The first sequence of the double bear markets (in equities and long-term bonds) adjusting to the end of easy money and rising inflation is almost complete. Now, the narrative has changed, with a shift in focus to deceleration of growth vs fears of inflation. The three main themes that should be monitored are:
- Lower growth, high inflation: DM in a stagflationary scenario with divergences and potential effects of gas rationing on European GDP growth.
- Earnings expectations could still come down. Current market pricing is still coherent with a return to a normal inflation regime and not entirely pricing in a profit recession. In a capitulation phase, markets should anticipate the worst, with either stronger EPS drawdown or lower prices (or both), but we don’t think we’re there yet.
- Dollar rally: room to continue. With no changes in the Fed stance, we see downside risks to our EUR/USD targets for year-end, with a possible downside level at 0.94 while the six-month target remains around parity. Recession or a higher probability of recession would be positive for the US dollar as long as the Fed stays hawkish.
For investors, this backdrop translates into being cautious, tilting towards inflation protection.
- From a cross-asset perspective, higher uncertainty and increasing downside risks regarding the economy call for a relative preference for bonds vs equities after the 2022 repricing. Economic momentum has failed to rebound and risk sentiment remains negative, still pointing to possible further market downside. For a period, we may see the safe-haven appeal of bonds returning, but the approach to FI markets has to remain flexible because inflation pressure will at some point resurface and keep volatility high. We continue to call for increased diversification and consideration of alternative strategies, currencies and commodities as well.
- In equities, we stay defensive. Bond yields will have to fall consistently and the Fed to pivot before we return to a pro-cyclical equity stance. Hence, while sticking to the view that rising rates favour value, we believe it’s key to complement this call with quality and selectivity. On a regional basis, we maintain our preference for the US vs the Eurozone. Any signal that a US recession may be avoided or postponed further could lead to a tactical relief rally in upcoming months. But pressure on earnings will increase moving into 2023 as inflation will still be high (although decelerating), financing costs will be higher after rate hikes, and the economic outlook could have deteriorated.
- In bonds, core govies are now more attractive, at least in nominal terms, and they may act as a diversifier in case of higher recession risks. Hence, short term, we maintain a neutral overall stance, but given the still-high market volatility, we stay flexible to take advantage of tactical movements in yields. Credit markets have also repriced significantly, even more relative to equity, and valuations are now more attractive. Here, we favour investment grade credit – in particular, in the US based on a more resilient economic outlook vs Europe.
- The emerging markets (EM) outlook is improving across the board, with China equity favoured to play the desynchronisation of the cycle. On the equity front, earnings expectations look to be stabilising and bottoming. Revisions are very positive in LatAm, slightly decreasing in EMEA, and very negative but bottoming in EM Asia. Overall, we don’t yet call for a positive overall stance in EM equity but remain selective. We have further improved our outlook for China equity given the policy support, economic reopening, and signals of possible relaxation of the zero tolerance of Covid approach. In bonds, the current environment remains unfavourable to local debt, but nominal yields could be close to peaking. Hard currency debt, instead, offers opportunities, as spread widening looks to have gone too far. High oil prices also continue to be supportive.
In conclusion, we continue to be in the phase when central banks have to assert credibility, and this is also a function of the pain in the market. So, investors should resist the temptation to take bold steps, as the tightening of financial conditions is not over yet. However, we believe that CBs may stop hiking earlier than expected in an attempt to avert more economic damage, and at that point, some further tactical opportunities may arise. Looking long term, inflation will likely continue to be above central bank targets. For investors, the need to keep the inflation focus at the core of their investment strategies remains paramount.