Navigating uncertainty as recession pressure builds

UK inflation eased slightly to 9.9% in September¹, still remaining close to a 40-year high. Yet the slight drop in inflation is unlikely to offer any respite to thousands of households across the country, especially as winter arrives and the cost of living crisis bites. It also presents an ongoing challenge for investors seeking to navigate the uncertainty.

Energy prices have seen record rises and food prices continue to soar, exacerbated by supply chain issues and unusual weather conditions. Meanwhile, reduced gas supplies from Russia are fuelling the ongoing energy crisis across Europe.

“There are many inputs at the moment that are coming from different directions and influencing markets, both fixed income and equities.”

“There are many inputs at the moment that are coming from different directions and influencing markets, both fixed income and equities,” says Fabiana Fedeli, Chief Investment Officer for Equities and Multi Asset at M&G Investments.

“Because there are a lot of uncertainties on how many of these elements will eventually conclude, we believe this is not a market for broad macro calls. Right now, big sweeping bets are extremely risky. [When looking at the market] we're being tactical and very selective.”

A volatile landscape

Many companies can get caught up in the indiscriminate market volatility, and experience price action that is not necessarily warranted. The good news is that the market volatility is providing some significant idiosyncratic opportunities where price dislocation is evident.

According to Fedeli, there are attractive opportunities where we’ve witnessed market drops and names with strong fundamental outlooks have been unduly affected by the price action, particularly in areas such as technology, but selectivity remains key.

In terms of regional opportunities, Fedeli notes the value opportunity in the UK market. “We do like some of the largest names in the FTSE 100, but we are very cautious about the overall macro backdrop in the UK,” she says, particularly “the potential for a rise in debt levels, and the fact there is a significant portion of the UK overall government debt which is linked to inflation and affected by inflationary pressure.”

However, around 75% of FTSE 100 company revenues are in currencies other than the British pound. Despite the uncertainty, this means companies can benefit from sterling weakness, which provides a boost to translated revenues. At the same time, FTSE 100 valuations are currently trading at a multi-decade lows.

Inflationary impact

Central banks across the globe are hiking interest rates in an attempt to tackle persistently-high inflation. Most recently, we’ve seen both the US Federal Reserve and European Central Bank implement 75 basis point rate hikes, while the Bank of England currently has the base rate at 2.25%². However, the World Bank has warned that rising interest rates could trigger a global recession in 2023³. Despite the risks to growth, it seems central banks remain committed to taming inflation.

After a period of dislocation over the summer months between market expectations and central bank actions, investors are now trying to ascertain whether asset prices are effectively reflecting a tighter pace of monetary tightening, or whether further falls could yet be seen.

“That is a key question,” says Fedeli. “On the fixed income side, we’re seeing some weakness at the shorter end of the curve, driven by rate hikes, while there’s been more stability at the longer end of the curve, particularly in the US. We're quite cautious, in general, though – also on corporate bonds, although we do admit that valuations have improved and there are opportunities there.”

“When it comes to the equity market, we're going to be in a market that is very much driven by news flow. We do feel that in the end, the appropriate valuation of the market will probably be closer to the lows that we witnessed in June. That boundary, those June lows, really, would reflect a mild recession, a slowdown in the global economy, which obviously will be different according to regions.”

“Notably though, we don’t expect a credit crisis scenario, which would put additional downward pressure on share prices and we could, obviously, see more stress in corporate bond markets.”

The caveat

Fedeli notes: “On the other hand, there's always a possibility that the war in Ukraine comes to a conclusion. The key there is not a conclusion of the war, per se, but a conclusion that would allow the removal of those sanctions on hydrocarbons.” This would potentially be a strong boost for markets, but it is difficult to foresee this outcome happening any time soon, or in a clear fashion whereby sanctions would be removed, while a U-turn from central banks is not likely in the near term.

Looking ahead, as multiple factors continue to weigh on the investment landscape and uncertainty persists, a key question is how to invest in a market such as this.

Fedeli points out the impact of inflation on nominal returns, and that if equity markets risk delivering negative real returns. “We need to make our capital work,” she says.

“Just sitting in a market that is down anywhere between 20% and 25% [hoping for a bounce], is probably not going to deliver an inflation-beating return, but for an active investor taking advantage of some of the volatility and the dislocation in the market, I think there is actually a lot of opportunity to make a good return.”

¹ Office for National Statistics, “Inflation and Price Indices”, (ons.gov.uk), 14 September 2022.
² Bank of England, “Official Bank Rate history”, (bankofengland.co.uk).
³ World Bank Group, “Is a Global Recession Imminent?”, (worldbank.org), 15 September 2022.

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.