By Colin Vella CFA, Head of Wealth Management at Jesmond Mizzi Financial Advisors

The first half of 2022 saw Russia’s invasion of Ukraine push already rising inflation to unprecedented, sending financial markets into freefall in the process. Jesmond Mizzi Financial Advisors’ Head of Wealth Management Colin Vella discusses the year so far, the outlook for the future and how investors can make the most of the present volatility.

It’s been a tough year so far for financial markets. What’s your take on the present situation?

Out-of-control inflation and the resulting cost-of-living crisis are at the core of the problem. The markets have also been hit by uncertainty brought about by the Ukraine war.

Markets were in a long period of growth and trading at high levels, so a correction may have been due, but they would have remained relatively stable without the war.

Tracking inflation through prices of basic commodities, like coffee, wheat, oats and similar items, you can see it increasing since early 2020, but it has shot up since the start of the war.

The obvious implication is that people are less able to afford daily needs, but it also influences monetary policy, as we’re seeing with central banks raising interest rates.

Another consideration is the fact that during the first half of the year, people’s desire to get back to normal after all the COVID-19 restrictions resulting in artificially high spending, further pushing inflation up by keeping demand high despite relatively low supply.

If inflation has been increasing for so long, why have markets crashed now?

The pandemic resulted in less uncertainty than the war. Up until late 2021, markets continued to perform well despite rising inflation. They weren’t reflecting the situation on the ground mostly because the upward pressure on prices was being viewed as a transitory phenomenon linked to pandemic disruption which would eventually be resolved.

Unlike the war, which could develop in any way, the global effort to control COVID-19 offered markets reassurances that the return to normality would happen sooner rather than later.

In fact, markets fell at the start of 2020 as the virus started to spread around the world, but the decline was short-lived, and markets had recovered before the first lockdowns happened.

A large-scale war in Europe is different. Rather than the quick decline and V-shaped recovery, we have seen markets plummeting over a six-month period.

Markets don’t respond well to prolonged uncertainty and when you add the prospect of unprecedented interest rate hikes and persistently high inflation, it is unsurprising that the markets reacted as they did.

Declines have been registered across all asset classes, including those normally considered to be safe. Why?

Some asset classes are by nature more sensitive to inflation and interest rate levels, so naturally they were hit harder. For example, government bonds with a longer-term maturity and lower yields, are more susceptible to a slight interest rate change than assets with a higher yield, due to duration risk.

You have the same situation with investment grade bonds, where inflation is eating up the entire yield and forcing a market adjustment.

On the equity side we’ve seen more modest declines, even though they are normally considered to be riskier assets.

Growth-based equities, especially in the tech and consumer discretionary sectors, took quite a hit because their products tend to be less in demand during economic downturns, and more sensitive to increasing interest rates and high inflation.

How likely is it that markets will continue to decline in the second half of the year and what routes do you see to recovery?

Three scenarios could lead to a relatively quick recovery. The first is obviously an end to the war, which would result in a substantial reduction of inflationary pressures and in all probability a strong recovery.

In the absence of a resolution, things could start looking up if inflation is brought under control, either through monetary and potentially fiscal policy changes or by addressing energy shortages and supply chain challenges.

Another possibility is that we enter a global recession, which could see markets start to recover as they start to predict a shift in monetary policy aimed at speeding up the economy rather than slowing it down.

We saw this to some extent with government bonds in June, both in the US and the EU. With declines having been registered up until the end of May, June saw a slight improvement because markets have started to factor in the fact that interest rates in the US have already increased by 1.75% out of an expected maximum of 3.5%.

So, while there is pain yet to come, it can now be quantified more easily, reducing the uncertainty. We could continue to experience further declines, but they’re unlikely to be of the same magnitude as what we’ve seen so far this year.

Which assets can we expect to rebound first?

Equities that have been worst hit because they were most sensitive to inflation can be expected to recover fastest. This won’t necessarily be the case with growth companies if we enter a recession, however, since there will be far fewer opportunities for growth in such an economic environment.

We will also see bonds recover to some extent, particularly as yields stabilise and prices start becoming more attractive.

How should investors be changing their strategy?

A mix of assets remains paramount, but I would also say the current downturn has created several opportunities for investors to exploit.

For starters, there are many investors whose portfolio does not reflect their investment objective and who would be better suited adopting a different risk profile and overall strategy. It is always a good time to rebalance your portfolio but even more so now that there have been so many shifts in the market.

Investors who on the other hand have a sound investment strategy would also do well to re-evaluate their portfolio because while we’ve seen a decline across practically all asset classes, they haven’t all fallen at the same rate.

You can be certain that over the coming months there will be opportunities to buy several quality assets with good prospects which some investors, especially the more conservative ones, would have considered not to be worth the risk but which will now have a much more appealing price-to-earnings potential.

The next six months are going to be uncertain but there could be a lot of potential in the medium to long-term, so the time to act is now.

This interview does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]