Equity Market Review
Equity markets have fallen sharply in Q2 with the MSCI World Index (C$) down -13.44% for the quarter, hard on the heels of a -5.38% decline in Q1, resulting in a -18.8% decline so far this year and tipping investors into bear market territory. This marks the worst first half for equity markets since 1970.
The economic mood has clearly changed – from worries about inflation to added worries about how much rates will rise and the risk of recession. Investors are anxious and face more complexity and uncertainty over the path ahead. Central bankers now face a real policy dilemma – how far and how fast to raise rates into a weaker and slowing economy? Not doing enough risks stagflation (a toxic mix of fading growth and high inflation) whereas moving too far risks tipping the economy into recession – the risk of policy error has certainly risen.
What is most interesting is that there has been no place to hide. Most major asset classes have fallen sharply at the same time. The historic relationship between equity and bonds has broken down – both have fallen sharply. Bonds have seen their worst downturn since 1990 as investors brace for rapid rises in interest rates. Traditionally, bonds are supposed to act as a counterweight that tends to rally when riskier assets suffer. Even cash, the ultimate safe asset, has lost value in real terms due to surging inflation.
Within equity markets, the stand-out feature has been the one-dimensional nature of returns with energy topping the leaderboard again in Q2. Virtually every sector has fallen double digits year-to-date, whereas energy is up +25% ($US). There has never been a period when energy has outperformed by this much. Consumer discretionary and information technology were again the biggest decliners at the sector level after also falling sharply in Q1.
From a style perspective, there has been a clear shift to ‘deep value’ stocks and away from high growth stocks, resulting in the biggest gap between the MSCI World Value Index (-12% year-to-date) and the MSCI World Growth Index (-29% year-to-date) for 20 years. Expensive technology stocks have continued to fall sharply, as the valuation of these long-duration assets can be more vulnerable to rising interest rates, as growth is set far into the future. Investors have preferred to back near-term certainty. The problem with energy, of course, is its sharp cyclicality and historic volatility. Whilst so far it has all been a supply issue, one would now expect to see demand destruction start to bite as oil prices stay high and economies slow down.
Fixed Income Market Review
Global bonds extended their losses in the second quarter as central banks globally focused on persistent inflation, despite increasing evidence of slowing growth and increasing risk of recession. Such an environment provided a poor backdrop for both credit and rates markets, leading to record historical losses for bond investors. Risk sentiment was also impacted by increasing concerns around lock down
measures in China to contain COVID-19 cases. Several high-profile earnings disappointments from the likes of Target and Walmart also rattled investors and increased concerns that consumers were pulling back from discretionary spending amid rising food and energy prices.
The -4.30% Q2 return for the Bloomberg Global Aggregate Index (hedged to USD) meant 2022 has been the worst start to a calendar year (-9.06%) since records began for the Global Aggregate index in the early 1990s. The focus by central banks on anchoring inflation was epitomised by the Federal Reserve (Fed), who made the unusual move of raising rates by 75 bps at their June meeting following a surprisingly strong May CPI number. The move, the first of this magnitude since 1994, also further underwrote the strength of the USD as United States (US) real yields moved back into positive territory. Many other central banks surprised the market with the timing and magnitude of rate hikes. Several other previously dovish European central banks became far more hawkish in Q2 such as the European Central Bank (ECB), Riksbank (Sweden’s central bank) and particularly the Swiss National Bank which unexpectedly raised interest rates by 50 bps, its first hike in 15 years. In Australia, the Reserve Bank (RBA) also hiked rates despite previously saying they would not raise rates until 2024.
China continued its huge outperformance to Western bond markets in the post-COVID era. Local 10-year yields dopped beneath those of US Treasuries, limiting further yield opportunities for international investors on a hedged basis. By contrast, Canadian bonds were amongst the worst performing in Q2, with 10-year yield spreads to the US widening 14 bps. Within FX markets, the JPY was very weak, declining to multi-decade lows against the USD as the Bank of Japan (BOJ) maintained its loose monetary policy including negative overnight interest rates and daily operations in defense of its "around zero" target for 10-year bonds. This required huge bond buying by the BOJ including a record USD 81bn in one week in June, one of few central banks now increasing their balance sheet. This also meant Japanese government bonds outperformed other global bond markets in Q2.
Emerging market (EM) currencies such as the Chilean peso (CLP) and South African rand (ZAR) also suffered from the broad-based risk-off sentiment and declines in commodity prices such as copper. The main
exception was the Russian ruble (RUB) which appreciated close to 50% over the quarter on the back of capital controls and a rising current account surplus resulting from higher energy prices.
Credit markets were weak in Q2 and represented a high proportion of the index losses compared to Q1 where higher government yields were the main contributor. Global investment grade (IG) bonds widened 51 bps over the quarter to 175 bps compared to a 27 bps widening in Q1. Of note was the significant underperformance of European investment grade bonds which ended the quarter at 218 bps, only a few basis points away from the peak of the COVID-19 crisis. The moves also represented a 50 bps cheapening to the US investment grade market, reflecting the aforementioned ECB pivot and quantitative easing (QE) wind down. The market also sensed a greater chance of recession in Europe compared to the US, given the increased reliance on unreliable Russian energy supplies.
Lower-quality credit underperformed as concerns focused more on growth and not just rates which had caused BB-rated bonds to hold in well in Q1. US BB-rated corporates widened 122 bps to BBB in Q2, while CCC had a poor quarter by widening 418 bps. US high yield also started to underperform hard currency EM in Q2 with spreads for the index now above those of the JPMorgan EMBI (OAS of 526 bps for US high yield versus 460 bps for EM). Local EM was also under pressure given the risk-off tone to markets and redemptions from retail investors.
The Sun Life MFS Global Total Return Fund F outperformed its blended benchmark (60% World, 40% Global Agg Hedge C$) in Q2 2022. The Series F returned -6.93% while the Fund’s blended benchmark posted -9.84% during the second quarter.
Within the equity sleeve, underweight positions and stock selection in Information Technology, Consumer Discretionary and Communication Services contributed to relative performance. Overweight positions and stock selection in Consumer Staples and Health Care also contributed to performance as the defensive sectors held up well during the quarter. Stock selection and underweight position in Energy hurt performance.