Central banks (CBs) are trying to work out how far they should go in terms of their aggressive tightening talk. We see four main factors to consider when assessing whether we will see pivots from CBs: (1) The still strong job market does not support a shift in stance from the Fed. Signs of some moderation are emerging in wage growth, but this remains above pre-crisis trends, though decelerating sequentially; (2) Inflation is persistent and challenging. While the peak in US inflation is likely behind us, recent data confirm that core inflation remains sticky. Goods inflation is falling, while the services inflation print came in at a 40-year high; (3) Sovereign debt sustainability is under scrutiny, together with the functioning of markets. Slowing economic growth would require a fiscal push, especially in Europe, at a time of rising interest rates. Questions over long-term debt sustainability come at a time when markets are clearly addicted to CB liquidity. This has become the key to supporting market functioning and the UK is an example that shows how miscalibrated fiscal and monetary policies can affect market functioning and force a central bank to act; and (4) Financial conditions are tight, but could become even tighter as the risk of the Fed being forced to overshoot remains high.
The high-inflation/low-growth backdrop, with CBs on a tightening path, means that a profit recession is materialising, not only in Europe but in the US as well, and the probability that this will translate into an economic recession as we move into 2023 is rising. After the September sell-off, risk assets are less expensive, but still do not discount a profit recession. It’s also difficult to see what catalyst might come before a Fed’s pivot and lower rates, although some short-term relief is possible after the recent sell-off. Therefore, we confirm an overall cautious stance around five investment convictions:
- We keep a cautious risk stance in light of stagflation fears, recession concerns and the energy crisis. Both in the US and Europe, we think downward revisions to earnings are on the cards. In particular, we are watching for pain points and forward guidance around rising input costs and their effects on margins, the strengthening dollar, which lowers international earnings for domestic companies, and supply chain constraints. Finally, investors should remain vigilant for some signs of capitulation in equities and downward EPS revisions that may pave the way for a better backdrop for equities. For now, we are convinced that relatively better inflation, economic growth and consumption in the US should mean US companies remain resilient compared with European firms, confirming our preference for the US over Europe. We also recognise that there could be a short-term rebound after the recent sell-off.
- In FI, current yields make US Treasury valuations attractive, allowing us to stay neutral on duration in the US. But we are active and keep a tactical view so we are ready to adjust this stance depending on the evolution of the Fed’s rhetoric and economic growth. In core Europe, we are close to neutral and believe the ECB’s tightening stance could move short-term yields in Euro area curves.
- Corporate refinancing is an important factor to watch. We retain a preference for US IG, but are cautious on HY as the risks are mounting. While corporate fundamentals are currently solid, the near future is uncertain, particularly when demand is slowing and margins are under pressure. Nonetheless, the effect of monetary tightening on IG and HY spreads in the US and Europe has been limited so far given companies currently have low refinancing needs and have dipped into their reserves. However, this has resulted in declining cash balances in most sectors, leading us to be cautious about the evolution of liquidity, companies’ working capital needs and the default outlook in low-quality segments. In Europe, fiscal policies could be supportive of businesses, thereby slightly limiting the drag on corporate cash holdings, but we do not rule out higher spread volatility.
- Still neutral on EM given the environment of weak global growth, with an increasing need for selection. On China, despite the short-term challenges, the country could see a rebound in demand next year amid accommodative policies and fiscal support for local governments. Across EM assets, our preference remains for HC debt, while we are defensive on local rates in light of the continuing USD strength. CBs for Latin American exporters, such as Brazil, have been proactive in tightening policy to tame inflation, providing a favourable environment given the attractive carry.
Investors should increase the focus on liquidity because any rise in market stress could make it difficult for them to exit more volatile assets.