5 min read 6 Sep 22
It has been a challenging year for markets so far, and the recent “summer lull” rebound in equity and credit markets is raising more questions than answers for investors positioning their portfolios ahead of the end of 2022.
The macroeconomic picture remains extremely complex, with elements of the pandemic still unwinding while new trends are emerging in different parts of the world.
Inflation pressure remains elevated and although peak inflation might be behind us, as supply chain bottlenecks continue to improve, the cost of energy continues to be highly volatile, while food, housing and labour costs remain high. As such, central banks are continuing to focus on fighting inflation (where possible) with an aim of keeping inflation expectations anchored.
It is difficult to say if high inflation levels and higher interest rates are already having an impact on economic activity and to what extent. Earnings have remained resilient but the growth outlook is starting to deteriorate. Weak US GDP data has been influenced by various factors (including inventories and balance sheet directional shifts), but leading indicators are now starting to turn more negative across geographies (ISM, PMIs, FED leading data etc).
Source: Bloomberg 31 August 2022.
At the same time, the labour market in the US in particular remains tight, with payroll numbers and initial jobless claims still indicating a very robust trend (while the participation rate is surprisingly still below pre-pandemic levels).
It is not our role to try and forecast what the next set of economic data looks like, but to merely observe the evolution of these fundamentals and try to interpret how market players are responding to it with an aim to identify potential investment opportunities.
Since the start of the year, equities and fixed income markets have reacted to a very complex fundamental environment by losing significant value and “derating”, despite relatively resilient corporate earnings. As a consequence, equities and corporate bond markets offer better value today than they did at the start of the year (even after the recent rebound). However, that might still not be enough to compensate investors for the risk of an imminent recession. Moreover, should interest rates continue to rise in the fight against inflation, valuation multiples might continue to suffer versus cash.
Source: Bloomberg 30 August 2022.
Another important observation is that since the start of the year, we have seen a high level of correlation across asset classes, providing limited opportunity for diversification for multi asset investors (other than holding cash). With interest rates likely to rise until the end of the year, positive correlations across assets might continue to exist. However, should economic conditions start to deteriorate faster and the outlook for rates change, sovereign bonds might provide a much needed element of diversification for multi asset portfolios in a risk-off environment.
Finally, the “summer lull” has brought with it a decent rebound in prices across equities and credit markets, reversing some of the trends we saw in the first half of the year. What might be useful to understand is if this represents a real shift in investor sentiment, or simply a readjustment following June’s price capitulation.
Trying to understand the sentiment behind some of the recent price moves might help us in identifying investment opportunities for the coming months.
Overall, sentiment remains very bearish with Bloomberg Economics forecasting a 50% of recession in the next 12 months in the US.
Source: Bloomberg 31 August 2022.
However, investors’ pessimism eased from the peak of June, especially since rate hikes continued and inflation accelerated. However, news flow has continued to be quite negative, particularly following new data releases, with many market players providing gloomy outlooks about the coming months, often contrasting with the buoyant markets seen in July and early August. Reduced flows have often been cited as a factor in the recent market recovery (but evidence is somewhat lacking).
Despite the recent market repricing and latest US inflation print potentially providing some respite to market participants, it is difficult to detect much optimism amongst investors in relation to what lays ahead. However, investors seem more focused on inflation and interest rates than they are on growth (perhaps due to short time horizons and a focus on the “here and now”).
Sustainability, in all its forms, continues to be an undercurrent trend which, we believe, will continue to shape our economies and societies for years to come; from social reforms to an increased role of public spending, to stronger attention to biodiversity and ecosystems protection.
The latest piece of regulation in this sense is the “Inflation reduction Act”, which came into law in the US on August 16th. The bill aims to support the transition to a low carbon economy by offering businesses incentives and tax credits for various energy transition related investments including EV, solar panels and energy efficiency improvements.
Other than being partly funded by a 15% corporate minimum tax, the bill is fully focused on incentive structures rather than disincentives. This is a significant shift from previous (often not very effective) pieces of regulation.
The name of the bill is an interesting one and somehow defiant of the "greenflation” belief. Although incentives would likely create additional demand for low carbon technology (and the relative raw materials needed) which will potentially push prices higher in the short term, the longer term outcome of an economy becoming less reliant on the variability of oil and gas prices might lead to a more stable and lower inflation picture. In this sense, the transition to a lower carbon economy which relies much more heavily on a mix of wind, solar, geothermal, nuclear and hydrogen energy might be a useful tool to fight long term inflation.
There has been nowhere to hide for long only multi asset portfolios this year. However, there have been opportunities for tactical scaling both in fixed income and equities. Also, higher levels of cash have provided some benefits during correlated market sell offs.
As we look at how to best position our multi asset portfolios to navigate the end of 2022, we feel that for the first time in a long time, a neutral position in equities is warranted. Within equities we continue to favour cheaper markets, like Europe, Japan and global financials. Our sustainable strategies continue to see opportunities in some selected US tech names and exposure to renewable energy.
Fundamentals are challenging, valuation signals are more muted after the summer rebound and investors are still bearish (but in a less extreme fashion than earlier this year). Our portfolios are ready to benefit from potential macroeconomic improvements (lower inflation and stable growth) and less bearish investor sentiment, while at the same time, being relatively resilient to a possible further deterioration in fundamentals (slower and deteriorating growth and stable or falling rates). In the meantime, we remain ready to deploy spare cash to capture any tactical opportunity the market might provide us with.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.