Bedrock’s Newsletter for Friday 8th July, 2022



“Character is destiny.” 

Heraclitus

Friday 8th July, 2022

______________________________________

Following a tumultuous first half of the year – which was the worst for the S&P 500 Index since 1970 – equity markets seem to be on a firmer footing as we enter Q3. Indeed, most indices are enjoying a fairly strong recovery in July so far, helped along by lower long-end US rates. Whether this equity upswing turns out to be just another dead-cat-bounce is as yet unknown; but our sense is that further falls are likely given the deteriorating outlook for the global economy and the momentum behind the sell-off.

Moreover, it is worth noting that the present rally is taking place in the aftermath of a ferocious crescendo of selling at the end of June when investors finally and fully capitulated to the dual risks of soaring prices and stuttering global growth. The only equity market that generated bumper returns in June was China, where the Shanghai Composite Index (+7.1% in USD) and the Hang Seng Index (+3.0% in USD) both benefited from the easing of domestic coronavirus restrictions. Other regions were not so lucky: the S&P 500 Index (-8.3%) and the Euro Stoxx 600 Index (-8.0%), for example, both closed down for the month and at fresh lows for the year. To make matters worse in June, there were very few places for investors to hide outside equities either as correlations between assets spiked and many of the erstwhile 2022 winners – such as commodities – underperformed. For example, copper, which is set to play a huge role in the energy transition, fell -13.2% for the month as cyclical economic concerns trumped the secular bull case for the metal. As we look ahead, dwindling liquidity, tighter financial conditions, slowing global growth, sinking consumer confidence, record high inflation, and a plethora of geopolitical crises in Europe and Asia present an alphabet soup of risks for investors, most of which are skewed to the downside. However, how much of this is already priced in? Can long-term investors afford not to buy-in given the scale of losses seen year-to-date? Will the US buck the trend and dodge a recession (given the strength of the jobs market shown by the latest nonfarm payrolls beat)? Whatever the answer to these questions, diversification across asset classes, regions, and styles is our clear preference to ride out the inevitable bumps in the road.

Notwithstanding the challenging macro environment, the sudden collapse of the benchmark US 10-year treasury yield (from a high of 3.47% in mid-June to a low of 2.81% at the end of last week) together with the inversion of the 2-year and 10-year points on the US sovereign yield curve (a harbinger of recession) may prove to be an inflection point for sovereign bonds (and thus present an entry point for investors). The 10-year yield has since climbed back up above 3%. However, higher yields from here are no longer our base case. Instead, we see the 10-year hovering around this level for some time. Large institutional investors with buy-and-hold strategies appear to purchase treasuries in bulk at this level, while the Fed’s balance sheet run-off and rising policy rates are likely to have put something of a floor under yields. Positioning in longer maturity bonds to benefit from greater rate duration is starting to make sense again. But given the uncertain outlook, all strategies are high risk.

In a year when geopolitics has already played an outsized role in driving financial markets, this week’s events in the UK and Japan (not to mention the relentless drama of the January 6th hearings on Capitol Hill) have added to the sense of instability and unease. First off, UK Prime Minister (‘PM’) Boris Johnson was finally forced to resign on Thursday after his Deputy Chief Whip was accused of multiple instances of sexual harassment going back years (accusations that had been brought to the PM’s attention before the Whip was appointed). After ‘Partygate’, this latest scandal (and BoJo’s attempt to plead ignorance) finally led to a full-scale Cabinet revolt that put an end his turbulent premiership. The PM was in office during one of the toughest periods in which to govern Britain in living memory, with Brexit negotiations, the pandemic, and the war in Ukraine all taking place on his watch. He also nearly died of covid-19 in spring 2021 (and became a father, again). However, having won a giant mandate in the 2019 general election, he has since lost the support of >50% of these voters (according to the latest polls) due to the scandals of the last few months. There is no obvious successor, but former Chancellor Rishi Sunak and Defence Secretary Ben Wallace are the bookies’ favourites. With inflation expected to rise above 10% later this year as economic growth (already negative) continues to slow, getting a new PM into No.10 soon will be crucial to maintain investor confidence. This is not the moment for the UK to be adrift.

Then as we prepared to go to print, the shocking news broke that former Japanese PM Abe Shinzo had been shot and killed (both gun crime and political violence are – thankfully – vanishingly rare in Japan). Abe was comfortably the most consequential Japanese politician of his generation, especially during his second stint in the Kantei from 2012 to 2020. This secured his status as Japan’s longest-serving PM, bringing welcome stability by ending Tokyo’s long run of short-lived administrations (including Abe’s first from 2006-7). Growth-chasing Abenomics and greater diplomatic activism were the hallmarks of Abe’s premiership. The former’s structural reforms had only a shallow impact, unable to shift Japan’s long-standing struggle with growth, while its hyper-accommodative monetary policy is currently under enormous pressure, as we discussed last time. In foreign policy, Abe chalked up more successes. He flexed Japan’s geo-economic muscles to save the Trump-aborted Trans-Pacific Partnership free-trade deal (in the shape of the CPTPP) and repositioned the country for a more coherent response to China’s rise by establishing a National Security Council, reforming the Japanese military’s role and strengthening Japan’s alliances (above all via the revitalised ‘Quad’ of Japan-US-Australia-India, but also with European powers France and the UK). After illness forced him from office in 2020, Abe took on a discreet but crucial role as Liberal Democratic Party kingmaker and elder statesman. It is in this latter role that Japan’s allies will feel his loss most keenly. Since leaving office, Abe not only continued to influence Japanese foreign policy but had also begun to play a diplomatically important role as a voice just beyond official government policy – for instance, subtly signalling Tokyo’s waxing support for Taiwan, whilst maintaining official plausible deniability. Abe’s legacy – but also his absence – may yet have a decisive impact on the course of events in a geopolitically tense, economically pivotal region.