The return on LD Discretionary, which is the largest and most diversified investment fund within The Cost-of-Living Allowance Fund, stood at a negative return of -9.3% on 23 June 2022. Over a 36-month period, the portfolio has generated a positive return of 3.7%. The return for the employees' holiday allowance fund is also negative. As at the end of May 2022, it stood at -5.3 per cent – although since the freeze was imposed, the return has been -0.9 per cent.
Stock markets have faced challenges in the first half of 2022 on a scale not seen for a long time. Inflation has really taken hold, which is reflected in higher interest rates and falls across almost all traditional asset classes.
Price falls across asset classes
Global equities have fallen by 15.2% in 2022, as measured by the MSCI World Index in Danish kroner. Danish equities, as measured by the OMXC25 index, have fallen by 21% over the same period, whilst technology and growth stocks, as measured by the NASDAQ, have fallen by 25%. The price falls are widespread across the entire stock market, but shares that are particularly sensitive to interest rate rises have been hit especially hard. These include, for example, companies with high growth but low current profitability and earnings capacity – such as start-ups in the IT sector.
The interest rate and bond markets have also been hit hard. US yields on 10-year government bonds have risen from 1.5% at the start of the year to 3.25% in June. German 10-year yields have likewise risen from -0.2% to 1.8% over the same period. Rising interest rates are taking a heavy toll on the bond market. When interest rates rise, bond prices fall, and US high-yield bonds in particular have suffered severe price losses. Danish mortgage bonds are also facing major challenges as Danish mortgage rates rise.
In a high-inflation scenario, such as the one we are currently experiencing, where central banks are raising interest rates to curb inflation, bonds do not provide protection against falls in the stock markets, as has typically been the case since the 1980s.
Higher inflation leads to tighter monetary policy
The US Federal Reserve raised interest rates by 0.75% in June, having raised them by 0.5% earlier in the year. The European Central Bank has also signalled interest rate rises and scaled back its bond-buying programmes. The last few months have therefore marked a shift in monetary policy. Over the past several years, interest rates have gradually fallen, and, particularly in the wake of the coronavirus crisis, fiscal and monetary policy became more accommodative. However, higher inflation has given cause for concern, and one of the primary tools for bringing inflation down is a tighter monetary policy, which means interest rate rises.
Inflation has been a key issue in the financial markets over the past six months. During 2021, the first signs of rising prices became apparent, particularly in the second-hand car market. Oil and energy prices rose sharply in February and March 2022 following Russia’s invasion of Ukraine, and we are now seeing higher prices for both services and consumer goods. In the US, the May inflation figures once again took the financial markets by surprise, as the consumer price index rose by 8.7% compared with the same month a year earlier.
The scale of inflation comes as a surprise
The question now is how persistent inflation is. If inflation continues to rise and wages follow suit, further tightening by central banks may be necessary. However, there are also signs that growth and consumers’ willingness to spend are beginning to slow, which could bring inflation down. Leading indicators of economic growth are falling in both the US and Europe, and consumer confidence has also weakened significantly over the past few months. This, in turn, increases the risk that corporate profit margins may be eroded, which could lead to redundancies and even lower consumption and growth. The risk of a recession – defined as negative growth for two consecutive quarters – has therefore risen.
It is difficult to find assets that generate positive returns in such scenarios. The US dollar is one of the assets that has generated a positive return in 2022. Against the euro and the Danish krone, the dollar has risen by 8 per cent in the first half of the year.
The stock markets had anticipated rising inflation in 2022, but the scale of the rise has nevertheless taken many investors by surprise. Growth and high employment levels continue across the economies, but a slowdown in activity is highly likely in the coming months, which is also necessary to bring inflation down.
