Panorama - June 2022 -
Are there any reasons to hope in these pessimistic times?
Head of Investment Strategies
Deputy Chief Executive Officer, Chief Investment Officer
The situation in the first half of this year has been very complicated indeed, with high inflation, rising interest rates, a very tense geopolitical climate, and serious risks of an economic slowdown.
These conditions are of course reflected in the financial returns being delivered by the main asset classes, which have been negative year-to-date.
So there is a great deal of pessimism and it is widespread, which also means that a lot of the bad news has already been priced in.
What reasons are there to be hopeful?
Context and analysis
Overall returns are in deeply negative territory so far in 2022 and a reflection of today’s jittery circumstances which, in some respects, are even shakier than at the peak of the Covid-19 crisis. The possibility of armed conflict between the world’s great powers is no longer completely far-fetched: the situation in Ukraine could last and in fact deteriorate, relations between China and the USA remain tense, and there is a latent risk that the tension surrounding Taiwan might escalate. In addition, inflation has reached unprecedented levels not seen for more than 40 years in the USA and Europe, to the extent that the ultra-accommodative monetary and fiscal policies that have spurred economic and market activity are naturally being wound down; the credibility of the central banks is at stake here. The Fed has explained on several occasions that it will stick with its current policy until inflation has peaked. But intervention by the central banks is rendered more complicated by the fact that monetary policies are being tightened at a time when economies are showing signs of weakness.
Indeed, the market’s attention has now turned to the risk of an economic slowdown. This raises another concern as the economy had until now been recovering quite strongly thanks to an almost global post-Covid reopening, with the notable exception of China. So although growth has proved quite resilient so far, there are threats hanging over it for the second half of this year: consumer spending will be affected by rising food and energy prices, and the wealth effect will diminish as asset values (financial assets and even real estate assets) fall in a number of countries. There is therefore also a risk that this outlook will lead to a drop in corporate investment, especially as margins will be squeezed by rising wages and commodity prices.
Global economic growth has been revised downwards from 4.4% at the start of the year to 3.5% at present according to the Bloomberg consensus, but downside risks have worsened. The USA looks most resilient even though it disappointed in the first quarter, with GDP contracting by -1.4% on an annualised basis versus an expected +1.0%, and forward-looking indicators have been trending downwards for the past two months. The job market remains firm, with the jobless rate holding steady at 3.6% in April. US growth is ultimately expected to reach about 3.0% this year. The euro zone seems more fragile as it is closer to the ongoing war in Ukraine and more dependent on energy supplies from the region. The services sector remains robust post-Covid, but there is a risk that consumer spending will be penalised by higher prices while wages are increasing only slowly. The industrial sector is already showing signs of weakness, with the manufacturing PMI (index measuring the business activity of Purchasing Managers in the industrial sector) having lost ground. Growth in the euro zone is expected to reach 2.8%, but its momentum seems under threat. Elsewhere in the world, the market is paying most attention to the situation in China. China is pursuing its zero-Covid policy, which does not seem compatible with the 5.0%/5.5% growth target range it issued back in February. This already looked ambitious following the wave of regulations introduced in 2021, which have taken a heavy toll on the real estate sector (accounting for close to 30% of the economy). So the decision to enforce lockdowns in several of the country’s large cities has made things worse. But the big issues in China at present are political in nature ahead of the 20th Congress of the Communist Party, at which President Xi Jinping intends to be appointed “for life”. And he currently does not appear to enjoy unanimous support. We are beginning to hear murmurs of dissent in the upper echelons of the country’s government, which is rare indeed. Prime Minister Li Keqiang has expressed some concerns about economic growth. But President Xi Jinping is unable to loosen his public health policy as this would rapidly trigger over a million deaths since only a small share of the elderly population has been vaccinated. Such a scenario would be inconceivable in the current political climate and with the prospect of a new co-option. The most likely scenario, therefore, is that the current zero-Covid strategy will be continued, followed by a massive stimulus plan once the Omicron wave has passed. The country has the resources for this and a ready-made strategy. Economic growth is therefore unlikely to meet the official target this year, but ultimately it will not be much lower. China’s equity markets seem to have settled in recent weeks and appear to have factored in such a scenario.
Global growth forecasts for 2023 are still rather upbeat at 3.4%, but they do not seem all that reliable considering the risks hanging over them at the moment.
Despite the rather worrying situation overall, we nevertheless believe there are at least two possible reasons to be hopeful:
- Monetary tightening in the USA might not go as far as initially intended. The inflation peak question is a crucial one and has guided the Federal Reserve’s movements in recent months after it was accused of ignoring the issue and of being “overtaken by events”. So Fed Funds rates are rising at a rather aggressive pace and the markets expect them to reach about 3% by mid-2023. It is still too soon to say whether inflation is close to peaking, but long-term inflation expectations have calmed down and are now settling at just under 3%. Although they are stabilising, the Federal Reserve could slightly soften its objective and instead refocus on the problem of growth. So the uptrend in bond yields, which has pushed asset prices downwards since the start of the year, should ease or even fall back slightly. In this case the US 10-year yield could settle in the region of 2.50%/3.00%. It will therefore be interesting to see what comes out of the Jackson Hole meeting of central bankers to be held in late August. Changes to monetary policy are often announced following such events…
- Valuations across the world’s equity markets have tumbled. Earnings growth forecasts are still quite solid despite the uncertainty hanging over economic growth. They have not been revised downwards and lie within the 8%-10% range in the USA and euro zone alike. So far companies appear to have seen no reason to reconsider their rather upbeat guidance targets or their investment plans. There are two possible reasons for this, as we have already mentioned on previous occasions: either analysts began the year underestimating the capacity of companies to generate earnings and have therefore not had to revise their forecasts downwards, despite the risks that have arisen in the meantime; or we will begin to see downward revisions in the weeks ahead…
But even if this is the case, the equity markets do not look all that overpriced: European stocks are trading on a 12m fwd PER (Price to Earnings Ratio. A stock market analysis indicator: market capitalisation divided by net income) of around 13 while US stocks on the S&P 500 index are trading on less than 18. The 12m fwd PER of Chinese stocks has also dropped sharply to about 10. The valuations of big growth stocks have fallen particularly steeply, and some of them look appealing at current levels. If we factor in the rather generous dividends (certain bank and oil stocks offer divided yields of 7% to 10%), equity valuations as a whole are starting to look reasonable again, even in today’s nervous and highly uncertain conditions which could keep volatility very high.
In short, it is difficult in today’s troubled times to adopt aggressive investment strategies and equally difficult to make predictions. However, the upward trend in bond yields (especially in the USA) might possibly be almost over. In addition, equity valuations have plummeted and investment opportunities could emerge on the highly likely assumption that the markets will remain volatile in today’s very gloomy world.
The drive to tackle inflation: the ECB is back in the game
Last month we talked about the ECB’s cautious stance (compared to the Fed) when discussing its anti-inflation efforts, which had pushed 10-year inflation expectations up to a historical high of 3.00%. Given the surging inflation figures coming out of Europe, the ECB has since changed tack significantly and adopted a more hawkish tone. A first interest rate hike is now definitely on the cards for July and there are plans for at least another two increases between now and the end of the year. The effects were almost immediate, as was the case with the US yield curve. Although nominal interest rates did not react all that much (with the German 10-year yield still a shade above 1.00%), 10-year inflation expectations have fallen back sharply to 2.25%.
This change in narrative was important in preventing an upward spiral in interest rates. This is because, all else being equal, actual inflation in Europe is not expected to peak until the end of Q3 or even in Q4. So it was crucial for the ECB to regain its credibility and not be seen to be too “behind the curve” as this would have risked harming economic growth that little bit more, which would have been the case anyway if interest rates had spiralled too much out of control. However, we expect German bond yields to ease off a little bit more (provided inflation does not peak) to around 1.50% before stabilising or even falling back once concerns about economic growth overtake concerns about inflation.
Over in the USA, having clearly stated its position on tackling inflation and thus brought inflation expectations under control as reflected in the yield curve, the Fed is opening up a new door (via the minutes it published recently). Protecting growth is now once again among its priorities, thereby reassuring the markets that it will not tighten monetary policy to excess and triggering a fallback in the 10-year yield to 2.80%, which is the Fed’s new terminal rate target. It should be mentioned that the Fed is likely to benefit from the fact that US interest rates appear to be at the peak level of actual inflation and should gradually decline over the coming months, thus easing the pressure currently hanging over the central bank. In the meantime, US bond yields should settle at around 3.00%.
Credit spreads (Credit spreads representing the yield differential of a private corporate bond with that of a sovereign bond) remain highly volatile but the margins achieved on carry strategies still seem attractive in both the Investment Grade segment and High Yield segment.
Still a great deal of resilience
The equity markets are proving surprisingly resilient given the circumstances. Although the Nasdaq shed more than 30% after peaking in December - before then picking up again - and the US markets in general are still down by about -12%, Europe’s markets as a whole are down by -10%. The top prize goes to our national index, which has lost only 7% over the first five months of this year (including divided payments).
But is this really all that surprising? The answer is both yes and no. Admittedly, inflation indices continue to suggest that inflation is not as temporary as initially thought, global economic growth forecasts are continually being revised downwards (the latest projections put it at just above 3%), and there are absolutely no indications of the current geopolitical risk fading, which means that commodity prices remain very stretched indeed. But there is nevertheless a whole range of arguments pointing in favour of the equity markets.
First of all, the quarterly earnings reports published and guidance targets issued by company bosses have been excellent and prompted analysts to revise their earnings forecasts for this year but also for next year, despite a risk of margin contraction that we cannot rule out. Secondly, if we assume that 10-year yields are close to peaking, there is no longer any reason to expect market capitalisation multiples to decline. Furthermore, the combination of falling share prices and upward earnings revisions has dragged PERs down below their historical averages, especially in Europe. Last of all, investor sentiment in the stock market is in steeply negative territory, which means that investors are not overinvested in this asset class. Having taken on board these various positive and negative arguments, we have opted to maintain a neutral rating on equities as we believe that market movements will remain within variations of no more than 10%. But this should not prevent investors from taking advantage of the prevailing volatility and remaining active within these boundaries.
Breaking our analysis down by sector, we would point out that for a long time we preferred cyclical stocks because we were concerned about rising interest rates, but we have now adopted a more balanced view as growth stocks are expected to benefit from a calmer situation on the bond markets.
And breaking our analysis down by region, we would say that the US markets remain something of a safe haven during periods of uncertainty and benefit from the prevalence of high-potential tech stocks, but valuations in Europe’s markets are lower and so we would not underweight euro zone stocks.
Our central scenario
Central banks on both sides of the Atlantic are now openly on a mission to tackle inflation, and the markets seem to find them convincing since longterm inflation expectations have fallen back. The potential consequences for growth could even hold the Fed back from completing its monetary tightening cycle. In these circumstances, interest rates in the USA should stabilise at their current levels (unless energy prices spiral out of control again). In Europe, inflation is not expected to peak until the fourth quarter, so volatility is likely to remain quite high and interest rates should edge up again a little before stabilising. The credit markets have priced in much of the bad news and still look attractive to us at their current levels.
Equity valuations have fallen sharply but we would not overweight equities for the time being as there is little short-term visibility, especially as regards an economic slowdown. However, with no obvious trend in sight, investors could take advantage of the likely bout of volatility over the coming weeks to take up contrarian positions on the upside as well as on the downside.
Document completed on 02/06/2022
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com