The first half of 2022 has simply been one of the worst in the history of markets. Today we’ll look back at what happened, and of course share our perspective for what’s next.
Back in January, our 2022 Global Investment Outlook was titled Low Visibility Ahead. Between high inflation, slowing growth, and the beginning of the end of magic money, we had more questions than answers for the year ahead. We were, however, not outright bearish, as we thought that the recovery still had legs, and that inflation was about to start normalising.
Bottom line, our key message was to expect volatility and to be more reactive than proactive.
A lot happened. The conflict in Ukraine: it amplifies inflation, especially through commodities, and it darkens the outlook for growth with the double-edged sword of sanctions for Russia.
If that wasn’t enough, China went through a severe Covid outbreak and an even more severe response, which added pressure on global supply chains. The result: Inflation hasn’t normalised, forcing central banks to go ballistic in fighting it at all costs.
It’s important to point out – with no inflation for decades, central banks used to be markets’ best friends, supporting growth and financial stability. Things have changed. The battle against inflation is their existential mission, while the others have become secondary. The Fed chairman said it is “unconditional” and the BOE governor said there are “no ifs and buts”.
Price pressure is about high demand meeting constrained supply. Central banks can’t influence supply: Their only tool is to make money more expensive to slow down activity and pressure demand. They have now raised rates at the steepest pace in recent history and withdrawn liquidity.
Whatever it takes? Or whatever it breaks?
This is a terrible combination for investors. Inflation and higher interest rates directly affect bonds and pressure equity valuation multiples. Meanwhile, growth scare questions the trajectory of corporate earnings and the solvency of issuers. There is nowhere to hide: 2022 so far is a crash of everything, with every single segment of both fixed income and equity down between -15 percent to -20 percent.
So what’s next: Stagflation?
Indeed, the June consumer price index in the US came out at an eye watering +9.1 percent year-on-year, an acceleration from May and a higher number than forecast. It means that the Fed could hike by more than 75 basis points later in July, which in turn will threaten growth further. To that extent, the IMF cut its 2022 real GDP growth forecast for the US from 2.9 percent to 2.3 percent, and expects only 1 percent next year. The European Commission did the same, trimming their projections to 2.6 percent this year and 1.4 percent in 2023.
Are we about to hit the wall of stagflation?
We don’t think so. These institutions are not known for their blissful optimism, and it’s worth noting that their revised growth numbers remain positive. So far, the global economy has been very resilient, with record low levels of unemployment in particular.
Of course, a recession is possible, especially in Europe, but we firmly believe that our inflation problem would also vanish under this scenario. And policy responses would dramatically change, especially given the stellar levels of debt in the system – not to mention political turbulence.
Crucially, lower valuations on all asset classes now discount a substantial economic risk – which could materialise, or not.
Investor sentiments follow suit with record levels of pessimism: markets are not ready for good news, and it is interesting to see that after risk assets initially dropped when the US CPI came out, most recovered to close only slightly lower.
You have guessed it: we believe that the medium-term outlook is not adverse. Between base effects and central banks’ actions, inflation should start to normalise, but not to the 2 percent we were used to. Current levels are probably at their peak, which should halve at some point. That should be enough to justify a pause in tightening and providing relief to markets. The question is probably not if, but when.
Since the timing is the key unknown, we have two messages for the near future. First, volatility should remain extreme in the coming months – until we see the only true catalyst for sustainable market recovery, which is, again, convincing evidence that inflation is abating. We expect sudden and unpredictable corrections and rallies, which means that short-term speculation and leverage are dangerous games.
Second, the medium-term perspectives are reasonably constructive, as risks are adequately priced-in and sentiment is very pessimistic. We may be wrong of course, but we are prepared to increase exposure, should another severe correction happen.
This is the positioning we currently recommend in our tactical asset allocation. Cash doesn’t compensate for inflation, but it absorbs shocks and provides flexibility; we are close to neutrality. We are still underweighting fixed income, especially on its riskiest segments: Some spreads are a bit complacent with the economic risk. By contrast, government bonds are becoming more compelling: we have cut our underweight and recommend being opportunistic when rates overshoot.
Within equities, we are neutral on developed markets but overweight on emerging ones – China has a very different dynamic as we discussed last month in this column. We also keep on favouring UAE stocks and find opportunities in India. Finally, we overweight alternatives due to their very different sensitivities to both inflation and growth.