Global equity markets remain in thrall of the economy’s gyrations as near-term uncertainty is still quite high. In this environment, we remain cautious by maintaining our overall equity and bond positioning in line with our long-term allocations.

We still see relative value opportunities within equities and fixed income markets, and we’re maintaining our preference for a higher allocation to US and emerging market (EM) equities. In order to increase our weights in those regions, over the summer we reduced our exposure to the euro area and global equities.

In our view, earnings and sales expectations in the euro area are optimistic compared with those in the US given their relative positions in the economic cycle. EM equity valuations remain attractive relative to those of global equities. Current economic conditions offer support for major EM countries through the prospect of policy easing or no more rate hikes as EM central banks are ahead of the curve and/or via a sense that most of the economic deterioration may soon be behind us.

Within fixed income, another change we implemented over the summer was to increase our high-quality interest-rate exposure. Moreover, we continue to prefer EM hard currency sovereign bonds (in USD) to low-yielding government bonds in development markets such as the euro area and the UK. This is because we think EM sovereign bonds offer attractive carry over their European counterparts.

What we’re watching
The first thing we’re watching is the macro fundamentals. Although the US economy hasn’t fallen into the ‘true’ definition of recession, more rate hikes perhaps imply a slightly higher probability of (a shallow) one within 12 months. Gas shortages will likely trigger a contraction in Europe, as implied by forward-looking indicators. The UK will likely follow Europe into recession, triggered by a mix of inflation, energy squeeze and rate hikes. Economic data from China has been disappointing recently and further stimulus is probably on the way.

Secondly, we’re watching interest rates. Central banks are prioritising fighting inflation over supporting growth. The European Central Bank is likely to continue increasing rates, but may pause next year if recession takes hold as we expect. The pace of hikes by the US Federal Reserve will probably slow over the next few months, though balance-sheet retrenchment is accelerating. China’s rate cuts aren’t helping much right now, but they should filter through once the economy reopens and demand rebounds.

Finally, geopolitics continues to add to uncertainty. We’re cautious on any potential ceasefire between Russia and Ukraine, with the conflict remaining unpredictable. The latest news suggests quite the opposite, with yet another escalation by Russia. That said, markets haven’t overreacted and at this juncture it looks more like a volatility spike than an enduring repricing of risks. Russian gas exports to Europe have nearly stopped, and we believe the energy squeeze is likely to be greater than expected.

What’s happening
The dataflow is confirming our expectations of recession in the euro area and the UK. Record-high energy prices are likely to squeeze spending for both consumers and businesses. Gas flows from Russia to Europe through the Nord Stream 1 pipeline have come to a halt. The US is more resilient, with pockets of weakness mainly linked to the ongoing increase in interest rates but also to the global slowdown. China faces further domestic challenges with more local lockdowns.

Inflation remains a dominant issue. In the US it appears to have peaked, but at a high level, and it’s unlikely to be a straight line down. Job market pressures may start to slow as the participation rate rises and wage growth stabilises, but housing costs and services inflation remain strong. Inflation isn’t yet peaking in the euro area and the UK although energy price caps are likely to help.

Stock market volatility was unusually subdued before the pandemic. Low inflation and interest rates coincided with the post-Global Financial Crisis recovery supporting economic and earnings growth. Over the past two years, volatility has increased to levels we consider ‘medium’ on average. However, they mask sudden and sharp volatility spikes, which have mostly been triggered in 2022 by unexpected geopolitical events. They also highlight the market’s fears that central banks will withdraw their support hard and fast – a support that has tended to suppress volatility previously.

The first signs of autumn are already in the air and the temperature feels even cooler than usual on the back of a record-breaking hot summer. Central banks have been working hard to take some of the heat out of the economy too this year as they seek to tame inflation, which has been quite high for a long time now. A series of interest rate rises appears to be having the intended effect, with US inflation looking like it has probably peaked.

Financial markets have been reacting positively to any data that suggests the economy is cooling. For the moment, bad news is good news. Investors are forward-looking and they are already thinking ahead. Of course, these trends are at an early stage and, given high volatility, we think it’s not yet the time to take directional views. While the rate hiking cycle has so far been fast, a slowing economy means central banks should be able to stop hiking rates at relatively low levels.

In the near term, a catalyst we’re watching is if central banks at least slow the pace of hiking. We’re not there yet and there are likely to be some bumps along the way – just as when the seasons change. This time, though, may be approaching. The right framework, at this stage, is to seek opportunities within asset classes rather than across them. For example, reducing exposure to euro area equites versus the US as the outlook in the former looks worse than in the latter.

The economy is already slowing as central banks tighten monetary policy to tame inflation, and long-term bond yields may have already peaked or be close to peaking. Here’s why this matters for the investment landscape.

Fighting inflation

COUNTERPOINT
OCTOBER 2022