Quarterly markets review - Q3 2022
A look back on markets in Q3, when central banks made clear that their priority is fighting inflation.
The quarter in summary:
After a rally in July, both shares and bonds turned lower and registered negative returns for Q3. Any hopes of interest rate cuts were dashed as central banks reaffirmed their commitment to fighting inflation. The Federal Reserve, European Central Bank and Bank of England all raised interest rates in the quarter. Emerging markets underperformed their developed counterparts. Commodities generally declined.
Please note any past performance mentioned is not a guide to future performance and may not be repeated. The sectors, securities, regions and countries shown are for illustrative purposes only and are not to be considered a recommendation to buy or sell.
US equities fell in Q3. The communication services sector, including both telecoms and media stocks, was among the weakest sectors over the quarter, along with real estate. The consumer discretionary and energy sectors proved the most resilient.
In July, the market had started to focus on the possibility of interest rate cuts from the US Federal Reserve (Fed) in 2023, given concerns about slowing growth. However, such hopes were dashed at August’s Jackson Hole summit of central bankers, where the Fed reaffirmed its commitment to fighting inflation. This sent stocks lower in the second half of the quarter. The Fed raised the federal funds rate by 75 basis points (bps) to 3.25% in September; the third consecutive 75bps increase.
The Fed’s preferred measure of inflation (the core personal consumption expenditure index) ticked up again in August - on a year-on-year (y/y) basis - from 4.7% to 4.9%. GDP data confirmed that the US economy is in a technical recession with GDP falling by -0.6% y/y in Q2 after a -1.6% contraction in Q1. However, other data showed resilience, such as the August non-farm payrolls report that showed 315,000 new jobs added that month.
Eurozone shares experienced further sharp falls in Q3 amid the ongoing energy crisis, rising inflation, and consequent fears about the outlook for economic growth. Every sector posted negative returns, with the steepest falls for communication services, real estate and healthcare. Some pharmaceutical stocks were hit by worries over potential liabilities related to US litigation around heartburn drug Zantac. The real estate sector has been pressured by rising bond yields.
The European Central Bank raised interest rates in July and September, taking the deposit rate to 0.75% and refinancing rate to 1.25%. Annual inflation for the eurozone was estimated at 10.0% in September, up from 9.1% in August.
Energy costs continued to be the largest contributor to inflation. Nord Stream 1, the main pipeline supplying gas to Europe from Russia, was closed for maintenance in July. It came back onstream temporarily before Russia shut it down again in early September. This put further pressure on power generators, many of whom need to buy natural gas from higher cost sources, and intensified worries over potential energy shortages this winter. The news also sent the euro to a 20-year low versus the US dollar.
GDP figures showed the eurozone economy grew by 0.7% quarter-on-quarter in Q2. However, forward-looking indicators signalled a weakening economy. The flash composite purchasing managers’ index (PMI) for September came in at 48.2, representing a third consecutive month below 50. (The PMI indices are based on survey data from companies in the manufacturing and services sectors. A reading below 50 indicates contraction, while above 50 signals expansion.)
UK equities fell in Q3. A key event in the quarter was the election of Liz Truss as new Conservative Party leader and hence as prime minister. The new government announced a fiscal package in September which was poorly received by markets and sent sterling to an all-time low versus the US dollar.
Sterling weakness had already been a feature of the quarter, especially after the US Fed warned it would ‘keep at it’ in relation to raising interest rates. After expectations in July that the peak in US rates might be close, this moved the market’s focus back towards near term cash flows, such as those offered by the UK’s large cap constituents.
Large multi-national consumer staples and energy companies outperformed. These areas are seen as better placed to cope with a ‘stagflationary’ economic environment, where growth is low or slowing while inflation is high or rising. The very strong dollar was also positive for sentiment in these areas of the market given that such companies derive a large part of their revenues from overseas.
In contrast, fears around the impact of rising energy bills on consumer discretionary spend weighed heavily on retailers, travel and leisure, home construction and other domestically focused companies. The same concerns which contributed to a bout of extreme sterling weakness at the period end exacerbated some of these trends.
After rising through July and August, the Japanese stock market followed global equity markets lower in September to end the quarter down 0.8%. Other than a brief period in late July, the yen weakened almost continuously against the US dollar, easily breaking the 140 level for the first time since 1998.
Early in the quarter, market events were overshadowed by the shocking assassination of former prime minister Shinzo Abe on 8 July. Mr Abe, who resigned in August 2020 as Japan’s longest serving prime minister, was shot while delivering a campaign speech in Nara, two days ahead of nationwide Upper House elections.
Meanwhile, the first estimate of GDP showed a quarter-on-quarter annualised growth rate of 2.2%, which was slightly below consensus expectations. The detailed breakdown was interpreted more positively with some resilience in consumption and capital expenditure.
The Bank of Japan left policy unchanged and the interest rate differential with the US therefore widened sharply after the successive decisions by the US Fed to raise rates. This differential has been a significant factor in the consistent weakening of the yen so far in 2022. On 22 September the Ministry of Finance did intervene directly in currency markets when the yen was seen depreciating rapidly intra-day, towards 146 against the US dollar. This was the first such direct intervention in support of the yen since 1998. By the end of September the yen had already weakened again, closing the month at 144.6 to the dollar.
Data showed Japan’s inflation continuing to edge up with the headline rate reaching 3.0%, while the core rate, excluding fresh food and energy, reached 1.6%. Aside from political events and macro data, the main influence on individual stocks came from the results announcements for the March to June quarter, which were completed in August. Although profit momentum slowed from the previous quarter, overall results were again ahead of expectations and profit margins appear to have remained resilient so far, despite increasing cost pressures.
Asia ex Japan
Asia ex Japan equities were weaker in the third quarter on investor concerns over rising inflation, higher interest rates and fears over a global slowdown. The war in Ukraine and ongoing tensions between China and Taiwan also weighed on sentiment during the quarter.
China was the weakest index market in the quarter on concerns over rising interest rates, as countries around the world battle soaring inflation. This was despite data released in September which showed that Chinese factory activity unexpectedly expanded during August. The alarming spread of Covid-19 throughout China also weakened sentiment, prompting fears of further lockdowns as the country continues to pursue a policy of zero-Covid.
Share prices in Taiwan and South Korea were also weaker. In Hong Kong, share prices were sharply lower as investors continued to sell riskier assets, such as shares, for the safety of government bonds amid the threat of more interest rate hikes and economic recession.
India ended the quarter in positive territory, although concerns over the pace of interest rate hikes by the US Federal Reserve weakened sentiment towards the end of the quarter. Share prices in Thailand, Singapore and Malaysia were weaker in the third quarter, while Indonesia ended the period in positive territory.
Emerging market (EM) equities posted negative returns in Q3, against a backdrop of slowing global growth, heightened inflationary pressure and rising interest rates.
Poland was the weakest index market, with Hungary and Czech Republic also among the biggest decliners, as the Russian war in Ukraine escalated and led to an energy crisis in Europe, which in turn has contributed to accelerating inflation. China also underperformed by a significant margin. Not only has a slump in the property market weighed on investor sentiment, the imposition of Covid-related lockdowns in various major cities has had a negative impact on domestic demand.
Growth-sensitive north Asian markets, such as South Korea and Taiwan, suffered as the outlook for global trade deteriorated. Colombia also performed poorly as commodity prices fell, while the Philippines and South Africa, where concerns about the power situation weighed on sentiment, also lagged the index.
Turkey was the best performing market. Despite inflation that is over 80%, the central bank cut interest rates twice during the quarter and the economy continues to grow strongly. India and Indonesia also posted positive returns which were ahead of the broader index. Brazil performed well as investors took comfort from a narrowing in opinion polls ahead of October’s presidential election, and as growth and inflation improved. Data showed the economy growing strongly in the second quarter while the CPI inflation rate has been easing for two consecutive months.
The heightened market volatility during third quarter continued as central banks and investors continued to grapple with persistent inflation amid a slowing growth backdrop.
The Federal Reserve (Fed) tagged on another 75 bps increase onto existing rates in September which brought the rate to between 3.0% and 3.25%. This is the fifth interest rate in the year so far, following rate hikes to 1.75% in June and 2.5% in July. Chair Jerome Powell stated that the Fed’s outlook remains unchanged since the Jackson Hole meeting. The US 10-year yield rose from 2.97% to 3.83% and the 2-year yield from 2.93% to 4.23% in Q3.
The UK’s budgetary announcement accelerated the sell-off as investors questioned the credibility of the government’s fiscal framework. With the gilt market suffering significant losses, the Bank of England intervened by temporarily buying long dated gilts. Sterling hit an all-time low of $1.03 in the closing days of the month before recouping some of its losses.
In a statement, Governor Andrew Bailey noted that the BoE was monitoring developments in the financial markets “very closely”. The UK 10-year yield increased from 2.24% to 4.15% and 2-year rose from 1.88% to 3.92%.
The ECB raised interest rates by 75 bps in September, following a rise of 50 bps in July. Eurozone CPI landed at a record high of 10% year-on-year. The German 10-year yield increased from 1.34% to 2.11%.
Government bond yields were generally higher and credit spreads wider across the global market, weighing heavily on market returns. The credit spread is the difference in yield between bonds of a similar maturity but with different credit quality. Credit spreads widened amid fears that tighter monetary policy may undermine further economic growth prospects.
Across global credit, returns were poor as the market drawdown continued. Sterling investment grade and high yield were the worst performers. European investment grade and high yield, as well as emerging markets credit, fared better but only on a relative basis as returns remained negative. Investment grade bonds are the highest quality bonds as determined by a credit rating agency; high yield bonds are more speculative, with a credit rating below investment grade.
Emerging market currencies weakened as investors fled to the US dollar on recession fears. Central and eastern European currencies were mixed against the euro.
Convertible bonds protected well against the gale-force equity market headwinds. The Refinitiv Global Focus Index shed just -1.7% for the three months which translates into a very low 25% downside participation. After a better month for primary markets in August, September was yet another lacklustre month for new issues. For Q3 as a whole, there were only US$14 billion of new convertibles coming to the market.
The S&P GSCI Index recorded a negative performance in the third quarter, driven lower by weaker prices for energy, industrial metals and precious metals. Energy was the worst-performing component of the index in the quarter, with sharply lower prices for crude oil, Brent crude and unleaded gasoline offsetting higher prices for natural gas.
Within industrial metals, prices for aluminium, copper and nickel were all lower. Price declines for zinc were more muted in the quarter, while lead achieved a small price gain. Within the precious metals component, the price of both gold and silver declined in the quarter. Within agriculture, higher prices for wheat and corn helped to offset price falls for cotton, sugar, coffee and cocoa.
The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
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