As we wrote last month, the economic outlook has materially darkened. Slowing growth and rising inflation are magnified by the war in Ukraine and lockdowns in China, while Western central banks are radically tightening. This is not business as usual for markets, for at least two reasons.
First, high inflation was virtually out of the equation for 4 decades – an entire investment professional career. It matters: when markets are concerned by both inflation and growth, the so-called stagflation risk, it affects both fixed income and stocks, annihilating their diversification benefits. Interest rates are higher, pressuring bonds and lowering equity multiples, while earnings are at risk.
Second reason: we are historically used to seeing central banks cutting rates quickly and aggressively to fix a growth issue, but to be careful and slow when they raise. Procyclical, and asymmetric.
Today, it’s the opposite: the pace of hikes is ballistic, and instead of fixing a growth concern, since their focus is inflation, they now play against growth. Their worst nightmare is not a slowdown, but a wage-price spiral.
Stock markets took note since our last column a month ago, losing -10 percent in developed markets and -6 percent in emerging ones. So far in 2022, both are down -17 percent. Bonds are of course no shelter this year, even if their recent behavior is ambiguous, between their sensitivity to inflation and their safe haven status.
Still, there has been nowhere to hide: global REITS are sharply down, gold, which was the last standing 2022 winner is now negative year-to-date, and it’s a bloodbath for crypto assets.
So, let’s look at the current concerns and share our views on their consequences for markets, through three questions.
Is inflation here to stay?
The word “transitory” has become taboo in the last months. Still, some of the drivers of the current price pressures should moderate naturally: energy prices should stabilise, base effects will normalise, and at some point China will control its Omicron outbreak. The war in Ukraine and lockdowns in China were indeed not expected, and they materially worsened the situation.
Still, inflation on goods shows signs of rolling-over and we believe it’s the trend ahead. There are however two caveats. First, the timing is unknown, and a clear inflexion is needed for central banks to pause. While inflation is primarily about energy and commodities in many parts of the world, there are also endogenous factors, crucially in the US. The job market is buoyant, pushing wages higher, with more than 5 million open positions struggling to be filled.
Second, on the longer-term, between shrinking globalisation and stalling productivity gains, inflation in the years ahead should be higher than in the previous decade – maybe 2.5 to 3.5 percent instead of the 1 to 2 percent we’re used to. This doesn’t sound unmanageable, and there is a possibility that central banks move their own target away from the previously inflexible 2 percent mark, but that’s another unknown in timing and monetary strategy to which markets should adapt.
Is the growth scare justified?
The short answer is yes. High inflation is evil for central banks, at the core of their mandate. Since they can’t control supply (disruptions on energy, food, factories in China…), they have to pressure demand. They want growth to slow, by reducing the velocity of money, raising borrowing costs and even temper the “excess” wealth from the previous stimulus. They have no issue with lower asset prices, slightly higher unemployment and even a mild recession.
The Bank of England was transparent enough to say it candidly. In the US, the coming quarters will also see a fiscal drag and potential risks on the currently hot housing market, between higher mortgage rates and a rebalancing of supply-demand. In Europe, high energy prices will take a toll, and in Asia, Chinese lockdowns hurt. A recession is not our central scenario, but the risk is material.
What are the investment perspectives?
Our single most important conviction is that volatility should remain extreme in the short-term, for all the reasons described above. It’s a change of paradigm, with many unknowns, in the relation between markets and central banks– and we didn’t even mention the runoff of their balance sheets.
There are also tail risks, with a low probability but a potentially devastating impact – from geopolitics to Covid. We thus expect sudden corrections and rallies to be the norm until we have better visibility on inflation. It leads to two simple pieces of advice. First, avoid short-term speculation in erratic markets. Second, be very careful with leverage, which can tie your hands at the worst possible time.
On the medium-term however, the picture is much more constructive. First, the backdrop remains reasonably benign, even assuming a mild recession. After all, it historically happens every 6 or 7 years; it resets the cycle and triggers different policy responses, it’s not a catastrophe. Second, valuations are much more accessible.
Interest rates are not crazily low anymore, and the current levels may mean real positive yields once inflation normalises. Equity valuations are much more reasonable, arguably taking into account at least partially a recession risk, which is good news. Finally, sentiment and positioning are in very pessimistic territory. Not in full panic, but it also supports returns for the medium term.
Finally, we will potentially have to adapt to a higher inflation regime over the longer-term. The good economic news is that inflation erodes debt, the bad investment news is that real positive returns are harder to achieve. Income may become more important, and we will have to be creative in terms of both diversification sources and portfolio construction.
Maurice Gravier, chief investment officer at Emirates NBD.
Follow us on
