Multi-asset portfolios have become more cautious since late February amid skepticism over market expectations of a “soft landing” in the face of hawkish central banks battling inflation and higher bond yields, justifying the short duration of the bonds. On equities, this configuration leaves us short on Europe, but positive on Asia (Japan and China). We stay long commodities.
For central banks, the facts have now changed: inflation has been persistent enough for them to drop the “transitional” moniker and start to act. At the same time, markets do not expect the US Federal Reserve, or the ECB for that matter, to be able to sustain monetary policy tightening, with a sharp reversal in the current rate hike cycle. expected from 2023.
Obligations generally do not yet signal a recession, but stock price all the more. There is a ‘Covid sensation’ in the markets: Yield moves and weakness in major stocks are reminiscent of March 2020. Global growth optimism is at an all-time low, with stagflation concerns at June 2008 levels ; unsurprisingly, the earnings outlook is at its lowest since September 2008, although analysts’ views are lagging.
Whereas credit spreads widened, deeply negative returns in the asset class were mainly duration driven. The liquidity premium demanded by investors for corporate bonds has increased, but the movements have been relatively contained. In high-yield credit, the premium is still well below the highest 400 basis points required in times of stress. We wonder if the current spreads can really compensate investors for a deterioration in credit risk as circumstances become more difficult.
Compared to equities, Investment Grade credit looks particularly attractive in the US and Europe. We see credit as a clear buying opportunity if our appetite for more risk increases.
Actions – The first shoe
The more than 20% drop in US stocks in mid-June is a signal to some that the markets are already pricing in recession. We believe this misinterprets the situation. The decline was almost entirely due to US 10-year real yields rising from -1.2% to over 0.8%.
If the markets were truly anticipating the recession, earnings forecasts would have fallen sharply. Excluding raw materials, they did not progress much despite the deterioration in the outlook. Even Europe ex-UK earnings held up.
However, recent gas supply cuts by Russia cast doubt on any optimism about Europe’s prospects. Europe needs gas more than Russia needs the revenue from its sale. Russia seems to have little need for foreign currency. Indeed, a complete shutdown of Russian gas exports would likely lead to stagflation in the region, with GDP growth turning negative while inflation remains high.
And the Fed?
The recent 75 basis point rate hike from the US central bank indicates that policy rates are now back to where they probably should have been months ago. The trajectory of rates will now depend on the evolution of inflation in the months to come. The Fed expects headline personal consumption expenditure inflation to fall to 5.2% by the end of 2022 and 2.6% in 2023, with core PCE falling to 4.3%, then to 2.7%.
The hoped-for transitory inflationary factors will have to come into play if these inflation projections are to be met.
While some of the forces driving inflation, such as supply chain bottlenecks and pent-up demand, are expected to fade, more lasting structural factors could keep prices up by more sustainable way. Relocating production would negate the cost savings from globalization, declining labor force participation rates could hamper service sector production, and house prices continue to rise by 20% a year, which will translate into an increase in rents.
Will the recession (defined as two quarters of negative GDP growth) be avoided in the United States? We believe so, but we still see growth slowing sharply in 2023, with rising unemployment weighing on wages and ultimately core inflation (services). Property prices are expected to rise more slowly (or fall in some cases) as base effects play out, while rising mortgage rates will dampen house price appreciation.
Asset class views as of June 30, 2022
 The title refers to the quote “Well, when events change, I change my mind. What do you do?”. This has been attributed to economist Paul Samuelson. Source: https://quoteinvestigator.com/2011/07/22/keynes-change-mind/
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