The past three months have seen a dramatic selloff of risky assets, driven largely by a recalibration of expectations of where global interest rates might be headed. With rate expectations rising, fixed income assets have also fallen in value, generating a nasty positive correlation between bonds and equities on the way down. Looking ahead, a lot depends on the evolution of inflation, and therefore interest rates from here.
We see 3 factors as being crucially important:
- There is the situation in Ukraine and how the conflict develops over the next few months. An attritional, unresolved outcome looks increasingly likely, meaning high energy prices, high food prices and economic sanctions are here to stay.
- There is the disruption to global supply chains, itself related to the Ukraine war, but also manifesting itself in semiconductor shortages from Taiwan and disruption to the supply of durable goods. China’s zero-Covid policy may have exacerbated this disruption, but probably not as much as the standard narrative might suggest.
- It is becoming clear that inflationary pressures are broadening out to core (ex-food, energy) elements of the index and that longer-term inflation expectations may be rising.
In the current recession-risk and inflationary environment, a scenario approach continues to prove its worth. Our global investment outlook can be summarised in the following 3 scenarios:
Scenario 1 – Best case (40% probability) – the Ukraine conflict winds down, energy & food price spikes abate
- Ukraine – the ongoing conflict remains localised, and food and oil prices do not escalate further
- Supply – pressures fade, and global production, shipping and logistics continue improving
- China – the country manages zero-Covid more efficiently and its production-led recovery exceeds expectations, normalising supply chains quickly in East Asia
- Policy response – monetary policy tightening slows, and as a result, yield curve inversion is forestalled, and divergence in global policy is contained
Scenario 2 – Real Recession in 2022 (30% probability) – Ukraine conflict intensifies with energy and food price shocks
- Ukraine – the conflict escalates and supply-chains fragment, worsening the cost-of-living crisis, pushing major economies into real recession, with no recovery in risk assets likely until the end of 2023.
- China – zero-Covid policies are inefficiently implemented, and manufacturing and logistical disruptions continue across East Asia, resulting in a near-term spike in energy and food prices. Further shortages in production inputs and manufacturing disruptions result in rising retail prices and reduced consumer purchasing power
- Europe – hit hard by rising retail, energy and food prices, particularly given dependence on Russian energy
- Policy response – monetary policy tightens through Q3 2022 but pivots towards quantitative easing by early 2023, in response to recessionary conditions and output gaps
Scenario 3 – Monetary Recession by 2023 (30% probability) – poor US demand, high inflation and broad wage-price spiral
- US – demand holds up through 2022 as US labour markets stay tight, but a worsening wage-price spiral results in persistent inflation
- Policy response – the Fed applies a harder policy brake to rein in demand, resulting in a steep fall in risk assets. The Fed funds rate moves towards 5% in 2023, the yield curve inverts and the US dollar strengthens considerably. As a result, the S&P index price-equity multiple falls to Global Financial Crisis lows, likely staying low until 2024
- Europe – the EU takes a monetary tightening approach becoming worse off
- EMs – extreme policy divergence impacts Japanese and Chinese currencies, worsening market volatility. Frontier and EM sovereigns exposed to heightened interest rate and Fx risk, causing high-yield and EM spreads to widen
Forecast summary – what do we think?
Inflation has hit multi-decade highs across major economies. Although wages have responded, to varying degrees across countries, they are yet to do so in full. As a result, many households have seen significant reductions in the purchasing power of their incomes. Consumer confidence in the US and in Europe have fallen to levels that typically herald a downturn, however households have built up sizeable pots of additional savings, most of which remain unspent and have the potential to provide a cushion against a fall in real incomes.
In the US, inflations has now reached 8.6%. The last time US policymakers succeeded in bringing inflation back down from such heights while simultaneously avoiding recession, was in 1951. In the past, it has almost always needed a period of declining economic activity to force inflation expectations and inflation lower.
Equities – we further dial down risk exposures as markets are likely to remain volatile, risk premia remain high, and our forecasts suggest risks are skewed to the downside. Short-duration parts of the market are likely to outperform long-duration assets. On a relative basis, we see income equities (equities of companies that return cash to shareholders either through dividends or share buybacks) outperforming non-income paying stocks as income provides a hedge for upside inflation surprises and implies a lower sensitivity to higher rates. US and non-European Developed Markets stocks are likely to fare better than European, where the economic impact is largest and uncertainty greatest. Within emerging markets, we prefer to be invested in commodity-exporting Brazil, Mexico, and Indonesia. We have reduced our underweight and prefer staying neutral on China with a tilt towards infrastructure, technology, and consumer staples.
Fixed income and credit – there is still a small chance of further increases in market rates if core inflation surprises on the upside. But at current yield levels, and with the (near) inversion in 10s30s and 5s10s across most Developed Markets curves, we would reduce our longstanding underweights on fixed-income duration.
FX – from a major dollar index perspective, we still believe that the USD has further upside given the euro comprises 60% of the index. We continue to believe that the euro will come under pressure on markets pricing in fragmentation risks, proximity to Ukraine crisis and energy supply risks.
Markets took a dimmer view of key macro drivers during Q2. In recent weeks, a combination of higher-than-expected inflation and weaker growth signals has forced the market to acknowledge elevated recession risks.
The S&P 500 entered a bear market on 13 June, with growth slowdown fears mounting. Caution continues to be warranted given downside scenario risks, however the consensus appears relatively more sanguine, particularly for the path of equities – this optimism is consistent with consensus expectations that inflation could decline relatively quickly, whereas we see greater risk of inflation becoming entrenched. Thus, we assign a higher probability that central banks must “jam on the brakes” to ultimately regain control of inflation, proving a challenge for risk assets.
Deeply pessimistic sentiment indicators are often associated with market cycle lows and can thus serve as a guide to inflection points. Right now, although some indicators suggest we may be nearing conditions for a market low, the macro-outlook overshadows these indicators.
Despite the poor performance this year, the market does not appear to be priced for a recession yet. One plausible explanation for this is that there remains a possibility that recession can be narrowly avoided, and markets could then begin to recover later this year.
History suggests that bear market rallies are frequent but fleeting in the face of economic challenges. Indeed, most bear markets throughout history are associated with recessions. Yet, some optimism can be taken from the past. Analysing the S&P 500 performance in every bear market since 1929, in most instances the S&P records a positive return in the next year after entering a bear market.
The market’s resiliency over its long history should be comforting and kept in mind during challenging periods.