Hiking towards a recession?

The second quarter of 2022 was an incredibly challenging period for investors as the MSCI All Country World Index, a broad measure of global equity markets, fell 16%. Stock prices experienced a sharp decline during the quarter as central banks opted to accelerate the pace at which they raise interest rates owing to historic levels of inflation which are proving to be stubbornly resistant. In what appears to be somewhat of a vicious circle and is adding further downward pressure to stock prices, is the possibility of a recession in the not-too-distant future, the likelihood of which increases as central banks continue to hike interest rates.

Not many stocks escaped the selling pressure during the quarter as the decline in stock prices was fairly broad-based though some fared better than others. Though there were declines in the MSCI All Country World indices for Consumer staples (-6%), Health Care (-7%) and Utilities (-7%) their relative outperformance during the quarter suggests a pattern of investors positioning themselves for a potential recession. On the other end of the spectrum, stocks more closely associated with economic growth that are likely to underperform during a recessionary period were harder hit. As a result, there were steep declines for stocks within the Consumer discretionary and Industrials sectors as reflected by the respective declines in the MSCI All Country World Consumer discretionary (-21%) and Industrials (-16%) indices. The MSCI All Country World Financials index also fell heavily as even financials, which should benefit profitability-wise from higher interest rates, suffered with investors fearful of a stall in lending should a recession ensue. The stock prices of growth-orientated stocks have benefited from lower interest rates, especially during the pandemic, owing to their longer duration profile. It therefore follows that a rise in interest rates would have the opposite effect leading to relatively greater falls in their stock prices. As such, we saw large declines in many TMT (Technology, Media and Telecommunication) companies leading to large declines in the MSCI All Country World Information technology (-23%) and Communication services (-18%) indices.

Following the onset of the Russian invasion of Ukraine, we saw a surge in commodity prices due to the prospect of supply shortages resulting from the conflict in the region. However, with central bank rate hikes serving as a potential brake to economic growth, demand concerns have counterbalanced those on the supply side leading to a cooling in commodity prices. During the quarter we saw sharp falls in the prices of metals such as aluminium (-32%), copper (-20%), iron ore (-14%), lead (-22%), nickel (-31%), zinc (-24%). PGM’s were also impacted as there were declines in platinum (-9%), palladium (-14%) and rhodium (-28%). The steep fall in the prices of the various metals was mirrored in the fall of global metal and mining stocks with the MSCI All Country World Metals and Mining Index falling 27% during the quarter.

One commodity-based segment that remains elevated is the energy sector. The impact of the US and Europe banning the import of Russian oil and gas has already been felt as the gap in supply saw the price of Brent crude climb above $120 a barrel. However, the potential impact of higher interest rates on economic growth led to concerns over demand for oil, pushing the price back down to $115 a barrel, still 7% higher compared to the end of the previous quarter. Despite the modest increase in the price of oil, stocks within the global energy sector declined during the quarter, as the MSCI All Country World Energy Index ended the period down 5%.

The persistently high level of inflation in both the US as well as Europe has seen their central banks, as well as many others across the globe for that matter, become increasingly hawkish. With US inflation still trending above 8%, the US Federal Reserve (“Fed”) opted to raise interest rates by 50 basis points in May followed by an additional increase of 75 basis points in June, the highest single increase in nearly three decades. The UK continued with its trend of raising interest rates as the Bank of England implemented two 25-basis point increases during the quarter. In somewhat of a surprise for markets, for the first time in 15 years, the Swiss National Bank raised its benchmark rate. The 50-basis point increase saw the Swiss benchmark rate increase to minus 0.25% as inflation levels in the country reached 2.9%, their highest level in over a decade. The European Central Bank (“ECB”) has to date kept its powder dry but with inflation in the region continuing to trend above 8%, the ECB now intends to raise its benchmark rate by 25 basis points in July with the possibility of an even larger increase in September.

From a regional perspective, the S&P 500 Index, a broad measure of the largest companies in America, fell 16% during the quarter but the tech-heavy Nasdaq Composite fared worse having declined 22%. European stocks appeared to have performed relatively better than those in the US as the declines in European indices such as the UK FTSE100 (-4%), French CAC (-9%), German Dax (-11%) and the Netherlands AEX (-8%) did not appear as severe, at least in local currency terms. However, the US dollar outperformed most other major currencies during the quarter and when converting the returns of these European indices into US dollar terms, the declines in the UK FTSE100 (-11%), French CAC (-15%), German Dax (-17%) and the Netherlands AEX (-13%) were a lot closer to that of US equity markets.

The strength in the US greenback can be associated with the accelerated pace at which the Fed has been increasing interest rates which in turn increases the attractiveness of US treasury bonds and therefore leads to an increase in demand for the US dollar. The attractiveness of US treasury bonds has been further bolstered by investors opting for safety amidst a volatile stock market and recessionary fears lingering in the background. Increased demand for US treasuries naturally drives their prices higher but also leads to falling treasury yields as the prices and yields for bonds behave in an inverse manner. This may explain in part why, despite the Fed increasing interest rates during the quarter by 125 basis points, the yield on the 10-year US treasury only ended the quarter at 2.98%, having previously reached 3.48% during the period.

While the US, Europe and various other nations around the globe have begun to tighten their monetary policy and increase interest rates, Japan has maintained its approach of loose monetary policy. Rather than increase interest rates to tame accelerating levels of inflation in the region, which are now trending above the Bank of Japan’s (“BoJ”) target level of 2.0%, the Japanese central bank has opted to maintain its low level of interest rates by keeping its 10-year benchmark rate below 0.25% through a process of yield curve control. As a result, Japanese stocks have not endured as severe price declines when compared to their global peers, with the Nikkei 225 Index only falling 5% during the quarter, at least in local currency terms. The growing gap between bond yields in the rest of the world relative to Japan as a result of interest rate hikes has however caused the Japanese Yen to lose ground, especially against the US dollar, with the Yen having moved towards a three-decade low against the US dollar. As a result, the decline of the Nikkei 225 Index in US dollar terms was 15%, more in line with other global benchmark indices.

It was a relatively positive for quarter Japan’s neighbour, China. Earlier this year, the country had implemented stringent lockdowns following a fresh outbreak of Covid-19 across various regions causing factories to shutter and the economy to grind to a slowdown. As such, inflation has not been running as hot in China and investors fearful of a slowdown in growth were shying away from Chinese stocks. However, a recent string of positive updates from China saw investors return, leading to relative outperformance in Chinese stocks, reflected by Hong Kong’s Hang Seng Index and mainland China’s CSI 300 Index “only” declining 3% and 8% respectively. The positive updates that supported a recovery in stock prices included the lifting of stringent Covid-19 lockdown restrictions as well as whisperings that the regulatory crackdown within the country, which had been particularly detrimental to Chinese tech companies, was beginning to ease.

Unlike China, for most emerging market countries the second quarter proved particularly challenging and South African stocks were not spared as the JSE All Share Index declined 12% during the quarter, in rand terms. The commodity heavy index felt the effect of falling commodity prices as mining stocks across the board experienced double-digit price declines. On a more positive note, the stronger oil price contributed to Sasol ending in positive territory for the quarter but the real standouts were Naspers and Prosus. In somewhat of a surprise, management announced that they would implement a share repurchase programme which put simply is an alternative form of a dividend payment to shareholders. The “dividend” would be funded by selling down their stake in Chinese tech giant, Tencent. Market excitement over this corporate action led to significant price gains for both Naspers (+42%) and Prosus (+33%) during the quarter. Despite the South African Reserve Bank implementing another rate hike during the quarter, with the 50-basis point increment taking the prime lending rate to 8.25%, US dollar strength saw the rand weaken from R14.61 at the start of the quarter to end the period at R16.30. This of course meant that in US dollar terms, the JSE All Share Index declined by more than 20% during the second quarter.

The stronger US dollar and higher interest rates have not helped the investment case for gold or cryptocurrencies such as Bitcoin. The price of the yellow metal declined 6% during the quarter, edging closer towards $1,800/ozt and as for Bitcoin, it lost more than half its value over the period as its price tumbled from over $45,000 to below $20,000.