denies. MSCI China’s relative valuation sat at its lowest level in over fifteen years this week as US regulators threatened to delist several Chinese companies (listed in the US) unless they provided detailed audit documents that supported their financial statements. However, Chinese stocks performed a major U-turn on Wednesday and rebounded very strongly (the Hang Seng rose +9% with tech stocks up significantly more) as China’s top economic official intervened to reassure investors. The State Council said Beijing will take strong measures to boost the economy this quarter, would take steps to prevent further risks building in the property market and will keep the stock market stable, though details of such stimulus measures didn’t appear to be provided. There is certainly a lot of bad news already in the price of Chinese equities. These historically low relative valuation levels certainly warrant a closer look at the region.

What does the chart show?The chart shows the German 10-year inflation breakeven rate, derived from the difference between conventional nominal and inflation adjusted government bond yields of the same maturity. Its value indicates what market participants expect inflation to average annually over the next 10 years. It is coined the breakeven rate as it refers to the average level of inflation that would need to be achieved to make an investor indifferent from buying an inflation linked bond or a nominal bond. If you think inflation will exceed this breakeven rate over the period, buy the inflation linked bond; if you think inflation will fail to hit this level, buy the nominal bond. Germany’s 10-year breakeven rate has risen materially in recent weeks amidst soaring commodity prices leading to further rises in inflation expectations. The rate has recently surged as much as 43 basis points since the beginning of March to an all-time high of 2.62%, in a sign that investors are moving to price in higher, persistent inflation for the years ahead.Why is this important?Prior to events in Ukraine, the ECB had been widely expected to draw back stimulus at a faster pace in an attempt to tame inflation – with the Euro Area flash CPI print for February coming in at 5.8%, its highest level since the formation of the single currency. Now, Russia’s invasion of Ukraine has unleashed significant uncertainty since the EU relies on Russia for some 40% of its gas supplies. In the last few days the EU has committed to cut Russian gas imports by two-thirds within a year, and we have also seen the US and UK move to ban Russian oil imports. Energy prices are a key component of inflation baskets and thus these developments are expected to push inflation sharply and rapidly higher. These risks surrounding higher energy prices are unlikely to dissipate in the short term and remain a threat to short-term market stability. The ECB is now widely expected to keep its monetary policy settings unchanged at its March meeting (which will have been announced by the time this note is published) a 180-degree turn since its shift to a more hawkish stance at the February meeting. With the price of oil and gas soaring in a very short space of time, economies have little time to react to absorb those jumps and its impact on consumer spending and confidence could instead tip economies into recession and prove to be deflationary over the long-term. Who would want to be a central banker now?!

What does the chart show?Given recent events, we thought it would be a good opportunity to examine past wars/conflicts and analyse the drawdowns of the US equity market (as measured by the Dow Jones Industrial Average index) and how long it took for the index to return to its prior peak. Major wars clearly impact stock markets by creating uncertainty, hitting investor sentiment, and potentially damaging economic activity. However, analysing past military conflicts shows that permanent damage wasn’t inflicted on markets, and they eventually recover. The Dow Jones initially sold off around 6% from 10th February but has rebounded since. For most events we have charted, markets returned to their prior peak in less than 60 trading days (3 months). The exceptions are the Cold War and the Gulf War which took 107 and 137 trading days respectively to recover. Whilst these might look significantly longer than the other events charted, during WWII it took the Dow 1,368 trading days to recover and throughout the Global Financial Crisis it took 1,359 trading days. In all of the conflicts charted, the US equity market never fell more than 20%.Why is this important?The rapid and alarming turn of events in Ukraine has shaken markets and compounds an already uncertain environment due to high inflation and central bank monetary tightening. We expect the direct global economic impact to be limited as Ukraine and Russia are smaller economies compared to more developed economies. This unwelcome turn of events in Eastern Europe is unlikely to cause a major bear market but rather a short-term shock. We do not underestimate the disaster that this brings but wars do end and this one is expected to be of limited duration and spread. It comes at a time when the global economy and corporate sector are recovering robustly from the Covid-19 pandemic and while there is likely to be some knock to confidence, directly from the escalation in Ukraine and from second order effects including higher energy prices, the broader impact should be limited.

What does the chart show?The chart shows the quarterly net flows and total assets in sustainable or ESG (environmental, social and governance) funds since 2011. The last two years have seen a stark increase in demand for these funds, accelerated by the pandemic as well as events such as COP26 which have put issues around sustainability into the spotlight. With total assets of $2.4trn in Q1 2020 more than doubling to $4.6trn by the end of 2021 it highlights the greater consideration that investors are giving to responsible and sustainable investing. Whilst rising markets over the period have supported the increase in assets, the extent of the rise has also been helped by much higher flows, with these sustainable funds recording net flows of close to $190bn in Q4 2021.Why is this important?Coinciding with a heightened focus on sustainability, there has been a proliferation of ESG-labelled strategies in the last two years. Issues of greenwashing (where managers’ marketing material and disclosures paint an impressive picture of the level of ESG integration that masks the reality within) are becoming more prominent. Morningstar recently announced the culling of 1,200 funds, totalling $1.4trn in assets, from its sustainable fund universe after an investigation into fund manager disclosures. Taking time to properly research, meet and understand managers’ approaches and processes is integral in navigating this issue. It is also crucial that investors never lose sight of the fundamentals. It is easy to be swayed by positive sustainable messaging made by companies and fund managers, but business fundamentals might not necessarily stack up. We advocate an integrated approach, whereby one considers the ESG risks, or indeed opportunities, as part of a broader appraisal of company fundamentals.

What does the chart show?The chart shows the Atlanta Fed’s Flexible-Price and Sticky-Price Consumer Price Indices (CPI) since 1970. The Flexible-Price CPI (green line) represents goods and services included in the CPI that change price relatively frequently, whereas the Sticky-Price CPI (blue line) represents those changing price relatively slowly. For example, some sticky prices are those for medical care services, alcoholic beverages, household furnishings while things like new vehicles, fuel and gas, or bakery products are part of the flexible price items. The latest readings showed the US headline CPI index at 7.5% year-on-year, once again above analysts’ estimates. The Atlanta Fed’s flexible price component is, as expected, sitting at all-time highs at 17.8% year-on-year, whereas the sticky price component is up 4.2% on a year-on-year basis, its highest since 1991.Why is this important?As sticky prices are more gradual to change, when these prices are set, they include expectations about future inflation to a greater degree than flexible prices, which tend to be more responsive to short-term changes in the current economic environment. Last year the debate was on whether the inflation spike was transitory or not and now that the “transitory team” has badly lost the match, we are all gauging when it will come back to lower levels. The sticky price component therefore may provide key insight when trying to gauge where inflation is heading. In January, the flexible measure reduced slightly from 17.9% to 17.8% whereas the sticky metric has reached new highs, this could indicate that the supply chain and pandemic related pressures are improving but inflation expectations are shifting meaningfully higher. When the sticky price items are hitting multi-decade highs, the risks of inflation becoming persistent cannot be dismissed. Markets are in the process of adjusting rapidly to this new reality, and already financial conditions have been tightened significantly by the policy pivot.

What does the chart show?Last week, Facebook (now known as Meta, reflecting Mark Zuckerberg’s desire to focus on construction of the virtual metaverse) saw its market value drop by $250bn in a single day following its quarterly earnings release that missed expectations and was accompanied with lower future earnings guidance. That $250bn drop was the largest one-day drop (in market value terms) ever recorded in US stock market history. To put this into context, that is the equivalent of an entire Nike disappearing in a day, or a Netflix, or two Goldman Sachs, or three Fords. Each are as staggering as the last!  Why is this important?Facebook missed on earnings expectations last week, albeit by only 4% at the headline level, revealed its daily active users (DAUs) fell for the first time in the company’s 18 year history and lowered future earnings guidance, not helped by huge investment expenses associated with building the metaverse. Furthermore, it also warned it might shut down Facebook and Instagram in Europe if new data protection legislation isn’t adopted. No doubt plenty here to challenge the future growth trajectory of this business but we think a key takeaway is that when company valuations become too overstretched it need not take a huge disappointment for Mr Market to punish a stock severely. Companies priced for perfection, despite how popular and glamourous they might be, can suddenly look far from that in share price terms if those once stellar earnings suddenly look a little more challenged. We should disclose Facebook/Meta was an exception this quarter with the other tech giants actually delivering strong earnings updates on the whole but it serves as a handy reminder of the importance of valuation within one’s investment selection.

What does the chart show?After a volatile start to the year, US equity benchmarks, the S&P 500 and NASDAQ, have ended the month trading well below their highs of the beginning of the month and mid-November respectively. The S&P 500 ended the month down -5.2% and the NASDAQ down -9.0% in local terms. The chart shows the net monthly fund flows of the Invesco QQQ Trust since 1999, one of the most actively traded exchange-traded funds (ETFs) in the world. The fund only invests in non-financial stocks listed on the NASDAQ, which has naturally seen higher weightings to large tech names. It ultimately is trying to track the performance of the NASDAQ 100 Index. In January 2022, the monthly outflows reached levels not seen since the 2000s, reflective of the changing investor sentiment after weeks of turmoil in US large cap companies. $6.2bn was exited during January with the majority of the outflows taking place towards the end of the month, suggesting that investors have been taking profits after a number of very strong years for US equity markets in addition to concerns over inflation and interest rate rises.Why is this important?US large cap stocks have suffered a volatile start to 2022, largely attributed to the Fed signalling tighter monetary policy this year in order to combat the highest inflation levels seen in decades. Expectations of rising interest rates have driven investors to reassess the valuations of large cap growth stocks as these are generally more sensitive to interest rate movements. With such a significant shift in the monetary policy landscape coming into view, we expect the best returns are now likely to come from a very different cohort of stocks than those that have led returns over the past decade. We continue to see a lot of opportunities in value stocks, which have generally proved resilient during the sell-off in January. As well as maintaining broad diversification, we believe it is more important than ever to include a significant allocation to value stocks in portfolios, across a broad range of industries and geographies.

What does the chart show?US equity markets have fallen under strong pressure recently, as expectations build that the Fed will unwind monetary stimulus measures quicker than expected. In fact, markets are now expecting the Fed to increase interest rates as much as four times this year, starting in March, to fight surging inflation. Higher interest rates raise borrowing costs for all businesses as well as making companies’ future earnings worth less in terms of discounted value. The effect is magnified for tech and other growth companies, whose earnings are further out in the future. The prospect of a faster pace of rate hikes sent US equities to their lowest levels so far this year. Coupled with concerns over the effect that the Omicron variant has had on economic activity as well as rising geopolitical tensions, the S&P 500 experienced its third consecutive weekly decline with tech shares and growth stocks being amongst the worst performing, which drove the NASDAQ and Russell 2000 down 13% and 11% YTD.  Why is this important?With the fiscal stimulus measures of the past few years disappearing into the rear-view mirror as we head into a rising rates cycle and a quantitative tightening environment, the backdrop isn’t particularly reassuring. During periods of volatility, markets can swing wildly as investors reduce risk and reposition their portfolios in light of changing news flow. Making rational, informed decisions during periods of heightened uncertainty is not an easy task, and fear can dominate in the short-term. A more prudent approach is to build additional diversification levers, which can reduce volatility and drawdowns, smoothing the investment journey – an approach that we promote and implement.

What does the chart show?The chart shows the Federal Reserve’s FOMC (Federal Open Market Committee) ‘dot plot’ – essentially each official’s expectations on where interest rates will be at future dates. Each dot represents an individual’s prediction as to what the federal funds rate will be at the end of each year until 2024 and then longer-term views. The median of all dots is then used as a basis to set the official rate forecast. Since its introduction, the Fed dot plot has become one of the most closely watched news releases among investors. The most recent projections from the FOMC meeting dated 15th December (so admittedly now a bit dated) indicated three rate rises before the end of 2022 and another three moves in 2023. Only two members were pointing to four rate rises this year. Looking at the median of the dots from December’s meeting against prior dot plots from September and June shows the shift to a more hawkish stance in response to inflation levels not seen in decades. It is noticeable that the dots show a wide range of predicted outcomes for the long-term, and even as soon as 2023, reflecting a great deal of uncertainty.Why is this important?A tightening labour market and inflation at multi-decade highs have pushed the Fed to adopt a more hawkish stance. Minutes from the December FOMC meeting showed officials voted to maintain the current target rate of 0% - 0.25%, but that members were on board with accelerating the tapering of the bond buying programme adopted at the onset of the pandemic. The pace of tapering will be increased from $15bn to $30bn per month beginning this month. This would result in the Fed ending its purchase program (quantitative easing) by March 2022 if there are no further changes, giving greater flexibility to raise interest rates. They have also now pointed towards quantitative tightening soon after commencing rate rises. Interestingly the market is now pricing in four rate rises through 2022, ahead of current Fed projections. You might often hear this referred to as the Fed being ‘behind the curve’. Importantly, with four rises now factored into market/government bond prices, if the Fed doesn’t see these through then positive capital returns could be made in government bonds. However, a faster and sharper move higher would almost certainly be negative.

What does the chart show?The chart shows the US 10 year government yield (red line) and the share price performance of the MSCI World Financials Index relative to the MSCI World Index (blue line). An upward sloping blue line indicates the MSCI World Financials Index is outperforming the broader MSCI World Index, whereas a downward sloping line means it is underperforming. Since the beginning of the year, the performance of the MSCI World Financials Index has bettered the broader index.  The yield on the benchmark 10-year Treasury bond has climbed for seven consecutive days to 1.77%, now above the highs of last year. Through time there has been a fairly tight relationship between the two. Higher yields have been positive for financial equities whilst lower yields are often associated with underperformance.Why is this important?Minutes from December’s US Federal Reserve meeting were released last week which pointed to the central bank potentially raising interest rates and shrinking their balance sheet faster than previously anticipated, in response to consumer prices rising to multi-decade highs and the labour market showing strong signs of recovery. This triggered a sell-off in US government bonds in anticipation of tighter policy from the Fed which coincided with a sharp increase in bond yields. We saw this feed through into the equity market. Higher bond yields have a greater negative impact on growth stocks than value names, as the interest rate used to discount their higher future earnings increases, meaning the present value of those earnings (in theory, the share price) decreases. This has hit tech stocks, whose valuations are better supported in a lower interest rate environment. Financial stocks, on the other hand, can benefit from increasing interest rates through higher net interest income (the difference between income earned and income paid out). Furthermore, banks have started to release loan loss provisions set aside earlier in the pandemic and more of this is expected which should be supportive for earnings. So far this year we have seen financials outperform the broader equity market by over 5%.

What does the chart show?For our first chart of 2022, we thought we would reflect on the performance of a number of asset classes in 2021. The strongest performer which we chart here was global equities (blue line) boosted by loose monetary policy for most of the year, government stimulus packages and a recovery from the most severe lockdown restrictions. The MSCI World Index rallied 20% in 2021 in contrast to the MSCI Emerging Markets index which fell 5% over the same period, weighed down by tightened regulations in China which particularly targeted the education and tech sectors, along with default concerns within the country’s real estate market. What was more remarkable was the returns seen in certain commodity markets, including UK natural gas (+294%) and oil (+50%). Government bonds were more challenged as higher inflation and the prospect of tightening monetary policy saw yields continue to rise, ending the year with a -7% total return. Rising cases of Covid-19, stemming from the Omicron wave, and surging inflation threatened investor returns towards the end of the year. However, global equity markets pulled through the increased volatility and these developments failed to ruin the year’s rally.Why is this important?The year started on a high after last November’s vaccine success and it has largely been one way for risk assets since then. There was a handful of small drawdowns in global equity markets in 2021, but these proved short lived. Given obvious uncertainties around further mutations of Covid-19, how central banks will tackle surging inflation and geopolitical tensions in Europe and Asia, markets have looked through a lot of the ambiguity of late and whilst they have come a long way since the lows of 2020, there is still much disparity, and thus opportunity, within. 2021 was really a year to stay invested and not try and time the market. Anyone who sat on the sidelines waiting for a better entry point will likely be ruing that decision. Finally, last year proved that bonds are not risk free. They still have a role to play in more defensive portfolios, but investors should look to diversify their diversifiers as the classical ‘60/40’ portfolio will be challenged going forward.

What does the chart show?The chart shows the yield to maturity on Chinese high yield (sometimes referred to as “junk”) bonds over the last 5 years. High yield bonds are rated below investment grade bonds by credit rating agencies due to their higher perceived risk of default. They typically offer higher yields in order to compensate for the increase in credit (and sometimes liquidity) risk. In recent weeks, the yield on this broad index has moved north of 20% indicating the spiralling cost of borrowing for sub-investment grade rated Chinese companies. What began as a confidence crisis around the health of Chinese property developer Evergrande has reverberated to numerous other real estate firms that have either already defaulted or appear close to default. This of course has led to fears of broader market contagion.Why is this important?The market has suffered another wave of selling as the latest news on Evergrande suggests that the property developer is very close to default, with some investors claiming that they have not received bond payments after the end of a 30-day grace period on Monday (6th December). The sharp increase in yields (that coincides with a sharp decline in bond prices) shows how regulatory restrictions on borrowing and slowing home sales have pressured the real estate sector in China, which today accounts for approximately 55% of China’s high yield market but would have been higher in the past. Demonstrating the severity of the situation, on Monday the People’s Bank of China (PBOC) said it would reduce financial institutions’ reserve requirements by 0.5% which would free up 1.2tn yuan ($188bn) of liquidity for the banking system, in a move widely seen as intending to reassure investors if the troubled real estate developer collapses. However, there does seem to be an element of the ‘baby being thrown out with the bathwater’ with some less correlated and higher quality credits also impacted amidst a broad market selloff. You hear us say this a lot but it is another good example of the opportunity in active management, taking advantage of market mispricing to selectively identify attractive entry points for long term investments.