The summer season has temporarily brought some sunshine to investors as the main equity markets had been rallying until mid-August. Supporting this trend was a series of assumptions on key themes driving the market: inflation was assumed to be at its peak and starting to recede; growth was assumed to be on a soft landing path; and central banks were assumed to have done most of the work needed.
Back in June, we thought a rebound was in sight as the market had oversold amid a still-resilient US economy and this underpinned our preference for the US equity market within an overall cautious to neutral equity allocation. The main story supporting the market over the summer was the expectation of a possible pivot by the Fed, after its more-hawkish-than-expected actions so far. In a ‘bad news is good news’ scenario, the negative quarterly US GDP number supported this narrative. With Q2 earnings season still showing positive trends, the buoyant market environment has translated into looser financial conditions, further complicating the task for central banks. Now that the Fed has reasserted its hawkish stance, we are starting to see some further downward movements, which we think may continue as markets have further to go in the repricing of higher real rates. At this point, we see no positive triggers to keep the rally going, while there are rising risks moving into autumn amid a gloomier economic backdrop. To cope with this environment, we believe investors should adjust their asset allocation stances. In particular:
- It’s time to reduce equity exposure and become more defensive. While a global recession may be avoided, after the recent rally there are no elements supporting a positive stance in equity markets while risks are increasing. Taking into consideration the factors that may bring volatility in the short term (CBs’ communication, news flow related to the energy crisis, some global macro weakness), we have started to move to a more cautious stance on equities.
- In equities, we keep our preference for the US vs. Europe and also for China, though on China to a lower extent than before amid the volatility driven by Covid restrictions and a weak housing sector. Even if the US economy is decelerating, it remains far more resilient than Europe. With contracting margins, squeezed consumers and decelerating economic activity, there is a limit to how much pricing power and top-line growth companies can deliver. While Q3 corporate results should be resilient, we could see earnings turn negative in 2023. As a result, overall we are now more defensive than before and particularly selective.
- Bonds are back, but an active approach is paramount given the still-high uncertainty. After the great repricing in the first half of the year and as we move to an environment with a higher risk of recession, government bonds are worth looking at as yields are now more appealing. Here we recommend a tactical approach to duration management, considering markets are being driven by both inflation and growth expectations, pushing yields in different directions depending on the prevailing narrative. In credit, we remain cautious, particularly on the high yield segment. We favour the investment grade space and the US over the Eurozone, as US fundamentals are at less risk of deterioration thanks to the more resilient economy. We emphasise that an active management approach in bonds is key at this stage amid the risks of a further pick-up in inflation due to energy prices and supply chain disruptions, possibly leading to a more hawkish Fed stance than is currently priced in by the market.
- Emerging markets (EM) offer selective opportunities. Despite the macroeconomic headwinds, we do not see systemic risks for EM though we believe there is a higher probability of an idiosyncratic crisis, therefore a highly selective approach is needed in the EM space. Downward revisions to EM have been more subdued than for DM, confirming the growth differential in favour of EM despite the downward revision of China. In terms of investment opportunities, overall EM equity appears cheap and earnings expectations are stabilising. We look for opportunities in LatAm (Brazil) but are cautious on some Eastern European countries (Hungary and Poland). In the EM debt space, there are some interesting income opportunities and our preference is for hard currency bonds, in particular those in the high yield space.
Looking ahead, the probability of downside risks remains high while the inflationary environment is confirmed. A further fundamental deterioration could trigger another correction, with the second-round effects of monetary policy on the economy being the potential catalyst for de-risking. Therefore, this is a time to keep a cautious view and be vigilant towards the evolution of the economic backdrop.