The summer started on a positive note for financial markets: some signs of moderation in US inflation and overall strong Q2 corporate earnings came out at a time when markets were not expecting any good news.
It was a summer rally in both stocks and bonds, but it didn’t last.
At the end of August, Fed chairman Powell delivered an unambiguous message: the fight against inflation is the absolute priority, it will mean pain for the economy, and hopes for an imminent pause in monetary tightening are delusional.
So, we’re back in FUD (Fear, Uncertainty, and Doubt) with reasons to be concerned for all asset classes: safe bonds suffer from higher inflation and rates, while risk assets are affected by a darkened outlook for growth, pressuring future earnings and solvency.
Gold is no shelter despite inflation and a war. Even oil prices took a hit, as concerns over demand seem to outweigh supply constraints for the time being.
When it comes to investments, it becomes difficult, unpopular and nonconsensual to have even a mildly optimistic view. Yet, our own analysis of the situation gives us reasons to be less pessimistic than most when it comes to the medium-term investment perspectives.
A major crash is certainly not impossible, but we see a stronger probability for a combination of high volatility and low returns for the medium-term. Here is why.
Nuances of inflation and growth
Importantly, there are material regional divergences which are worth highlighting. Let’s start with the worst: the energy crisis in Europe is both the main inflation driver and a headwind on growth.
While central banks have no choice but raising rates, to avoid importing inflation through weaker currencies typically, this won’t solve the essence of the problem -energy- while pressuring activity further. It’s, sadly, a terrible situation and a recession seems probable, without gas from Russia.
Social unrest could be significant with a material squeeze in purchasing power – governments will help, but at the cost of more and costlier debt.
The US is different: inflation there has more to see with rising prices in services, due to high demand, and rising wages as the job market keeps on booming. The Fed tightening will have an impact.
US inflation may already have turned the corner, between lower gasoline prices, less demand for goods, a strong dollar and rising labor participation. It is however too slow, and employment is too strong, to change the Fed’s stance anytime soon.
Still, the US economy has proven resilient and a “soft-landing”, where growth would slow down below trend but avoid a deep contraction, doesn’t look impossible to us (unpopular opinion).
Needless to say that this would be good news for the world.
In China, concerns are less about inflation and more on activity, due to Covid situation, a troubled real estate market, and slowing global economy.
All numbers indicate loss of momentum, but the government has started to provide support, and it shouldn’t slow once President Xi’s leadership is confirmed later this year.
Finally, Japan remains an exception with accommodative monetary policy and so far modest inflation pressure.
What could go wrong?
There are two nightmare scenarios. The first one is geopolitical: further escalation in Ukraine, and more heat in Taiwan at the same time.
The second one is about inflation spiraling out of control, which could push the world into a prolonged period of economic trouble.
None of them are a central scenario, but their probability is not neglectable: markets will remain nervous.
Behavioral factors are by the way the only bright spot: the levels of pessimism are at record highs for months.
Investment implications
First and foremost, volatility, our key call for 2022, will remain extreme. Hopefully both ways. Second, we try to find an optimal positioning between valuation on one hand, and the growth/inflation risks on the other.
It’s not simple – our active bets are modestly sized, because we can’t find a “no-brainer” opportunity. Still, we underweight the riskiest segments of fixed income, as their spreads look a bit complacent with the current backdrop.
In a scenario of moderating inflation, safe bonds in the 3-5 years duration are interesting, we are neutral. By contrast, we are modestly overweight in stocks from emerging markets, especially India and the UAE, where growth is strong.
We are neutral on developed markets, where we favor the US. Valuations are not cheap, but we don’t believe that earnings will collapse – equities are a nominal asset class which many tend to forget.
Flexibility matters a lot in times of volatility: leverage is perilous, and if cash doesn’t compensate for the current inflation, at least it yields something and most importantly provides the ability to buy risk assets on material weakness.
Apart from the well diversified portfolios we maintain and recommend, in which we hold significant amounts of cash (up to 15 percent in a conservative profile), a simple but effective approach would be to hold cash and buy risk assets each time volatility spikes, to enhance the long-term expectable returns.
In the meantime, there’s only one true catalyst: abating inflation which would trigger a pivot from Western central banks, which is, we believe, the story of 2023.
In the meantime, we are less pessimistic than most, as we don’t see most valuations as outrageous while sentiment and positioning are very low.
The worst is always possible, but never certain.
Maurice Gravier, chief investment officer at Emirates NBD.
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