By Jessica Wee
How glad are we to live past the headlines in 2021 that were dominated by vaccine grabs, followed by the ease of lockdowns, an economic rebound, persistent and elevated inflation, as well as the emergence of new Covid-19 variants – however, all these headlines did not deter stock markets from climbing higher. In fact, online registration for brokerage accounts skyrocketed as people reviewed their finances and looked for exciting ways to spend their lockdown days.
Here’s the round up – In the 1H of 2022, the market was volatile with the global equity and bond market plunging into a sea of red. Investors had to stomach a difficult period in the first half and those hoping the arrival of spring would herald a sea change would have been disappointed as the bad news is far from being fizzled out.
High Inflation Post Pandemic
Compounding the damage from the Covid-19 pandemic, the Russian invasion of Ukraine has magnified the elevated inflation, and further slowed global economic growth. The key drivers of inflation: food and energy are considered the most volatile items driving inflation, particularly in the US where food prices rose 10.4% while energy prices were up 41.6% over the past 12 months ending June 2022. Very low unemployment environment has contributed to continued strong wage gains, and this, fed through to some stickiness in recently very high inflation.
Despite the aggressiveness of the US Federal Reserve (the Fed) and other central banks to quell inflation, June continued to see higher-than-expected inflation prints in many countries. Remarkably, the US inflation level in June reached a year-over-year rate of 9.1%, highest since 1981, according to the US Labor Department. Similarly, the UK inflation level also surged to 9.4% year-over-year, the highest rate in 40 years. Both US and UK inflation readings have been well above those in other industrialized nations, for example, Europe, which surpassed 9.0% year-on-year in June. Looking ahead, Bloomberg also expects the rate of yearly inflation could stay in the 8% range for most of the developed countries by the end of 2022.
One of the Most Striking Things in the H1 2022 is the Capitulation of Central Banks
Unexpectedly high inflation in June means that central banks need to do part of the dirty work (i.e. raising interest rates). Among the eye-catching moves from monetary authorities in recent days have been a 75 basis points (bps) hike than the 50 bps hike from the Fed and the 50 bps hike than the 25 bps hike from the European Central Bank (ECB). On the other hand, Asia has lagged as the rest of the world, including emerging markets, began lifting rates in mid-June after the Fed accelerated its rate hike.
Besides tightening monetary policy, the Fed began the quantitative tightening process in late June, a move to reduce the size of its $9 trillion balance sheet, up to a cap of $95 billion a month by the end of the summer. The expectation for how drastically central banks need to tighten monetary policy to fight soaring inflation has taken another leap, shaking up global markets and rattling investors. Markets now expect interest rates to rise to 3.4%, 3%, and 6% in the US, UK, and Europe, respectively, by the end of 2023. In view of more rate hikes through 2023, recession fears have risen and are sweeping through the global markets.
The broad consensus amongst global central banks is to hike more aggressively, the World Bank expects global growth to slump from 5.7% in 2021 to 2.9% in 2022 – a significant downward revision from the January forecast of 4.1%. The World Bank expects that the global economic growth to be hovering around that level over 2023-24, as inflation is becoming more entrenched and more widespread.
Risky Assets Have Borne the Brunt
The global equities are now at its worst 1H of a calendar year since 1970, as the prospect of higher interest rates curb inflation, supply chain disruptions, surging energy costs and geopolitical concern dented sentiment. Over the 1H of 2022, S&P 500 dropped ~ 21%. The NASDAQ, (tech sector) has suffered losses ~30%.
Some good news from the emerging market, both Shanghai Composite Index and Hang Seng Index finished the 1H of 2022 with only a single-digit negative return of 6.6%, as Covid-19 lockdown measures started to be relaxed in some major cities in China in the 2Q. The tech-heavy equity markets – Taiwan and Korea, were among the worst performers in Asia.
USD the safe haven
On the currency front – the USD aka a safe haven asset, has held up strongly in recent months buoyed by the Fed raising interest rates and as investors seek the safe haven of dollar assets in times of global turmoil. The USD moved higher against most other developed currencies. Its biggest gains were against the Japanese yen this year. In July 2022, the euro had fallen below the USD for the first time in nearly 20 years (lots of memes of 1:1 for USD:EURO). Most emerging markets also witnessed currency depreciations versus the dollar, for example, a drop of close to 6% in the Malaysian Ringgit.
Inflation caused by commodities
Commodities market is being squeezed from two directions. On one hand, demand is booming as economies recover from the coronavirus pandemic. On the other hand, sufficient supplies to meet this demand are being hampered by the Ukraine-Russia war. Hence, a broad swathe of commodity prices is on the rise, especially crude oil, natural gas, coffee, cotton, and aluminum rose more than double digits. The commodity surge is also making food more expensive.
What lies ahead?
There are 3 likely scenarios, depending upon both the macro-economic outcome and policymakers’ reaction to it. At this juncture, scenario 3 is the most likely outcome.
- A “soft landing” – In this scenario, a recession could be avoided if the Fed’s forecasts are broadly correct, and inflation gradually gets back to target without unemployment rising much. If a “soft landing” does happen, equities would benefit from the avoidance of a recession. Two-year bonds yields turn out to have priced in too much tightening. Gold would fall as risk-on sentiment picks up. Commodity prices could fall moderately as inflation dims. However, Bloomberg indicated that the chances of the Fed pulling off a soft landing this time are very low at this point.
- Persistent inflation– Inflation is more persistent than expected. The Fed has to tighten by more than is priced and therefore precipitates a recession. Equities fall because of higher short-term interest rates and a recession. Short-term yields head higher to price in more central bank tightening. Commodities could rise moderately at first but will then react to the tightening policy accordingly. Gold, by contrast, could benefit from risk-off market sentiment.
- A “hard landing” – If inflation falls by less than the Fed expects, the Fed is likely to combat the inflation by tightening more aggressively than current market pricings (happening already!), which could lead to tighter financial conditions and potentially risk a recession. Do expect equities, short-dated bonds, and commodities to fall together for some time. Similar to scenario 2, gold could also benefit from risk-off market sentiment.