Geopolitical risks have returned to investors’ radar screens with President Putin’s escalation of the war in Ukraine. At the same time, inflation remains in the spotlight: the latest US reading was concerning, causing yields to rise while equity markets tumbled. Looking ahead, we confirm the outlook of slowing US inflation (headline peak looks to be behind us), but well above the Fed’s targets in the near term and we think central banks, including the Fed and the ECB, will remain hawkish. Politics is also under the spotlight with US mid-term elections, a new government in Italy, and elections in Brazil.
On the other hand, the economic outlook could deteriorate. The US faces an extended period of sub-par growth and the outlook for the Eurozone appears gloomier, compounded by the ongoing energy crisis. While there are discussions around a coordinated EU solution in the form of potential taxes, price caps, etc., markets have yet to see concrete details regarding a full-fledged response. Initiatives at the single country level still prevail, such as Germany’s announced €200bn package to tackle the energy crisis and the fiscal package announced by UK PM Truss. The plunge in UK assets post the announcement of the ‘mini’ budget, on 23 September, triggered a restoration of BOE quantitative easing at a time when the CB is raising rates, indicating the challenging equilibrium in the policy mix and the risk of liquidity strain. Volatility in markets is here to stay. The key themes to watch include the following:
- The narrative driving core yields up at the moment is that hawkish CBs are pushing rates up. Attractive valuations for the UST 10Y, the amount of global pressure (supply and demand side) on economic growth, and geopolitical tensions mean that government bonds should provide a source of protection. Investors should keep an active view which takes into account tactical moves around ‘higher for longer’ rates. In Europe, a hawkish ECB has been forced to deal with supply chain shocks and factors beyond its control. This could put upward pressure on short-term yields for select Euro Area curves.
- On credit, particularly high-quality segments, such as US IG, the picture is positive while in the HY space we keep a cautious stance. In IG credit, debt growth and leverage look to be under control and margins are strong, despite upward pressures on costs. However, cash reserves and liquidity are areas that could emerge as concerns going forward, particularly as the earnings backdrop deteriorates. This is the case more for lower-rated issuers and those in HY, which would most likely consume their reserves when cash flows slow and it becomes more difficult to raise debt.
- In equities, we believe investors should remain cautious, and highly selective, looking for quality. Earnings estimates for the US and Europe do not fully reflect the deteriorating economic backdrop and we believe we are on a downward revision path. Hence, we remain very careful on the earnings front. That is why our focus is on the quality, value sides and names that reward shareholders through dividends, etc. Regionally, the US should perform better than Europe while we are now neutral on China and watchful on the evolution of the zero-Covid policy and regarding the housing sector.
- Emerging markets growth momentum has improved slightly, but there is a need to be selective as inflation is uncomfortably high. The broad decline in inflation has not started yet except in Brazil, where election-related volatility could hurt the real. As a result, CBs (Chile, etc.) have maintained their tightening stances. HC debt offers opportunities in terms of carry and valuations. In particular, we like commodity exporters (Brazil, Mexico) in Latin America, but are cautious on EM FX. Here, investors should watch for the impact of a recessionary scenario with regard to commodity prices and exports. EM equities present a mixed environment, with earnings expectations robust and valuations selectively attractive. Chinese authorities continue to pursue a zero tolerance Covid policy and that is shaping the outlook for near-term weakness but it is one of the few countries where policy is turning accommodative.
The environment ahead is likely to be characterised by how much pain CBs are willing to inflict on economies to bring inflation under control, particularly at a time when drivers of inflation in the US and Europe are different. However, what is clear is that they will put the brakes on economies, which could affect more vulnerable names in credit and equities. We think this is a time to include bonds and high-quality credit in portfolios, but maintain a diversified approach regarding real assets (commodities, gold). Thus, the overarching theme is to look for returns in areas that can offer protection in an economic downturn and at the same time provide inflation-adjusted returns.