Mid-Year Review 2022 – 10 Lessons for the Financial Markets.
The hardest part is probably still to come.
The records of 2021 seem far away on the financial markets. The first six months of 2022 have been marked by a series of shocks, mainly inflation amplified by the consequences of the war in Ukraine.
All these factors have created a lot of volatility, pushed up rates, and caused asset values to fall. As far as volatility is concerned, I had already told you in the early days of 2022 that its presence was the only certainty we could have for the year. For once, I was right.
For the rest, I offer you a ten-point overview of the characteristics of a sudden and violent turnaround in the financial markets in 2022.
1. Central banks turn the corner and admit they were wrong about inflation
Central banks have given the impression that they are constantly chasing inflation since January 2022. Betting at the end of last year on a transitory phenomenon, they have had to get into battle to counter a sustainable rise in prices, which has set new records every month. Until May 2022, the eurozone will reach 8.1% and America 8.6%.
Faced with this threat, central banks have done an about-face. No more unfailing support for the economy. The Fed has accelerated the winding down of its quantitative easing program while raising its key interest rates at a pace not seen in nearly 30 years. Two weeks ago, it raised them by 75 basis points. They are now between 1.5% and 1.75%, compared to a range of 0% to 0.5% at the beginning of March 2022. As for the European Central Bank, the QE will end in a few days, and a rate hike - the first in eleven years - will take place on July 21, 2022.
This delay in taking off may condemn the central banks to hit even harder. At the risk of triggering a recession. They have no choice, according to the director-general of the Bank for International Settlements, Agustín Carstens:
“Certainly, it would be better to have a soft landing for the economy, but even if that's not the case, the priority must be to fight inflation.”
2. Government bonds yields soar like never before
Could this be the end of a golden age of more than 40 years for the bond market? The surge in sovereign bond yields since the beginning of the year seems to confirm this. Hit by galloping inflation and rising central bank rates, investors have turned away from government debt, causing their borrowing costs to soar to historic levels. In six months, the U.S. 10-year bond has risen from 1.51% to 3.15%, just shy of 3.5%, and the yield on the French OAT of the same maturity from 0.18% to 2.1%. This brings the yield to levels not seen since 2014.
This violent rebound has raised the specter of a break-up of the eurozone. Not all countries are equal when it comes to rising interest rates. The yield spread between Italy and Germany has widened to 240 basis points, prompting the European Central Bank to call an emergency meeting. The risk is that if the rise continues at this rate, Rome will no longer be able to finance itself on the markets. To avoid this fragmentation, which would undermine the identical transmission of its monetary policy throughout the eurozone, the ECB will allocate a larger share of its reinvestments to countries in difficulty. And it should soon present a dedicated support tool, a sort of new monetary bazooka.
The question of debt sustainability is also beginning to be asked of large borrowers. The increase in debt was painless in times of negative interest rates. The new situation is more difficult. According to the Banque de France, a 1% rise in interest rates costs the state budget 40 billion a year in the long term.
3. The end of the euphoria on the world stock markets
A bloodbath, a carnage ... After having broken records throughout 2021 and until the very beginning of 2022, the world's stock markets have sunk into the red during the first half of the year. They have been weighed down by soaring interest rates, soaring inflation, and the many vulnerabilities plaguing the global economy - from Russia's invasion of Ukraine and its impact on energy to China's Zero-COVID policy and its deleterious impact on supply chains. While companies are posting record margins and profits, the major stock market indices are heading for historic losses in the first six months of the year, worthy of the greatest crises of the last decades.
In Paris, the CAC 40 has plunged by more than 15%, a little less than in 2020 - the year marked by the pandemic - or in 2008 - during the great financial crisis - but more than when the Internet bubble burst in 2000. The shock was even more severe on Wall Street. The technology sector is a major player there, and it has been particularly hard hit by the rise in interest rates. The S&P 500 plunged by about 20%, its heaviest losses in the first half of the year in more than 50 years. Indeed, we have to go back to 1970, and then to 1962, to find a fall of this magnitude. The technology-heavy Nasdaq, for its part, collapsed by more than 28%. It had simply never experienced such a counter-performance.
Can we expect a turnaround by the end of the year? Nothing is less certain. Professionals are watching for warning signs - from the capitulation of individual investors to inflection by central banks - but for the time being they remain on tenterhooks.
4. Commodities have caused inflation to soar
Whether it is energy, food, or metals, the commodity boom is historic and widespread. The war in Ukraine has considerably increased the tensions related to the post-COVID recovery already underway since 2021.
Oil has risen by 50% since the beginning of the year and is priced at around $115 per barrel, supported by the sanctions against Russia. The price of gas delivered to Europe has increased tenfold compared to 2019 and the ton of wheat has been propelled above 400 euros by the blocking of millions of tons of grain in the Black Sea ports. As for metals, they are also quoted at historic levels.
The weight of natural resources is far from negligible for the world economy, as according to Citi analysts, the global bill for raw materials in 2022 will increase by at least 5,200 billion dollars compared to 2019, or the equivalent of about 5% of global GDP!
Commodities are even the main driver of inflation in the eurozone: in May 2022, inflation in France was 5.8% according to INSEE, which estimates the contribution of energy and food products at 3.5 points. In Germany, it is even more obvious: inflation is soaring to 8.7% and raw materials are contributing 5.7 points.
5. The party is over in the credit market
The golden era of the corporate bond market has come to an end. Until December 2021, ever lower interest rates and the unfailing support of central banks (notably the ECB) had allowed more and more companies to raise more and more debt. Investors, delighted to find more generous yields than on government debt, had flocked to it. The situation has changed.
Risk-free interest rates and spreads (the risk premium demanded by investors about the rate on sovereign debt) have risen much faster than expected. Some see this as a lasting market repricing, linked to the turn taken by central banks, but also, increasingly, to the inevitable deterioration of corporate balance sheets.
For companies that need to raise debt to refinance, the situation could soon become more complicated. The most fragile could quickly find themselves in trouble. S&P expects default rates to rise to about 3% between late 2022 and the first quarter of 2023. And investors who had moved down to lower-rated credits are moving up to safer signatures.
As of June 22, 2022, U.S. investment-grade credit funds were experiencing their 13th week of withdrawals in a row, a first. On June 27, 2022, three debt issues had to be suspended due to lack of demand: those of the London-based financial services company Close Brothers, the Czech railway company Ceske Drahy and the French company Sagess.
6. IPOs are at a standstill
In 2021, companies were scrambling to go public. Since January 2022, the atmosphere has changed dramatically. Candidates for listing are very rare. According to Dealogic, since the beginning of 2022, less than 200 companies have taken their first steps in the markets, in Europe and the United States, compared to more than 600 over the same period in 2021. Capital raised has fallen from $192 billion to just $18 billion.
The unstable financial environment is discouraging companies from going public. As a result, many companies are postponing their projects. The craze for Spac, those empty shells that went public with the sole purpose of acquiring a company, has subsided in the United States, which largely explains the decline in initial listings across the Atlantic.
Investors, too, are reluctant to take risks as inflation rises and a recession looms. In June, Plenitude, owned by the Italian energy company Eni, and TeleSign, the US subsidiary of Proximus, decided to wait for better market conditions. The Italian company De Nora, which made its debut on the Milan Stock Exchange on Tuesday, June 28, 2022, is the exception.
7. Fear of a domino effect looms over the cryptocurrency world
The plunge in prices has exposed the fragilities of an interconnected, illiquid, and opaque sector. Decentralized finance has disseminated rather than neutralized the risks. About fifteen players in the crypto world (brokers, crypto lending platforms, dedicated exchanges ...) have already been impacted to varying degrees by the difficulties of the hedge fund Three Arrows Capital and the crypto bank Celsius.
Crypto players are exposed to each other through their trading operations and cross-shareholdings. The failure of any one of them can have cascading effects. When the cryptos pledged as collateral for loans collapse, the players who are unable to honor their commitments are sidelined. The opacity of the sector and its excessive risk-taking backfire after allowing it to reap huge profits.
Unlike the financial and banking sector, central banks and governments will not support struggling crypto firms. Traditional banks have little exposure to it and the crypto risk is for the moment confined. For the Fed, no actor has a systemic dimension and is thus “too big to fail”. The strongest players, such as the crypto platform FTX, can make good business by buying up cheaply or financing companies in peril. “We have a responsibility to seriously consider stepping in, even if at a loss, to stem the contagion,” said founder Sam Bankman-Fried.
8. Hedge fund icons are falling
Flexible and highly paid, hedge funds are supposed to protect the value of their portfolios and seize opportunities during crises. But for some of the icons of the alternative investment world, 2022 is shaping up to be a bust. Tiger Global, which has managed up to $125 billion in listed and unlisted stocks, lost more than half its value in the first five months of the year because of its bets on large, often technology-based companies.
In six months, the fund created in 2001 by Chase Coleman, one of Julian Robertson's former analysts, has lost three-quarters of the gains it accumulated over twenty years.
2022 is shaping up to be the sixth year of decline in the history of hedge funds, albeit a modest one with a 5% underperformance of managers (across all asset classes) as of June 24, 2022, according to Hedge Fund Research (HFR) indices. In the first half of the year, a hedge fund investing in equities lost on average between 7% and 9%. Managers who can use short selling have limited the damage but have not been able to perform miracles - with positive or even stable performance.
9. Revenge of the old economy with Warren Buffett back in the spotlight
It's a cold shower for the thurifers of the new economy. If no one has escaped the stock market fall, it is the big winners of the last few years who have suffered the most. Just compare the performance of Cathie Wood, the star tech manager behind the ARK Innovation fund, with that of Warren Buffett, the most famous of value investors, who are fond of stocks that are no longer in fashion.
His conglomerate, Berkshire Hathaway, active in heavy industry, chemicals, freight, real estate, and oil, has posted losses of just over 8% this year. This is not the same as the collapse of ARK Innovation, which fell by more than 55% over the same period. The “containment” stocks that had pulled ARK Innovation during the pandemic have erased all their gains. Over three years, the fund posted losses of 12%, while Warren Buffett's conglomerate posted gains of 27%. This renewed interest in the old economy has also benefited the London Stock Exchange. The FTSE 100, which includes many international mining companies and large pharmaceutical groups but only four technology stocks, is one of the few major stock market indices to have held up this year. It lost less than 1% in the first half of 2022.
10. Fund managers have lost their bearings
Don't put all your eggs in one basket. A popular maxim diligently applied for decades by investment professionals. In the financial markets, this translates into diversification: investing in different asset classes to avoid losing everything when a market turns. The traditional magic formula is a “60/40" split”, i.e. 60% stocks and 40% bonds. A largely theoretical allocation, as most investors also choose to invest a portion of their funds in commodities, real estate, private equity, or even cryptocurrencies.
Historically, a portfolio constructed in this way has helped to smooth out returns over the long term. When stocks fell, bond prices tended to rise, and vice versa. But this year, the two asset classes have sunk in tandem. “Is this the death of the 60/40?” asks Ben Carlson of Ritholtz Investment. It is far from certain, he believes. While the stellar performance of the past 40 years will be difficult to replicate in the coming decades, the benefits of diversification should reappear once the perilous transition to a higher inflation regime is complete, he assures.
Some reading
Inflation Is an Opportunity — Use These 5 Inflation Hedges to Take Advantage of It. Every situation represents an opportunity for those who take the right view.
Always a Contrarian, Michael Burry Predicts a Bullwhip Effect in the Months to Come. Some of the economic data in America point in his direction.
Recession Likely to Come to America — Bitcoin Will Soon Enter Uncharted Territory. Expect nothing in particular, but be ready for everything.
The Ruble Is the Best Performing Currency of 2022 Ahead of the USD, but This Is of No Use to Russia. The hardest part is yet to come for Vladimir Putin’s Russia.