Concerns over tightening monetary policy had a negative impact on global markets in August, leading to a significant pullback in equities and a rise in bond yields. UK investors holding dollar-based assets were somewhat shielded from the declines due to a notable depreciation of the pound, which experienced its largest monthly fall since the aftermath of the Brexit referendum in 2016.
While the rally in equity markets since mid-June has been encouraging, a cautious approach is warranted in the near term. We maintain a larger cash position than usual and have adjusted portfolios to adopt a more defensive allocation. The impact of rapidly rising interest rates is yet to fully manifest in company results, and although the second-quarter earnings season was solid, input prices and the cost of capital are increasing rapidly, potentially leading to earnings weakness in the coming quarters.
Government bond markets have exhibited significant volatility, driven partly by the transition to a post-quantitative easing environment and partly by the cyclical response to unexpected inflationary pressures. In the UK, the situation is compounded by policy instability under a new Prime Minister. Bond prices have declined sharply, especially for shorter maturities, with the two-year gilt yield surging from 1.71% to 3.00% in the past month, presenting an alternative to cash.
Global equities started the month positively but came under pressure as August progressed. Despite indications that US inflation may be peaking, the Federal Reserve remains committed to raising rates and dispelled hopes of a significant dovish shift in the coming months. Chair Jerome Powell's comments at the Jackson Hole symposium were interpreted as a strong signal by investors, leading to a decline in equity markets.
The Fed's determination to continue raising interest rates, even in the face of potential economic weakness, has been reiterated despite some encouraging signs of a peak in US inflation. Although the July Consumer Price Index (CPI) showed no increase on a month-on-month basis after a 1.3% rise in the previous month, the year-on-year reading of 8.5% remains significantly above the Fed's 2% inflation target.
US economic data generally remains strong, with little evidence of weakness in the labor market and a low unemployment rate of 3.7%. However, some indicators, such as declining new orders in manufacturing and softness in housing markets, suggest slower growth ahead. The combination of robust economic activity, rising interest rates, and the US dollar's safe-haven status has led to a steady appreciation of the dollar, negatively impacting commodities such as gold.
US equities declined by 4% in August, while global benchmarks dropped by 3.6%. Technology indices were slightly more affected, as is typical during periods of rising interest rates. The US 10-year yield rose above 3% again, climbing over 50 basis points to close at 3.20%. Market expectations now point to a 75 basis point hike at the Fed's September policy meeting, with the year-end rate projected to reach around 4%.
UK bond markets experienced significant downward movement due to the Bank of England's commitment to raising rates amidst inflation concerns and a faltering economy. Despite better-than-forecast GDP figures, the UK economy contracted by 0.1% in the second quarter, leading to increased speculation of a recession. Purchasing managers' indices dropped, indicating weaker demand and supply shortages. UK inflation reached double digits, marking the highest level since 1982, and is expected to rise further due to the energy crisis.
New UK Prime Minister Liz Truss faces the challenge of addressing high inflation and the cost of living crisis amid a slowing economy and rising interest rates. Her proposed policies, including potential changes to the Bank of England's inflation mandate, have not instilled confidence in financial markets. UK gilt indices fell around 8.2%, and the 10-year gilt yield increased to 2.80% in August. Sterling also depreciated by around 5% against the US dollar, contributing to the outperformance of large-cap UK equities that generate revenue in non-sterling currencies.
European equity markets followed global trends and experienced declines in August. Core eurozone government bond yields rose, reflecting similar headwinds faced by UK and US benchmarks. The ongoing war in Ukraine remains a significant risk to European economies, but there have been no major developments in recent weeks. Gas prices have eased slightly from their peak, and oil prices dropped by nearly 10%.
China's zero-Covid policy continues to hinder economic activity, with sporadic lockdowns impacting business operations. Economic indicators suggest that China will fall short of its GDP growth target, despite setting the lowest growth target rate in decades. The Chinese Communist Party congress is expected to see President Xi Jinping sworn in for an unprecedented third term in power, amidst ongoing lockdowns and geopolitical tensions.