After a strong rally in equity and bond markets in July, both sold off sharply again in August and September. Overall, developed market equities fell 6% over the quarter while global bonds fell 7%.
The rally in July was helped by markets starting to price in interest rate cuts from the Federal Reserve (Fed) in 2023, stoking hopes of a soft landing for the economy. However, in August, the Fed and other central banks reiterated at their Jackson Hole summit that their priority remains the fight against inflation rather than supporting growth. This was the primary driver of the sharp rise in bond yields and sell-off in stocks in the second half of the quarter.
Exhibit 1: Asset class and style returns
Central banks backed up their tough talk with policy rate hikes totalling 1.5% from the Fed, 1.25% from the European Central Bank and +1% from the Bank of England. Markets also moved to price in a much more aggressive path of future rate hikes, with rates now expected to rise to 4.5%, 3.5% and 5.75% by next year in the US, Europe and UK respectively.
Global inflationary pressures moderated somewhat over the quarter on the back of lower oil and food prices. The WTI (West Texas Intermediary) oil price has dropped by nearly 30% since the start of July, while the Food and Agriculture Organization world food price index dropped to its lowest level since the start of the war in Ukraine. Nevertheless, core inflation generally remains well above central bank targets in most countries, which is why markets are pricing in significant further policy rate increases in the coming months.
On the economic growth front, the data published over the third quarter, continued to point to a global growth slowdown. The J.P. Morgan Global Composite Purchasing Managers’ Index (PMI) business survey entered contractionary territory in August for the first time since June 2020. Moreover, the local surveys showed that Europe, the UK and the US are all already teetering on the verge of recession.
One positive, though, is that against a backdrop characterised by elevated inflation and slowing growth, global equity market valuations have now generally fallen below their 25-year averages. Even in the US, the market is currently trading on a price-to-earnings (P/E) ratio of 15.6 vs. a long- term average of 16.6. However, these valuations are based on current consensus analyst forecasts for earnings growth, which are gradually being revised down. Therefore, we could still potentially see further declines in equities.
Even though the US economy has already recorded two consecutive quarters of negative economic growth this year and the university of Michigan’s consumer confidence survey has dropped close to its lowest levels in 50 years, most economic data published in the third quarter continued to highlight the resilience of the US economy.
Exhibit 2: World stock market returns
This resilience is particularly true for the US labour market, with the latest employment and JOLTS (Job Openings and Labor Turnover Survey) reports showing plenty of momentum in the US jobs market as 315,000 payroll jobs were added across the economy in August and job openings are hovering around 11 million.
The tight labour market is also generating substantial household income gains, with wage and salary income rising by USD 1.04 trillion (or 10.0%) in the year ending in July, reflecting a 5.2% increase in average hourly earnings and a 4.1% rise in payroll jobs.
On the inflation front, consumer prices were flat in July and rose just 0.1% in August, with the year- over-year inflation rate falling to 8.2%. Markets nevertheless reacted badly to August’s consumer price index (CPI) print, as the modest 0.1% increase for the month was almost entirely explained by a 10.5% decline in gasoline prices, while there were plenty of hotspots elsewhere, such as shelter costs, which rose by 0.7%. Overall, inflation is still expected to moderate in the coming months, but core inflation is expected to remain above the Fed’s target.
That said, the Fed’s tighter monetary policy is already cooling down some parts of the economy, such as the housing market, as 30-year fixed mortgage rates have risen to well above 6%, their highest level since 2007.
Consequently, housing activity data, such as existing home sales or the NAHB (National Association of Home Builders) homebuilder survey, have remained on a downward trend. This weakness has raised some fears of a repeat of the 2008 housing-led financial crisis. However, the housing market fundamentals are now much stronger as 95% of mortgages have long-term fixed rates while the percentage of subprime mortgages has dropped from 14% in 2008 to 2.3% today. Therefore, while we expect a continued slowdown in housing activity and economic growth we don’t expect a financial crisis.
In the UK, the death of Queen Elizabeth II, the UK’s longest serving monarch, dominated much of the headlines over the quarter.
On the economic front, most data released in the quarter illustrated the loss of momentum in the UK economy. Consumer confidence fell to an all-time low in September and the PMI business survey dropped further into contractionary territory. The labour market remained a bright spot as the unemployment rate fell to 3.6% in July, its lowest level since 1974. However, on the back of the extreme tightness of the UK’s job market, private sector wage gains surprised to the upside again, with the annual growth rate now running at 5.5%.
Exhibit 3: Fixed income sector returns
Inflation remained elevated in the UK last quarter and even though the headline CPI slightly decreased in August from 10.1% to 9.9% year on year, core CPI increased from 6.2% to 6.3% year on year. With a further increase expected in October on the back of higher energy bills, the Bank of England announced two 0.5% rate hikes over the quarter.
However, it was the UK’s fiscal policy that attracted all the market attention as the new government announced a substantial unfunded fiscal package that will significantly increase government borrowing. Markets reacted very negatively to the announcement, with sterling falling sharply and Gilt yields increasing substantially. UK borrowing costs rose so rapidly following the announcement of the fiscal package that the Bank of England was forced to intervene to purchase long-dated government bonds towards the end of September. Nevertheless, UK 10-year Gilt yields still ended September at 4% compared with 2.2% at the start of the quarter.
In Europe, the energy crisis continued to dominate the headlines as Russia completely halted gas flows through the key Nord Stream 1 pipeline at the start of September. However, what had been considered the worst-case scenario for Europe didn’t lead to new highs in gas prices, which after having reached more than EUR 300 per megawatt hour in August dropped back to around EUR 200 by the end of the quarter.
Exhibit 4: Fixed income government bond returns
As we detail in our latest note “Exploring the economics of Europe’s energy crisis”, the decline in European gas prices from their peaks can be explained by several factors, such as above-average imports of liquefied natural gas, which has helped the European Union (EU) to meet its target of filling 85% of the total underground gas storage capacity ahead of the coming winter. Measures proposed by the European Commission could also help to ease tensions somewhat. The near-term EU proposals focus on three main areas: a plan for EU-wide electricity savings, with a broad target of 10% for general consumption; an EU-level uniform cap on energy prices; and a tax on the revenues of fossil fuels producers.
On the economic front, the situation continued to deteriorate during the third quarter, to the extent that a recession now looks like the base case. Most economic data published in the quarter pointed to a slowdown, such as the euro area composite PMI business survey, which is now in contractionary territory. Industrial production dropped sharply in July and euro area consumer confidence dropped to a new all-time low in September.
While growth is decelerating in Europe, this is not yet the case for inflation, which has reached 9.1% year on year in August and could exceed 10% in the coming months. In this context, the European Central Bank has become more hawkish, hiking its policy rate by 0.75% in September, and it is now expected to increase rates by another 0.75% in October and by 0.5% in December, to bring them to 2% by year end.
The Chinese economy was confronted with several headwinds in the quarter, such as the country’s zero Covid policy, weather-related disruptions and lingering weakness in the housing market. However, while at the start of the quarter most economic data remained weak, the data started to improve throughout the quarter on the back of policy measures which supported fixed asset investment and industrial production.
However, China’s economy remains fragile, as illustrated by weak credit demand. Weak domestic demand implies that China is not facing the inflation pressures faced by most other countries. Both CPI and producer price index (PPI) inflation came in below expectations in August, dropping to 2.5% and 2.3% year on year, respectively.
This benign inflation environment allowed the People’s Bank of China (PBoC) to ease monetary policy slightly by lowering its policy rate (the one-year medium-term lending facility rate) by 0.1% to 2.75%, and the one-year and five-year loan prime rates by 0.05% and 0.15% respectively. In addition, China’s State Council, chaired by Premier Li Keqiang, announced new measures worth 1 trillion yuan, to support the economy.
Exhibit 5: Index returns for September 2022
As we enter the fourth quarter, the global economy should continue to slow while some economies could enter recession. The magnitude of this potential recession will partly depend on the effectiveness of measures deployed by policymakers to reduce the impact of the energy crisis on households and businesses. Central banks, confronted with the biggest inflation shock since the 1970s, will for their part probably continue to prioritise the fight against inflation over supporting growth.
Overall, while the growth outlook remains challenging, many stocks are now already pricing in a relatively high probability of at least a moderate recession. Government bonds are now also pricing in a significant amount of further tightening. So, after a very difficult year so far for both stocks and bonds valuations now look more attractive for both.