In this first edition of our new quarterly EdenTree CIO View, Charlie Thomas, CIO, reflects on the factors that have continued to disrupt markets during Q3 of 2022, highlights positive developments for the energy transition and underscores the importance of ESG at this difficult time.
- US Federal Reserve pledges to “keep at it until the job is done”
- UK “mini” budget unsettles markets
- Green shoots for UK onshore wind and the US energy transition
- Times of crisis require heightened ESG scrutiny, not less
Markets in brief
In the last quarter, global markets continued to move sharply in response to a steady stream of unsettling news. In local currency terms, the FTSE All-Share Index ended down 3.5%, with domestic small- and mid-cap stocks faring worse than larger companies
with international earnings. The FTSE Europe ex-UK equities lost 4.3% while the S&P500 index in the US dropped 4.9%. Elsewhere, Japan lost ground but generally outperformed, while major indices in Asia Pacific and the broader Global Emerging Market
complex ended the quarter in the red.
Figures from bond markets were similarly fraught. The US 10-year Treasury yield rose to 3.8% from 3.0%, although the most significant moves were witness in the UK government bond market where the 10-year gilt yield rose from 2.2% to 4.1%. In price terms, the FTSE Actuaries UK All Stocks Gilt index retreated 12.9%, with long-dated UK government bonds (15+ years to maturity) dropping 18.8% compared to a 4.9% fall in the value of the shorter dated 5 years and under index. The large moves in the UK gilt market reflected the volatility that came after the UK Government’s mini-budget, which we discuss in more detail below. Overall, shorter dated bonds outperformed those with longer maturities, as did quality corporate bonds with high credit ratings.
Quarter in review
- Central banks continued to tighten policy
Central bank policy remained a key market driver during the quarter. The US Federal Reserve increased interest rates by 1.5% in two 0.75% increments, bringing the total increase since March to 3.0% – the steepest tightening trajectory on record.
Some commentators have rightly asked whether the Fed’s pace of tightening is therefore too fast, and more pointedly, whether a policy of bringing demand down sharply is the right one when supply is such a major part of the problem. Doing so
might inflict lasting economic damage. It is a concern that we share. Nevertheless, Fed Chair Jerome Powell made a strong speech at the annual meeting of central bankers at Jackson Hole, reasserting the Fed’s intention to “keep at it until
the job is done”. Interest rates are indeed expected to stay higher for longer.
A consequence of the Fed’s policy tightening has been an incredibly strong US dollar, which is inflationary for the rest of world given it is the reserve currency for global trade in oil and gas and commodities. This has added pressure to central
banks elsewhere to raise rates to support their own currencies. The ECB increased its policy rate by 0.5% in July and 0.75% in September – the first interest rate increase since 2011. Ahead of the second of these moves, the euro had sunk to
a 20-year low of 99 cents against the dollar. With eurozone CPI at 9.1%, ECB president Christine Lagarde has been clear that more rate increases are to come. The Bank of England, meanwhile, appeared to be behind the curve. CPI hit 10.1% in July before
coming back to 9.9% in August. The Bank of England lifted rates by two 0.5% increments during the quarter, setting the base rate at 2.25%.
Currency movements had a sizeable impact on stock market returns, too, especially for UK investors where the combined strength of the US dollar and a weaker sterling – driven by factors on both sides of the pond – significantly lifted the
returns of offshore markets to the benefit of investors in the UK. The S&P 500 index, for example, was up 4.1% in sterling terms despite its loss in dollar terms.
- A “mini-budget” in name only
The other major news stories in the UK, of course, were the sad death of Queen Elizabeth II and Liz Truss’s victory in the Conservative Party leadership contest. On 23 September, Truss’s newly appointed Chancellor, Kwasi Kwarteng, unveiled
a so-called “mini-budget” that ignited a crisis of confidence in currency and bond markets. Fiscally, the decision to announce £45bn worth of unfunded tax cuts at a time of high inflation and an energy price cap to soften the cost-of-living
crisis was viewed as irresponsible, especially as the cuts favoured the wealthiest segment of society. The Conservative Party’s ratings fell, as did the pound, which dropped to a record low of $1.035 before recovering somewhat in the final days
of September. The mini-budget also ignited forced selling in the bond market as pension schemes sought to raise collateral against liability schemes which led the Bank to backstop the market with the pledge to buy up to £65bn worth of bonds.
Russia’s war in Ukraine continued, with Ukraine reclaiming strategically important cities and territory late in the quarter. Putin rushed through “sham” referendums in four provinces to claim territorial sovereignty, a strategy that
heightened the risk that tactical nuclear weapons might be deployed. The Nord Stream pipeline leaks in the Baltic – presumably through sabotage – effectively ended the supply of gas from Russia and led to tighter security around energy
infrastructure in the region. Although both pipelines had already been shut down, the methane leaked of residual gas has been an environmental tragedy, with some estimates suggesting the gas emitted from Nord Stream 2 is similar to the amount of CO2
produced by a city the size of Helsinki.
While the UK Government’s decision to lift the moratorium on fracking and relax key climate thresholds for new North Sea oil and gas projects is misguided, its decision to remove a major policy hurdle for onshore wind projects in England was a notable
bright spot. This should further boost entire value chain for wind power in the UK, benefiting of some of our green infrastructure investments.
And the Biden Administration’s much-delayed package of climate-related measures that emerged through
the Inflation Reduction Act in the US marks a significant development in the country’s energy transition. The bill clearly responds to inflationary pressures, energy security challenges and climate change and will spur investment of about $369 billion
in climate projects and clean energy. Estimates suggest the bill will help the US cut GHG emissions by 40% from a 2005 baseline, compared to the 30% trajectory previously.
While it is impossible – and unwise – to predict economic turning points, the US employment data is perhaps one area that will be watched especially closely by markets. The job market remains tight and signs of softening in indicators such
as job ads and the quits rate could be a catalyst for a plateau in the US dollar and could temper interest rate rises. Research suggests a 25-to-50-month lag from the start of a tightening cycle to its maximum effect, with an average of 29 months
overall,1 so the Fed and other central banks need the market to do the heavy lifting in helping to increase the cost of capital and slow demand. It is notable that the Fed’s own rate setting committee forecasts a peak in the fed funds rate of
roughly 5% in 2023 – up from 3.0-3.25% now – with rates coming down slowly from that level over the following two years. China’s economic slowdown is also ultimately deflationary and is likely to be a factor in the length of the
current monetary tightening cycle. We are mindful of the cooling relations between China and the US, which are playing out in politics, but also in the global market for semiconductors and chipmakers, adding to an already complex environment for many
industries, including renewables.
In recent company reporting we have started to see signs of a slowdown in the real economy with the tone from management teams far more muted than a quarter ago and we expect more to come. That said, markets have already discounted falls in earnings into
stock prices. In some cases, these de-ratings seem justified, but we are seeing opportunities to buy into businesses at attractive valuations on a longer-term view. In the fixed income sub-set of our portfolios, we have been able to buy high quality
government and quasi-government paper at yields not seen for many years.
Sticking to our principles
The events we have described here have real world implications and we are deeply concerned about the potential impact of the policy response to the current macro backdrop to the most vulnerable in society, as well as the shift in rhetoric from sectors
of the government and media around ESG and issues like wealth inequality. We are in the midst of a cost-of-living crisis and the burdens of high inflation fall heaviest on society’s poorest who are least able to bear them – as do the burdens
of recessions, which are now expected to be the cost of lower inflation. The Fed is fighting a supply side problem with demand side tools, which could result in an excessive contraction of the economy and long-term scarring. And the UK Government
has unveiled plans to plug is fiscal gap with cuts to welfare spending in real terms.
In our view, times of crisis require heightened ESG scrutiny, not less, especially when notions of fairness are side-lined by short-term policy decisions. We continue to vote against excessive remuneration policies and engage with companies over workers’
rights. Moreover, we continue to work hard with investee companies to help ensure a Just Transition and were interested to see a statistic in recent weeks that the total number of employees in the renewable energy sector has eclipsed those in the
fossil fuel sector globally for the first time.
A final word on markets. Many global stock markets are now firmly in bear market territory. Similarly, bond markets have witnessed a significant lurch downwards amid an intense cycle of rising inflation and tightening monetary policy. For investors in
both asset classes, this is a deeply uncomfortable time. At such a time is it important to remember the distinction between the permanent impairment of capital and volatility. While periods of volatility can be distressing, they can also provide some
of the best opportunities for investors who take a long term approach and really understand the drivers behind the equities and bonds they invest in. And it is crucial to remain focused on your long term investment goals. At EdenTree we have been
redoubling our efforts to check our assumptions and to understand the headwinds to the holdings in our funds posed by the prevailing economic and geopolitical backdrop, but also the levers companies can pull to insulate themselves and emerge resiliently.
The views contained herein are not to be taken as advice or recommendation to buy or sell any investment or interest. Please note that the value of an investment and the income from it can fall as well as rise as a result of market and currency fluctuations,
you may not get back the amount originally invested. Past performance is not necessarily a guide to future returns. EdenTree Investment Management Limited is authorised and regulated by the Financial Conduct Authority and is a member of the Investment
Association. Firm Reference Number 527473.