Dramatic price action has taken place over the past weeks in equities and bonds, following hot inflation prints, central bank (CB) actions and rising concerns over economic growth. These events are a reminder of the regime shift, in which we are witnessing the resurgence of stagflationary risks and central banks trying to assert their credibility. Going forward, growth, inflation and central banks’ policies will continue to drive markets:
- Growth: We were already expecting a deceleration of growth at the start of the year, but we are now moving to a marked slowdown, particularly in the euro area, with the risk of a technical recession. This is mainly due to weak private consumption and investment in Europe (which is most impacted by inflation). In contrast, in the US stronger private consumption and investment should continue to support growth. But we expect a marked slowdown and rising recession risks for 2023. The market is going to focus on the growth path and, in particular, on any signal of deterioration in the US outlook.
- Inflation – not yet at the peak, with different drivers in the US and Europe: The expected peak in inflation has been postponed, while the peak level has moved higher than initially thought. The inflation drivers are different in the US and Europe, with inflation more demand-driven in the US, while in Europe, the primary reason for inflation has been supply constraints, with the energy shock from the war further exacerbating the outlook. In an environment of slowing growth, inflation should also slow.
- Central banks have the difficult task of restoring their credibility: In general, monetary tightening is more effective when inflation is driven by strong internal demand. However, when inflation is caused by external factors (supply constraints), then CB tightening is not very successful in taming inflation. Thus, there is more scope for tightening in the US, while the ECB is in a worse position as it also has to address EU fragmentation, as signalled by the announcement of a dedicated anti-fragmentation tool by the ECB. Overall, we believe that when inflation peaks and attention turns to growth trending lower, central banks will likely pause and deliver less than initially stated.
Against this still highly volatile backdrop, investors should stay diversified and avoid adding risk as the market repricing, although advanced, is not over yet. This is the time to move towards high-quality areas and resilient business models that can preserve margins. In particular:
- The recent bond sell-off makes this asset class selectively more attractive, as CBs’ hawkishness is now priced in and at a certain point, they could be forced to do less to avoid a recession or further fragmentation. The current levels are also becoming more attractive for investors such as insurers and pension funds and that could cap the potential further upside in yields. We are more positive than before and close to neutrality on duration in the US and core Europe, but keep an agile approach overall. In euro peripheral debt, we remain neutral and are closely monitoring the fragmentation risks.
- Credit – we recommend moving towards higher quality credit and being more selective in general across the credit spectrum (IG and HY), given some concerns over earnings. However, our regional preference for US IG remains in place in light of the strong consumption and labour markets in the country. This should help deliver better economic growth.
- Equities – we keep an overall vigilant stance and given that in Europe further earnings downgrades are not fully priced in, we are cautious due to the headwinds from high inflation, which could dampen consumer demand. The US, on the other hand, should fare relatively well and we maintain a preference for the US. In terms of style, investors should opt for the less cyclical areas in equities in value, quality and dividend oriented stocks. Companies with strong balance sheets and pricing power, as well as the ability to pass rising costs on to consumers and preserve margins, should do well.
- We are becoming slightly more positive on Chinese A shares as these appear more insulated from the developed world, where stagflationary risks are surging. We also expect this asset class to benefit from the reopening of the Chinese economy and the stimulus in place.
- For diversification purposes, investors should consider commodities and strategies with low correlation to equities and bonds. On currencies, we keep our preference for the USD versus the Euro and, to a lesser extent, for the Yen.