Investment Outlook August 2022

To chase or not to chase the rally? Is the market turning around or are we witnessing a bear market rally?

Despite the current market optimism that the FED could shift to a more dowish strategy, we believe it cannot affort to – and will not – pivot for now. We are therefore hesitant to declare the end to the bear market.

A simple rollover in inflation that reflects falling commodity and goods prices will not be sufficient for the Fed to make a policy U-turn and cut rates by 50 basis points next year.

Overall, we reiterate what we wrote in our last publications: the macro themes of the Fed tightening amid slowing global growth, the US dollar overshooting, and China’s disappointing recovery remain intact.

These factors still warrant a defensive investment strategy, despite a possible near-term rebound in the S&P 500.

We wish you an engaging and interesting reading time and lots of success with your investments.

Key Takeaways

  • US economic data has continued to deteriorate, with the Leading Economic Indicator pointing to recession. The situation in Europe and China looks even worse.
  • Inflation remains sticky, with US wages now rising strongly. Supply-chain repair will bring core inflation down to 4% – but to get to 2% will require a recession.
  • The market is betting that the Fed will lose its nerve early next year and start cutting rates (see Chart). We think this is unlikely: The Fed won’t want to repeat the mistakes it made in the 1970s.
  • Within equities, we continue to prefer the lower-beta US market, given the greater economic resilience of the US.

Bottom line: Investors should remain defensively positioned on the 12-month investment horizon, stay underweight equities and hold some cash reserves. Government bonds represent a good hedge; inflation-linked ones are also now more attractively valued.

BENDURA market views

 very unattractiveunattractive        neutral               attractive         very attractive    
 
Fixed Income     
  Government     
  Corporate     
  High Yield     
  Emerging Markets     
  Duration     
  Inflation linked     
 
Equities     
  United States     
  Eurozone     
  United Kingdom     
  Switzerland     
  Japan     
  Emerging Markets     
 
Foreign Exchange Rates     
  USD     
  EUR     
  CHF     
  EM Currencies     

Global Economy

PMIs are starting to dip below 50:

The US Leading Economic Indicator (calibrated to forecast GDP) is heading rapidly to below 100, even when one excludes its financial market components, such as stocks:

The US Leading Economic Indicator has fallen for four months in a row, historically a reliable sign of impending recession:

US consumer indicators have been moving in a worrying direction: Respondents to confidence surveys no longer expect their income to increase over the next six months, they see jobs becoming less plentiful, and the ratio of confidence about the present situation to expectations looks to be at a peak:

The US housing market shows further signs of weakness, caused by the 220 BP rise in 30-year fixed-rate mortgages since the start of the year: The NAHB builder confidence index has fallen sharply, and new house supply is the highest since 2010:

And the situation is much worse outside the US. Cyclical surveys in the euro area point to the economy already being in recession, with the manufacturing PMI likely to fall to well below 50 over the coming months:

The situation will be exacerbated if Russia further squeezes natural gas supplies in retaliation for European Union sanctions. Already, the European natgas price has risen by 933% since the start of last year:

If Russia were to completely cut gas supplies to Germany, the Bundesbank estimates that it would reduce output by 6.5% over two years.

In China, the government’s stimulus has been half-hearted, and hampered by the private sector’s reluctance to borrow: The pickup in the credit impulse has been driven mainly by frontloading of local government bond issuance:

The tenacious zero-Covid policy and dysfunction in the property market – and now a likely slowdown in demand for consumer goods in Europe and America – will weigh on growth.

Analysts have finally reacted to the worsening economic situation, and some have started to cut their forecasts. The dispersion of analysts’ forecasts has risen, and net earnings revisions have turned sharply negative:

However, forecasts still look much too optimistic, with analysts looking for 8.6% growth in US EPS and 8.3% in the euro area over the next 12 months. We showed in the last Quarterly, that earnings typically fall by 15-20% peak-to-trough in recessions.

And meanwhile, inflation remains stubbornly high and broad-based. Measures of underlying inflation pressures, such as sticky prices or the trimmed mean, continue to rise:

Wage pressures are strengthening, suggesting a price-wage spiral: The latest reading for the Atlanta Fed Wage Tracker rose to 6.7%:

Over the coming months, repair of the supply chain and a shift of consumer spending to services should slow inflation for manufactured goods. But a good proportion of US inflation is driven by excess demand, and not just supply disruptions:

Our bond strategists argue that, while it will not be difficult to bring core PCE inflation down to 4% (from the current 4.8%), it will require a recession to get it back to the Fed’s target of 2%.

The market consensus is that the Fed and some other central banks will lose their nerve in the fight against inflation as soon as they see the economy clearly slowing, and will cut rates next year:

For the US, at least, we think that is unlikely. Chair Powell has emphasized that the battle against inflation is “unconditional,” meaning the Fed will keep policy tight until inflation is clearly heading back to 2%, even if this means unemployment has to rise. The Fed’s institutional memory is of the 1970s, when then-chairman Arthur Burns cut rates too quickly in 1974 at the first sign of a slowdown, and inflation never fell below 5%. This set the stage for the stagflation of the late 1970s:

Slowing growth, stubbornly high inflation, and hawkish central banks are not a good environment for risk assets.

Equities

US equities have continued to outperform:

Despite the headwinds for the broadly-defined tech sector (which comprises 49% of the US market, compared to 34% in the euro area). The relative robustness of the US economy, lower beta, and likely further appreciation of the USD make the US the safest choice for an overweight in the current risky market environment. We would consider turning positive on other, more cyclical developed markets only when a bottom to the economic slowdown is in sight. Emerging markets continue to be buffeted by the China slowdown, falling commodity prices, and tightening US financial conditions:

Fixed Income

Bond yields will be driven by the “golden rule of bond investing” – whether the Fed surprises hawkishly or dovishly over the next few quarters:

We believe that rate hikes to end-2022 will be in line with what both the Fed projects and the futures markets are pricing.

However, the Fed will continue to hike interest rates until core PCE falls back to its 2% target range, implying that Treasury yields will likely be range bound, supporting our neutral duration stance.

TIPS and other inflation-linked bonds are looking more attractively valued after breakevens fell back recently, following the Fed’s and ECB’s hawkish turns:

This asset class offers a good hedge against the risk that inflation remains stubbornly high.

Credit looks more attractively valued than equities (hence our neutral recommendation on high yield bonds and overweight recommendation on investment grade bonds), with spreads on US HY bonds currently averaging 5%. According to our US bond strategists, this implies that the default rate will rise to between 4.7% and 5.9% during the next 12 months. However, the default rate in recessions has typically peaked at 8-14%, and so further spread widening is possible in the event of even a mild recession.

Currencies

Currencies will continue to be driven by how much central banks raise rates compared to what the market has priced in. While the USD looks massively overvalued (by more than 30% on a trade-weighted basis), the Fed is likely to proceed with – and even exceed – market-expected rate hikes, much more than other central banks, particularly in the euro zone where economic growth is notably weak:

We remain overweight the USD, therefore. The renminbi is likely to weaken further, which will pull down other EM currencies. Although the CNY has fallen a little against the USD, in line with interest-rate differentials:

...it has been strong against other currencies, hurting China’s competitiveness:

Commodities

Our energy strategists remain bullish on oil, expecting Brent to average $110 a barrel in the second half and $117 next year (versus $103 now). Their analysis is based on likely cuts to Russia’s crude output in the face of G7 sanctions and price caps, and the reluctance of Saudi Arabia and the UAE to boost supply. The risk to this forecast is to the downside, however, particularly if EM demand for oil comes in below forecast due to the strong USD and weak growth:

Despite these risks, we keep our overweight on the Energy sector, which has performed a little better than the recent correction in the crude oil price would suggest:

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