Bedrock’s Newsletter for Friday 16th September, 2022

Friday 16th September, 2022

It has been a bumpy ride for global markets since our last newsletter, with significant swings across most liquid markets (equities, bonds, interest rates, commodities, and currencies). The two-week period has been notably bifurcated, with an acute negative shift in sentiment catalysed by the worse-than-expected US CPI reading on Tuesday this week. Prior to that, there had been a tangible sense of optimism that we were at, or at least close to, peak inflation and that central banks might have some leeway to take their foot off the gas and, just maybe, engineer a soft(ish) landing. In light of this, the S&P 500 rose +3.7% last week, avoiding a fourth consecutive weekly loss, while most other equity markets also rallied (at least in local currency terms). A somewhat hawkish ECB meeting on Friday served to keep the bulls in check and remind markets that we are not out of the woods yet, but it was the CPI print this week that truly broke the momentum. Short-end rates shot upwards and equities tanked – the S&P 500 fell -4.3% on Tuesday and the tech-heavy NASDAQ fell -5.2%, its worst daily performance since June 2020. Equities rebounded somewhat on Wednesday but have since resumed their decline and the Bloomberg screens are flashing red today.
 
In the grand scheme of things, the CPI miss on Tuesday seems fairly modest – the August MoM CPI figure came in at +0.1% versus -0.1% expected, while the YoY figure was +8.3% against +8.1% expected and +8.5% the prior month – and the reaction to it somewhat excessive. However, the composition of the CPI print provides some more justification for the moves. Specifically, although August’s YoY figure was lower than the previous month’s, most of the slowdown in headline inflation was driven by falling energy prices, as WTI continued its decline and fell below $90/barrel. Stripping this away, core inflation (which excludes volatile energy and food prices) actually accelerated, coming in at +6.3% YoY – just shy of the March reading, which was the highest core inflation print since the ‘80s – pointing to worryingly broad and sticky price increases. With the Fed largely eschewing forward guidance throughout this hiking cycle and committing itself to a heavily “data dependent” approach, it is then not that surprising that an acceleration in their preferred (core) measure of inflation has quickly been translated into higher interest rate expectations. Some robust economic data from the US in the interim – namely strong employment data and a surprising MoM increase in retail sales – has only fed the hawkish narrative further. Prior to the CPI print, a 75bp hike at next week’s FOMC meeting was the broad consensus and, while that remains the most anticipated outcome, there is now a meaningful probability of a 100bp hike being priced in… Looking further out, a subsequent 75bp hike is nearly fully priced for November and the market is now expecting the Fed Funds rate to top out at 4.5% in March next year, a full percentage point higher than expectations at the end of June (and a level that was simply inconceivable at the start of the year). The whole yield curve has also moved upwards, though shifts have been steepest at the shorter end – the US 2Y yield is now sitting at just below 3.9%, having been at 3.4% at the start of last week. This has left the curve deeply inverted and if you needed any further indications regarding sentiment for the global economy in 2023, this is it… and it is not positive.
 
Things have been far from easy over in Europe either, as the region continues to battle with surging energy prices and escalating concerns about the physical availability of gas throughout the cold winter months and into 2023. European countries have made a substantial effort to build up gas inventories this year and many are approaching storage capacity ahead of schedule, but the announcement two weeks ago that Nord Stream 1 would remain shut indefinitely after a “leak” was detected has exacerbated concerns. Interestingly, natural gas prices across the bloc have actually come down meaningfully since the start of the month, but this is more a reflection of how absurd previous levels were; gas prices remain well above (i.e., 5x) historic levels and are anything but sustainable. The EU, and governments across the Eurozone, are working on an array of measures to help households and businesses cope but the question of how to pay for these measures has not really been answered yet. In the UK, new Prime Minister Liz Truss has proposed capping household energy bills at £2,500 a year, which is likely to cost the government well over £100bn (i.e., more than the furlough scheme) over the next 24 months if gas prices do not come down. Given Truss’ objection to windfall taxes, it looks like this is primarily going to be funded through massive debt issuance and wider deficits… That will be a problem for another government to deal with anyway. In light of this, the pound has continued to weaken and USDGBP is now at 1.14, its lowest since 1985.
 
From an investor’s perspective, the net impact of the last 14 days has been another leg down for traditional 60/40 portfolios. We are certainly pleased with our decision to hedge with equity puts in mid-August, which have done much to offset the recent drawdown. However, the outlook appears to be darkening further and hedging is becoming increasingly expensive, which makes positioning portfolios difficult. In such a scenario, we maintain that it is important to be diversified across asset classes and investing styles. That said, a key question to ask is always how much of the bad news is already in the price and there are certainly areas that are beginning to look attractive.
 
Lastly, we would like to bid a fond farewell to Queen Elizabeth II who passed away on Friday last week at the age of 96. Her 70-year reign was the longest in British history and the second longest verified reign globally, only behind Louis XIV of France. It spanned 15 Prime Ministers, beginning with Churchill and ending with Truss, and a period of enormous change for both the world and Britain’s role within it. It would be disingenuous to say that her reign was without controversy, or that the Monarchy itself is beloved by all, but there is little doubt that the Queen’s unwavering presence and commitment to duty has been an important touchpoint for much of the British population for their entire lives. Her death is a landmark moment in modern British history and the extent of the response to her demise has been a testament to the resounding impact that she had on so many lives.


 

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