French asset manager OFI Asset Management believes that the economic and market backdrop in autumn 2022 will be particularly difficult and tense, with uncertainties about inflation persistence, tight monetary policies and economic slowdown, severe political and geopolitical tensions, etc.
In this context, according to OFI AM it is not the time for aggressive investment strategies, although it points to two factors that reinforce optimism: equity valuations seem quite reasonable and can withstand downward earnings revisions; and markets are currently so pessimistic that the slightest bit of good news would trigger very aggressive rises.
Above all, the manager stresses that now is the time to invest in High Yield Fixed Income, after the Fed and ECB’s sharp monetary tightening, and despite the asset’s rally this summer. Implied default rates are too high and absolute yields are very attractive.
Fixed Income Expectations
Fixed Income markets have been subject to high volatility as they seek a balance between high inflation, central banks’ response to rising prices, and growth momentum.
This trend has been further reinforced following the recent withdrawal of forward guidance by the Fed and ECB, which was confirmed this summer. Investors “expected” an easing in the pace and extent of the next monetary tightening against the backdrop of a worsening growth outlook, which pushed down expectations for interest rates and long-term bond yields from mid-June to the end of July.
However, central banks, led by the Fed and the ECB, confirmed that their focus remains on fighting inflation risk. Powell’s speech at the Jackson Hole symposium served to reiterate the Fed’s direction, even if it means sending the US economy into recession.
The ECB, which first surprised by raising interest rates by 50 basis points in July (compared to 25 basis points expected), has raised rates again in September by 75 basis points, causing investors to rethink their expectations. Because they no longer expect a US interest rate cut in 2023, they are adjusting their expectations for the ECB’s rate upwards by more than 150 basis points by the end of the year.
With a final interest rate of 2.0% in the euro zone and 3.5% in the US, long-term bonds seem to have priced in the macroeconomic context, with current rates at 1.5% for 10-year bonds and 3.0% for the US equivalent. This justifies flat or even inverted yield curves, as is currently the case in the US.
Interest rate volatility is unlikely to be reduced in the short term. Greater visibility will require a pause in energy prices, and the release of figures showing a fall in core inflation.
The backdrop is favourable for corporate bonds, supported by yields in both Investment Grade, above 3%, and High Yield, just below 7%. Despite the upcoming economic recession, carry levels offer high protection. Credit spreads, especially versus government bonds are back to their 2012 levels and are already pricing in the recession and an unprecedented spike in High Yield credit default rates.
At first glance there seems little cause for optimism given the current fears of inflation and economic recession. However, global indices enjoyed a strong rally this summer, until the correction in the last week of August, so the OFI AM experts ask why this resurgence of confidence at a time of tightening and sacrifice and war in Europe?
The reason is that corporate earnings in the first half of the year beat expectations and companies have continued to send positive messages despite the current high macroeconomic uncertainty. At the beginning of the year, analysts expected corporate earnings in Europe to be less than 10% higher in 2022 than in 2021. Knowing the first half-year figures, they now put them 15% higher.
When earnings rise and stock prices fall, there is a sharp contraction in valuation multiples. Twelve-month P/Es are currently around 11 in Europe and no higher than 17 in the US, and with rising bond yields, these multiples would be expected to fall. But current levels are discounting a decline in earnings in 2023, or that interest rates will continue to rise on both sides of the Atlantic.
Moreover, market sentiment, which has never been so negative, is another factor supporting equities. Because, investors have already reduced their exposure to the asset, either by selling their stocks or by using option hedging strategies. In terms of style, while recent upward movements in interest rates undermine growth equity valuations, cyclicals and financials have underperformed, due to increased fears of a downturn in the economy.
So if market valuations are not too high, and if investor sentiment is negative, why not go aggressively long equities? Because too many uncertainties remain: geopolitics, central bank policies, the extent of earnings revisions that will occur if the recession is worse than expected and, above all, the ability of companies to maintain margins in the face of growing wage pressures.
As such, OFI AM’s stance on equities is neutral at current levels. The manager proposes to increase exposure by 10% from its lowest level and reduce it by a further 10% from its highest level. When some of these uncertainties become clearer, it will be time to take a more decisive stance on the asset.
Central scenario for OFI AM
In conclusion, according to OFI AM central banks have made it clear that their priority is to fight inflation even if that means undermining growth. This runs counter to market expectations, which had expected an easing in the face of early signs of an economic slowdown.
The decisive tone of central banks has also been reflected in the long end of yield curves, which have returned to levels much more consistent with the short-term rate hike cycle and inflation uncertainty. At current rates and spreads, corporate bonds appear to offer attractive carry opportunities.
Equity markets continue to fluctuate between the reality of the economy following corporate results, low valuations and strong uncertainties about the challenges in the coming months. The manager therefore focuses on increasing risk exposure during market declines, and reducing risk exposure during market rallies, as long as no clear trend in the asset class is emerging.