Global Investment Views - August 2022

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:

1. Lower growth, high inflation: DM in a stagflationary scenario with divergences and potential effects of gas rationing on European GDP growth.
2. 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.
3. 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.

Investors expect central banks to tame inflation whatever the cost, even triggering a recession, if necessary. This may indeed be policymakers’ approach in the short term, as they seek to re-establish credibility. The ECB’s decision to raise rates by 50bps is a case in point. While that could cement investors’ views of how rate-setters will act in the longer term, they risk overestimating central banks’ ultimate willingness to damage growth. What’s more, financial markets appear to be misjudging how long it will take economies and consumer prices to respond to increases in interest rates.

Inflation shows few signs of subsiding, and while activity may be slowing, economies continue to grow. That’s understandable given that monetary policy is still relatively accommodative, despite recent rate rises, and financial conditions remain easy. Yet markets are focused on the risk of an imminent collapse in growth; this may be a case of getting ahead of ourselves. Even assuming CBs hike rates rapidly to a more neutral level, it takes time for the effects of such tightening to filter through to the economy. We may have to wait anywhere between a year to 18 months for rate rises to really rein in demand. Then, there will be another lag before consumer prices respond to this slowdown. As a result, inflation may exceed policymakers’ targets for another 10-15 months even after growth hits the skids.

All this presumes rate-setters are willing to induce a recession to meet their mandates. But, in our view, they will balk at inflicting too much pain on the economy. Inflation will therefore be higher than many expect over the next couple of years, with important implications for asset prices:

• In fixed income, this will mean even higher yields. While recession worries have flared recently, the outlook for growth can only be the dominant driver for bonds if inflation is quiescent. Given that won’t be the case, yields will rise. Take, for example, the benchmark 10Y Treasury. Assume its yield can be decomposed into two basic components: the 10-year average of nominal US growth and a risk premium. That long-term nominal growth rate may previously have been around 4% – the sum of 2% real growth and inflation of roughly 2%. We therefore wouldn’t be surprised to see the 10Y Treasury yield rise to 4% or above. While this adjustment process happens, being flexible in duration management will be the name of the game.
• Higher average inflation rates could also weigh on stocks. The P/E ratio of the S&P 500 may drop another point or two, which implies another 10-15% decline in the index itself. Rising borrowing costs and falling equity values pose risks to companies that have taken on huge amounts of debt in recent years. However, high-quality credit has adjusted more quickly than equities to the shifting outlook, and may be less vulnerable.
• EMs present a slightly different picture. CBs in many of these countries responded more swiftly to accelerating inflation than their DM peers. Their monetary policy tightening may be nearly at an end, and some of them offer attractive inflation-adjusted interest rates.
• Such opportunities, alongside real assets and inflation-adjusted bonds, may be attractive for investors seeking to build portfolios that are able to withstand the ravages of inflation. Timing, as ever, will be crucial. And getting that right will depend on paying attention to economic lags.

With inflation forecasts revised up and growth predictions downgraded in Europe and the US, the key issue for us is the impact on earnings and consumers’ purchasing power. We think a lot of negative newsflow is already priced in some corners and we could see some temporary rebounds. However, we are still not directionally positive on risk assets because the economic environment is uncertain and so is monetary policy. We acknowledge that strong directional bets on risk assets are not easy to make and we remain slightly cautious overall. Instead, investors should explore the resilience of the US over Europe (in equities and credit), aim to benefit from (intermittent) economic reopening in China, and exploit relative value ideas. In addition, this is also a time to be well-diversified and maintain hedges.

We are slightly defensive on equities overall and believe Europe (cyclical and more open market) would suffer more than the US in case of a downturn and if Russia squeezes gas supply to countries such as Germany, causing the region to adopt gas rationing. Thus, we raised our regional preference for the US, including some growth. In EM, we are more positive on Chinese mainland shares owing to the supportive policy, economic reopening, and the focus on domestic growth. However, valuations in India look expensive. In FI, we maintain a very dynamic approach. Even though we are close to neutral on duration in the US and core Europe, we are monitoring pressures on inflation and growth across geographies. For instance, we are now positive on UK 5Y real rates which reflect our views on their attractive valuations and stagflation in the country. The market seems to have priced in a very hawkish Bank of England, but that is not justified by the UK’s weak economic backdrop. So, we think, the BoE is unlikely to hike as much as some other CBs, such as the Fed. Furthermore, inflation will remain high and would be exacerbated by a weak GBP. On peripheral debt, we keep our 10Y BTP-Bund spread holding for now amid the ECB’s commitment to preventing fragmentation. However, we are closely following the situation after Mario Draghi’s resignation and ECB policy tightening. In EMBI, we remain neutral due to the fallout from Fed tightening on EM spreads.

Corporate credit appears to be slightly attractive as valuations seem to discount a recession. But here, we prefer US resilience, maintaining our US IG preference owing to a relatively robust macroeconomic backdrop, corporate fundamentals (solid balance sheets, with high liquidity levels; good coverage ratios), and a low risk of refinancing debt in the near term. However, in Europe, although we acknowledge that valuations in HY are attractive, sentiment is now becoming negative on account of rising stagflation risks. FX is an area where diverging global trends are becoming more apparent. We stay positive on the CHF/EUR and cautious on the EUR/USD, despite the currencies reaching parity recently. The US/Europe rate differential, the Fed’s hawkish stance, and risks of a deceleration in growth globally are all positive for the greenback. The last factor is also supportive of the USD/CAD, which. In EM, we are particularly cautious on Eastern Europe and hold our BRL positions vs the PLN and HUF. Brazil could benefit from strong commodity exports, whereas the two latter currencies could suffer from a deterioration in outlook as the countries are net commodity importers and are close to the Russia/Ukraine war.

In light of a mild deterioration in the economic backdrop, and ensuing volatility and potential liquidity issues, investors should consider maintaining all their hedges, particularly on the equity side. Importantly, in the current environment, the USD/EUR would strengthen and investors’ FX hedges should reflect these FX dynamics.

Yields are caught between inflation and recession fears. While the Fed made it clear that it would hike rates sharply to control inflation, this would not be without risks regarding consumption, which for now looks strong. In Europe, the ECB has charted a path of tightening, but we think investors should not go overboard in their estimates of rate hikes, given that Europe appears more vulnerable. At the same time, credit spreads are not very far from long-term averages, implying that while there are clouds on the horizon, financial conditions have eased slightly, particularly in the US. As a result, investors should consider more qualityoriented credit but not de-risk portfolios while also focusing on liquidity amid challenging liquidity conditions.

We continued to reduce our cautious stance on duration, staying close to neutral. However, we are active across curves and geographies, looking out for any tactical opportunities. We have a defensive view on the US, and cautious/neutral stances on Europe (less defensive than before) and the UK. On peripheral debt, we are monitoring the yields on BTPs in light of political developments and the ECB’s transmission protection instrument. Elsewhere, our constructive stance on duration in Australia and New Zealand remains, although we marginally downgraded our optimistic view in China which is a strong portfolio diversifier in the long term. We keep a slightly constructive view in credit, with a preference for high-quality IG. Within this, we favour the US over Europe owing to strong corporate balance sheets. After the recent movements, IG valuations are attractive, but selection is key. We think investors should consider reducing beta, tilting more towards high-quality (Arated) and liquid securities. In HY, hedging may be used to protect against spread widening.

We are witnessing a growth deceleration but no signs of a recession and credit markets seem to realise this nuance. While sentiment is affected, in general, consumers’ financial situations are better than in the 2008 crisis. On the other hand, the Fed is aggressive, no doubt, but we should not underestimate its willingness to support economic growth, if the situation deteriorates. As a result, we stay neutral on duration but are tactical, staying active to adjust this stance depending on yields repricing. We are also monitoring the movement in real rates and TIPS. In securitised credit, agency MBS are particularly attractive when compared with other alternatives in the market. However, spreads are volatile, owing to the Fed’s diminishing support of the market. So, selection is important. Spreads in corporate credit (both IG and HY) are higher than long-term averages but not at extreme levels. We keep a stable beta and limit our spread duration exposure, with a clear inclination towards quality.

The recent EM spread-widening has created compelling valuations. Stabilisation of US 10Y yields, coupled with an improvement in EM-DM growth differentials in H2, should be supportive. We prefer HC bonds, favouring HY vs IG, but are more selective in LC and cautious on EM FX. In China, we are monitoring the real estate sector and boycotts of mortgage payments. Elsewhere, we favour commodity exporters (Latin America).

We are more constructive on the USD/EUR owing to a hawkish Fed and weakness in Europe (impacted by Russia’s gas sanctions). However, we are cautious on the EUR, GBP and CNH and in general are no longer positive on cyclical FX. In EM, we stay positive on the MXN, CLP and ZAR.

GFI = global fixed income, GEMs/EM FX = global emerging markets foreign exchange, HY = high yield, IG = investment grade, EUR = euro, UST = US Treasuries, RMBS = residential mortgage-backed securities, ABS = asset-backed securities, HC = hard currency, LC = local currency, MBS = mortgage-backed securities, CRE = commercial real estate, QT = quantitative tightening 

Overall assessment 

Rising volatility and falling prices point to market expectations on policy tightening in the face of high inflation. If earlier the concerns were ‘too much inflation’, now these themes are complemented by fears about ‘not enough growth.’ The latter is leading markets to reprice earnings expectations, but valuations and earnings downgrades still do not reflect an outright strong recession. We remain very bottom-up, based on a realisation that the macroeconomic environment (as reflected in recent PMI data) could supersede even those names with strong business models because correlation is rising. This should translate into a balanced stance for investors, with a focus on resilient regions, such as the US and China, and sustainable earnings growth.

We are more balanced now than we were at the beginning of the year amid pressures on growth. Our focus remains on process discipline and keeping exposure to defensive names in healthcare and staples (less positive). On the other hand, we think quality cyclical stocks should be better able to withstand selling pressures compared with expensive cyclical names.

Hence, we look for sustainable profits, differentiated products, and businesses that could pass rising costs on to consumers without affecting demand volumes. However, we are cautious on utilities and IT (less defensive). Importantly, investors should focus on socially responsible investments and real returns amid still high inflation. As such, dividend payouts are a solid way to complement total returns and we continue to explore this theme.

Rotation in the markets indicates a decline in expectations on economic growth, as evident from the sharp falls in the cyclicals sector (compared to defensives), possibly due to negative earnings adjustments. As a result, we think some quality cyclical stocks (strong balance sheets, high cash, not high leverage) are becoming attractive, along with some quality core/growth names.

However, this doesn’t represent a green signal to increase risk. We believe the coming months should provide clarity on whether we could see a growth deceleration or a recession next year. If we see an earnings recession, we could see a correction from current levels, particularly in defensive sectors because their current valuations seem high with respect to fundamentals. Thus, we remain very vigilant. Looking ahead, stocks with robust business models and pricing power should be better able to deal with challenges, such as low growth, high inflation and supply constraints. Overall, we like companies with a commitment to rewarding shareholders because this strategy complements investors’ incomes in times of high inflation. However, we are cautious on unprofitable growth and distressed value stocks.

Visibility is still low due to the ongoing war in Ukraine, Fed policy tightening, and large country divergences. The situation is supportive for exporters such as UAE and Brazil, but we are monitoring election-related uncertainty. In China, the re-opening and accommodative policy enabled us to upgrade our view, focusing on the consumer discretionary sector. Overall, we keep our preference for value over growth.

•  ADR: A security that represents shares of non-US companies that are held by a US depositary bank outside the US. They allow US investors to invest in non-US companies and give non-US companies access to US financial markets.
• Agency mortgage-backed security: Agency MBS are created by one of three agencies: Government National Mortgage Association, Federal National Mortgage and Federal Home Loan Mortgage Corp. Securities issued by any of these three agencies are referred to as agency MBS.
• Bear steepening of yield curve: Widening of the yield curve caused by long-term rates increasing at a faster rate than short-term rates.
• Beta: Beta is a risk measure related to market volatility, with 1 being equal to market volatility and less than 1 being less volatile than the market.
• Breakeven inflation: The difference between the nominal yield on a fixed-rate investment and the real yield on an inflation-linked investment of similar maturity and credit quality.
• Carry: Carry is the return of holding a bond to maturity by earning yield versus holding cash.
• Core + is synonymous with ‘growth and income’ in the stock market and is associated with a low-to-moderate risk profile. Core + property owners typically have the ability to increase cash flows through light property improvements, management efficiencies or by increasing the quality of the tenants. Similar to core properties, these properties tend to be of high quality and well occupied.
• Core strategy is synonymous with ‘income’ in the stock market. Core property investors are conservative investors looking to generate stable income with very low risk. Core properties require very little hand-holding by their owners and are typically acquired and held as an alternative to bonds.
• Correlation: The degree of association between two or more variables; in finance, it is the degree to which assets or asset class prices have moved in relation to each other. Correlation is expressed by a correlation coefficient that ranges from -1 (always move in opposite direction) through 0 (absolutely independent) to 1 (always move in the same direction).
• Credit spread: The differential between the yield on a credit bond and the Treasury yield. The option-adjusted spread is a measure of the spread adjusted to take into consideration the possible embedded options.
• Currency abbreviations: USD – US dollar, BRL – Brazilian real, JPY – Japanese yen, GBP – British pound sterling, EUR – Euro, CAD – Canadian dollar, SEK – Swedish krona, NOK – Norwegian krone, CHF – Swiss Franc, NZD – New Zealand dollar, AUD – Australian dollar, CNY – Chinese Renminbi, CLP – Chilean Peso, MXN – Mexican Peso, IDR – Indonesian Rupiah, RUB – Russian Ruble, ZAR – South African Rand, TRY – Turkish lira, KRW – South Korean Won, THB – Thai Baht, HUF – Hungarian Forint.
• Cyclical vs. defensive sectors: Cyclical companies are companies whose profit and stock prices are highly correlated with economic fluctuations. Defensive stocks, on the contrary, are less correlated to economic cycles. MSCI GICS cyclical sectors are: consumer discretionary, financial, real estate, industrials, information technology and materials. Defensive sectors are: consumer staples, energy, healthcare, telecommunications services and utilities.
• Duration: A measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates, expressed as a number of years.
• High growth stocks: A high growth stock is anticipated to grow at a rate significantly above the average growth for the market.
• Liquidity: The capacity to buy or sell assets quickly enough to prevent or minimise a loss.
• P/E ratio: The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS).
• QE: Quantitative easing (QE) is a type of monetary policy used by central banks to stimulate the economy by buying financial assets from commercial banks and other financial institutions.
• QT: The opposite of QE, quantitative tightening (QT) is a contractionary monetary policy aimed to decrease the liquidity in the economy. It simply means that a CB reduces the pace of reinvestment of proceeds from maturing government bonds. It also means that the CB may increase interest rates as a tool to curb money supply.
• Quality investing: This means to capture the performance of quality growth stocks by identifying stocks with: 1) A high return on equity (ROE); 2) Stable year-over-year earnings growth; and 3) Low financial leverage.
• Quantitative tightening (QT): The opposite of QE, QT is a contractionary monetary policy aimed to decrease the liquidity in the economy. It simply means that a CB reduces the pace of reinvestment of proceeds from maturing government bonds. It also means that the CB may increase interest rates as a tool to curb money supply.
• Rising star: A company that has a low credit rating, but only because it is new to the bond market and is therefore still establishing a track record. It does not yet have the track record and/or the size to earn an investment grade rating from a credit rating agency.
• TIPS: A Treasury Inflation-Protected Security is a Treasury bond that is indexed to an inflationary gauge to protect investors from a decline in the purchasing power of their money.
• Trade-weighted dollar: It is a measurement of the foreign exchange value of the dollar vs certain foreign currencies. It weights to currencies most widely used in international trade, rather than comparing the value of the dollar to all foreign currencies.
• Value style: This refers to purchasing stocks at relatively low prices, as indicated by low price-to-earnings, price-tobook and price-to-sales ratios, and high dividend yields. Sectors with a dominance of value style: energy, financials, telecom, utilities, real estate.
• Volatility: A statistical measure of the dispersion of returns for a given security or market index. Usually, the higher the volatility, the riskier the security/market.