Investment Outlook September 2022

Inflation, Stagflation, Recession or a Goldilocks Economy?

Financial markets have been caught in contradictions. The reason is that investors cannot decide if the global economy is heading into a recession with deflationary forces prevailing, or whether a goldilocks economy or a period of inflation or stagflation will emerge in the foreseeable future.

There are also plenty of contradictory data to support all the above scenarios.

As such, financial markets are volatile, swinging wildly as market participants absorb new economic data points.

In the following, we will try to shed light on the economic data and the different asset classes to help you navigate the difficult market environment.

Key Takeaways

  • Markets are still pricing in that the Fed will lose its nerve and cut rates in the first half of next year.
  • The market does not fully appreciate the Fed’s determination to get inflation under control, even at the price of the economy slowing significantly.
  • Inflation will ease somewhat over the coming months, but won’t get close to the Fed’s 2% target for some time.
  • Meanwhile, many indicators are pointing to the US economy heading towards recession, although the timing of recession is uncertain.
  • Conditions in Europe - buffeted by an energy crisis - and China - where half-hearted stimulus is being hampered by troubles in the property market - are even worse.
  • Investors need to be reminded of the old lesson: “Never fight the Fed”.

Bottom line: Heightened uncertainty means this is not an environment in which to be risk-on. We continue to recommend an underweight in equities, defensive sector and country weights within equities, and a high allocation to cash.

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

It’s taking the markets a while to understand there is no longer a “Fed put” – the expectation that every time the economy slows or stocks fall, the Fed will prop things up. Markets are still pricing in – even after Fed Chair Powell’s hawkish speech at Jackson Hole – that the Fed will cut rates in the first half of 2023:

But Powell could not have been clearer: “Reducing inflation is likely to take a sustained period of below-trend growth.…[It] will also bring some pain to households and businesses….We are taking forceful and rapid steps to moderate demand…. We will keep at it until we are confident the job is done.”

Which part of that do markets not get?

The problem for the Fed is that, while inflation is showing signs of softening, it is likely to remain well above the Fed’s 2% target for some time. Prices of consumer durable goods and energy have fallen in the past couple of months, but “sticky inflation”, services prices, and wages continue to rise strongly:

Meanwhile, the economy has not weakened appreciably (yet). Financial conditions have not tightened enough – and have even eased recently:

Unemployment, at 3.5%, is at its lowest rate since 1969. There is some early evidence that layoffs have started:

However, with two job openings for every unemployed person,  those openings will be quickly filled with people laid off, preventing the unemployment rate from rising – i.e., the “Beveridge loop” will move downwards first:

In the meantime, lead indicators are now starting to point to recession over the next 12-18 months. On our recession checklist, we can now tick off three of our six favorite indicators:

Only the Fed policy rate is clearly not signaling recession, since it is still below our estimate of equilibrium – but it will be there or thereabouts early next year if the Fed hikes at its planned pace.

Judging the timing and severity of the next recession is harder. US real GDP growth was negative for two consecutive quarters in Q1 and Q2 – the folk definition of recession. However, the National Bureau of Economic Research (NBER) uses a much broader range of data, including real personal income, nonfarm payrolls, and industrial production. Most of these numbers currently are strong:

Remember though, that these series should peak the quarter before recession begins – and most seem to have just peaked, or are likely to do so over the coming quarter or so. Moreover, while real GDP growth is not a good indicator (in recent quarters it has been distorted by inventories and strong imports), domestic private final demand, historically a reliable guide to future growth, weakened noticeably in Q2:

As an aside, it is worth remembering that inflation is distorting many indicators. We need to get back to the habit of measuring everything – including stock market returns – in real terms. Adjusted for inflation, retail sales and durable goods orders, for example, look nothing like as robust as their headline nominal numbers:

We don’t have a strong view on whether a US recession will begin in six or in 18 months’ time. However, it is highly unlikely that the Fed will be able to tame inflation without one. The stock market typically peaks 3-6 months before recession, and the period preceding that can often see strong returns, as stocks have a last-phase-of-the-expansion melt-up:

However, this is not always the case – in particular not in the 1960s and 1970s, when inflation was more of an issue. With the Fed likely to turn even more hawkish if stocks rise or the economy shows unexpected resilience, we think a sharp rebound is unlikely.

Markets need to remind themselves of the old maxim, “Never fight the Fed”. With inflation likely to remain uncomfortably high, which will make the Fed unwilling to bail out markets even if growth slows, this is not a time to time to be risk-on. We therefore continue to recommend cautious portfolio positioning over the 12-month investment horizon, with an underweight in equites, and maximum overweight in cash.

Equities

If the US economy looks vulnerable, growth in the rest of the world is much worse. Europe is being hit by an energy crisis:

In the same time, lead indicators point to a much deeper slowdown than in the US:

Chinese growth is sluggish, and the government’s (half-hearted) attempts at stimulus have been hampered by the problems in the property market:

Tightening US financial conditions are bad news for Emerging Markets stocks:

For these reasons, we continue to prefer US stocks which have outperformed global ex-US equities by 2% year-to-date, despite a challenging environment for Tech, where the US market is very overweight. Our sector preferences remain tilted towards defensive sectors, for example Consumer Staples and Healthcare – with an overweight in Energy as a hedge against further upside for oil prices.

Fixed Income

We continue to have a slightly shorter than benchmark duration and an overweight on defensive bonds. Slowing growth and easing inflation should keep a lid on long-term yields for the next few months. However, rates could start to rise sharply early next year when it becomes clear that the Fed is not going to make the dovish turn that the market expects. This would represent a hawkish surprise and, in line with our bond strategists’ “golden rule of bond investing”, would point to negative excess returns from bonds:

We may look to move to a stronger underweight in duration soon. Inflation-linked bonds are no longer as attractive as they were, with 10-year US TIPS breakevens moving up to 2.55% from 2.3% over the past two months. Still, they are priced around fair value and so represent a useful longer-term inflation hedge:

Our neutral position on credit (which we saw as better value than equities as a hedge against upside risk) has worked well, with spreads tightening over the past two months:

Going forward we remain neutral, although spreads are no longer as attractive, and we may soon need to downgrade this view.

Currencies

The crude oil price looks unreasonably low, given supply tightness. The EU ban on Russian oil imports starting in December will take out about 2 million barrels a day of supply; US inventories are very low:

With the USD looking very overvalued, however, there is a risk that more hawkish moves from the ECB and other developed central banks could put a cap on dollar strength. The yen is particularly undervalued and, as a safe haven currency, looks good value. Emerging Market currencies are still vulnerable, and are likely to be pulled down by the ongoing weakness in the renminbi, which reflects widening interest-rate differentials between the US and China:

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:

The US government has used up about 17% of its strategic reserve over the past year; and OPEC's spare capacity has shrunk significantly:

Weakening energy demand will have some negative impact, but our research partner’s energy strategists expect Brent crude to rise to $119 by year-end (up from $96 currently). Metals prices will continue to be negatively impacted by the slump in Chinese demand and by the strong US dollar. While the long-term story for metals that will be required in the energy transition (especially copper) remains attractive, cyclical factors mean that prices could fall further:

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