In our last blog for the year, we are looking at the most important events in the real world and financial markets. 2022 happened to be a tough one and from the current standing point, it could be worse until it gets better. 2023 is the first year in decades in which economists predict lower equity markets while a recession is almost set in stone according to the analysts. On the more positive side, there is a saying that economists predicted 9 out of 2 recessions and the positioning seems to be much lighter today than it was a year ago so there is less room for negative surprises.
2022 was meant to be a year in which we would forget about the coronavirus and start to live as we used to before March 2020. We entered the year with equity indices being on highs while yields were close to their lows. In 2021, when both equity and bond markets were flying high on hopes that corona crisis is behind us and on extremely loose monetary and fiscal policies, some of the sell-side analysts were comparing the 2020s to the roaring 1920s. Many equity indices reached their all-time highs in 2021 and there were trillions of world fixed-income assets that yielded below zero. The ECB’s deposit rate was at -50bps while Fed stood at 0, with both banks being net buyers of the sovereign bonds.
However, the worst enemy of the extremely loose monetary policy, inflation, started to emerge in 2021 driven by above mentioned loose policies. Governments and central banks were saying that higher inflation will only be transitory due to a low base from periods of strict measures related to coronavirus. In December 2021 inflation in the US stood at 7.0% YoY compared to only 1.4% a year before while in the euro area YoY inflation was at 5.0%. Commodity prices were already on the rise driven by strong demand and supply-chain difficulties across the globe. In the first two months of 2022, some central banks already were trying to tighten their policies, but their decisions were still gentle, coming out from the corona crisis and not standing in the way of global economic recovery. Yields started to rise across the markets only until the next risk-off event.
On February 24th, Russia invaded Ukraine in a major escalation of the Russian-Ukrainian war that began in 2014. Equity sold off while investors hid in bond markets, with a negative correlation between bonds and equities working perfectly. The yield on the German 10Y bund went from 0.33% on February 16th back to negative territory in just ten days. Yields on most developed markets tanked in a similar fashion. However, investors quickly realized that war will increase supply-chain difficulties while Russia and Ukraine being major exporting countries will result in a dramatic rise in commodity prices. What followed was one of the biggest selloffs in bond markets on record. The yield on the German 10Y went from below zero to 1.75% in just 4 months almost in a straight line. Obviously, commodity prices skyrocketed while inflation rates across the globe went to double-digits. Central banks responded with the only tool they have, increasing interest rates. Equity markets continued to feel the pressure from the higher yields with most developed equity indices being in a bear market until the end of H1.
However, inflation data that was overjumping expectations each month decelerated in July and markets started to celebrate the peak of inflation and hoped that from July on inflation will start to decelerate while economic expectations were gloomy meaning that recession is close which was once again cherished by the markets due to lower discount rates and back to the old normal. That period lasted only two months, until the most important central bank governor, Mr. Powell, said that he would be determined to curb inflation pressures and will continue lifting rates as much as needed. That was one of the several times that Powell surprised markets on the hawkish side in 2022. In the following two months, yields rose even more sharply compared to the last selloff in the February-June period and bund yield went from 0.65% to 2.45%.
With yields growing so fast, we just had to wait to see some things cracking in the economy. The first public victim was the UK whose newly appointed government wanted to increase their fiscal packages to help their citizens fight large inflation, but the market decided to punish their policies with an enormous selloff of GILTS. The result of the selloff was the collapse of UK pension funds which had to call BoE to start buying bonds only a few weeks after saying it will start its QT. Other victims of the fast increase of interest rates across the globe were obvious, expensive tech companies valued at 10 times revenues, PEs, VCs, and cryptocurrencies that fell by 50-80%.
2022 will be marked as a year of a great U-turn of central banks that started from zero and went to lifting rates by 50-75bps reaching 3-4%. ECB, which was one of the most dovish central banks in the world surprised markets in December when it said it will continue tightening its policy in 2023 with 50bps steps and with its plans of trimming its balance sheet. On top of the ECB, BoJ, really the most dovish bank in the world (if we exclude the Turkish central bank that cuts rates by 150bps to 9.0% as inflation runs at only 85% YoY), surprised markets this week when it said it will expand its YCC target from ±0.25% to ±0.5%.
Obviously, bond investors will not remember 2022 for anything good as it was the worst year ever with long-term bonds being 20% lower YTD. TLT, the most popular 20+ year US treasury ETF fell by 29% since the beginning of the year. Negative performances are present in the short maturities as well, but the moves are a bit more muted. For example, holders of German 5Y paper lost some 12%, with the yield on the paper going from -0.40% to today’s 2.27%. However, there is one good thing going forward and that is the current yield. You do not have to go to some obscure part of the world or another century to fetch some yield. You can have it wherever you look at.
Farewell, 2022: It’s been a year full of downs and some ups, but we made it through.
Me and the whole InterCapital team, wish you and your loved ones a very merry Christmas and a happy new year 2023 with much love, joy, and yield!