Monday digest

Posted 27 June 2022

Overview: Public sentiment wrestles with economic realities
Inflation continues to dominate the financial market narrative. Last week the Office for National Statistics (ONS) announced that inflation, as measured by the Consumer Price Index (CPI), rose from 9% in April to 9.1% in May, while the Retail Price Index (RPI) reading increased to 11.7% compared to May 2021. And yet, believe it or not, inflation pressures are receding. Signs suggest the global supply-chain squeeze is easing, and the cost-push is passing by. While energy prices have been stickier (especially in Europe) crude oil prices came down sharply last week. Perhaps most hearteningly, there has also been a broad-based decline in agriculture prices since peaking around mid-May. However, the good news is being accompanied by more negative growth signals and ramping up recession talk. Last Thursday’s flash Purchasing Manager Indices (PMIs) for major areas added to the gloom – showing a greater decline in optimism among businesses than economists forecasted one week ago. The lack of enthusiasm is not surprising. The follow-though of inflation sees people deciding they don’t want to pay the price for goods, thereby reducing demand, which means less activity and therefore less growth. The phrase “demand destruction” means exactly that.

There is undoubtedly a slowdown underway. Business confidence has deteriorated from very positive levels, but is still at neutral rather than negative. While employment may worsen (it does lag confidence measures), it is unlikely to contract massively unless there is another shock to the global economy. There has been a slowing in hiring but jobs cuts are few and far between just now, and employers will be reluctant to lose workers again, given how difficult it has been to recruit in the past two years. Therefore, the sequencing of the slowdown is important. The fallback in input cost-price pressures is welcome and, clearly, it’s a good thing that this is happening before firms have to set about cutting labour costs. This must lessen the chance that the slowdown will be prolonged. What’s more, central banks are only partially through their rate cycle, and they still have some degree of flexibility. They don’t have to tighten if they believe cost pressures are abating enough – they just have to convince markets that they will do what is necessary. Markets are – once again – climbing the wall of worry and that is likely to persist through the summer. We cannot expect a meaningful equity market recovery until the soft patch is likely to end but, equally, the likely payoff is high enough to stay invested. We will be watching and assessing changes as intently as ever over the summer months.

Emerging market resilience is encouraging
It has been a tough year for investors so far and riskier assets have been hit particularly hard. So far, emerging market (EM) bonds have suffered their worst losses since 1994 – with JPMorgan’s dollar-denominated bond index falling 15% year-to-date. EMs characteristically have plenty of their own problems – and this year has been no different, with idiosyncratic issues across China, Turkey and Latin America, as well as Russia’s invasion of Ukraine providing a major roadblock for growth. Investors have paid attention, and as of last month, $36 billion had flowed out of EM mutual and exchange-traded funds this year, according to research provider EPFR. This has had a negative impact on some EM currencies – none more so than the Turkish lira. Turkey’s currency has lost more than 23% of its dollar value this year, amid further political controversy for its authoritarian president Erdogan. Earlier this month, Erdogan vowed to cut interest rates again, despite inflation surging to more than 70%. The Turkish treasury responded with a new bond plan to ensure stability for the lira, but investors are yet to be convinced. Erdogan’s policies are a major barrier to foreign capital, making it hard to see an upside.

Elsewhere, Argentina continues to be on the edge of default and disaster, its currency falling nearly 17% this year. Argentina’s government negotiated a $44 billion debt refinancing plan with the International Monetary Fund (IMF) in March, but its central bank is still failing to get short-term interest rates high enough to stop the ongoing devaluation. However, apart from these two, EM currencies have fared reasonably well. The most shockingly ‘good’ performance is perhaps the Russian rouble, which has managed a near-unbelievable turnaround over the last three months. Despite war and isolation from the west, the rouble has gained 96% against the dollar since March, making for more than a 40% gain year-to-date. While not as dramatic, Brazil, Mexico, Colombia and Peru have all seen their currencies gain since the start of 2022. Asia has been a different story, as lockdowns in China have curtailed demand. Asian currencies have generally struggled, with all of them falling against the dollar year-to-date. Interestingly, the weakest currency in the region is not an EM, but the Japanese yen – falling more than 15% year-to-date. Divergent monetary policy – with the Bank of Japan keeping rates low while the rest of the world tightens – is the main cause. Tellingly though, the next weakest Asian currencies are the South Korean won and the Taiwanese dollar. These are both classed as EMs, but in reality, are much more similar to Japan in terms of development.

China’s drastic economic slowdown weighs heavily on Asia’s prospects. But like Japan, China has nothing like the inflation pressures we see in the west. This has allowed China’s government to keep monetary and fiscal policy broadly supportive. The zero-COVID policy is clearly a negative, but with Li Keqiang recently suggesting a change of tack, the outlook for the world’s second-largest economy could improve. Bond yields are currently lower in China than in the US, providing a decent foundation for risk assets.

Overall, EMs have outperformed major developed markets this year. This is impressive considering the headwinds many countries have faced and shows a level of resilience that will no doubt continue to be important. Moreover, many analysts suggest that with EMs much more oriented towards technology and services than in the past they are well-positioned over the medium and long-term. The early inflation fighting in some EMs is certainly paying off, despite hiccups here and there. While EMs could be in for more pain should commodities worsen, the outlook is relatively positive, considering the difficult global backdrop.

Has the music stopped for private equity?
The recent SuperReturn International private equity conference, held in Berlin, shone the spotlight at the rapidly changing fortunes of the private equity industry. In 2021, historically low-interest rates and abundant liquidity ensured a frenzy of dealmaking – leading to record profits at the largest industry names. But this year’s gathering was full of dire warnings: spiking inflation, a looming recession and a slowdown in fundraising. One executive called it “a time of reckoning for our industry”.

Private equity has enjoyed a ‘gilded age’ since the global financial crisis in 2008 introduced an era of cheap financing, which is a boon for this type of investment. As well as increasing the amount of capital available for buyouts (taking stock market quoted companies private), loose monetary policy also pushes up equity valuations (by decreasing the ‘risk-free’ rate of government bond yields, thereby making stocks more attractive). By the same token, the tighter monetary policy makes life difficult for private equity firms. When financing costs go up, valuations go down and buyers become scarce, leaving the owners of leveraged assets potentially exposed. Industry executives were fearful of this in early 2020, but lockdowns brought an unprecedented surge of monetary and fiscal support – increasing savings and generating impressive equity returns. Now though, the world’s major central banks are in full tightening mode as they battle surging inflation. Even as the cost-of-living crisis eats into consumer and business demand, there is no suggestion central banks will ease up – meaning financial conditions are likely to only get tougher.

There is no immediate threat of distress for funds run by private equity firms – and certainly not for the larger players. But if financing costs for private equity target companies become overstretched for a more extended period, the sector could become more stressed, with a potential impact on the wider financial system, given pension funds and other long-term investors are the major holders of these assets (both the equity and the loan capital). For private equity firms themselves, the reputation risk is big. If the ‘low volatility, high returns’ model is damaged, funding will be much harder to come by in the future. Most holders of private equity assets are not overly concerned right now. Our portfolios do not hold them directly and we believe any indirect exposure is insignificant. Nevertheless, the potential impacts are significant, so we will be vigilant in the months ahead.