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Global market outlook and asset allocation

What our House View means for asset allocation and portfolio construction.

  • Inflation broadening amidst aggressive central bank tightening remains the dominant dual theme, with direct impact on rates and strong influence on risk assets
  • Governments’ more proactive approach to fiscal support, in response to energy price shocks, may reduce economic volatility relative to no support, yet increases the risks of policy mistakes
  • Commodity prices and global fragmentation are a combined terms- of-trade and confidence shock, boosting the dollar but also creating relative winners and losers in FX

The deteriorating macro environment creates a challenging outlook for credit and equity markets, with outcomes skewed toward downside scenarios; these risks are somewhat mitigated by the strong fiscal response, which may have its own set of unintended negative consequences.

Central banks are determined to bring inflation to heel, having mostly abandoned the idea of soft landings and normalisation. Policies will be tight, and in some cases will induce recessions; this is in part a reaction to overly easy fiscal-monetary policy mixes during the strong post-COVID rebound as well as Russia’s invasion of Ukraine and the impact on commodities, and the concomitant global fragmentation and supply chain issues that continue to impact price pressures.

Yield curves have adjusted significantly

Yield curves have adjusted significantly as we are now in the intermediate stages of an aggressive synchronised global hiking cycle, with some laggards and a few already reaching terminal rates.

This tightening in financial conditions is exacerbating the growth slowdown, but this is a feature, not a bug: stock and bond markets are under stress from both factors, and the dollar remains supported too. Eventually, this combination will lead to slack emerging, and central banks will be able to take their heavy feet off the brake pedal – but not yet.

Despite ongoing strength in inflation, the economic cycle is now firmly in the below-trend and declining quadrant of the growth cycle and the market pricing is broadly consistent with this view (Figure 29). While fiscal policy is attempting to push back on the negative impact of rising energy prices, it will only partly mitigate the growth slowdown: below-trend growth is needed to moderate inflation.

Figure 29. Aviva Investors market implied pricing of global growth
Figure 29. Aviva Investors market implied pricing of global growth
Source: Aviva Investors, Macrobond as at 3 October 2022

In economies such as the US where the energy impact is smaller and the economy more robust, the slowdown will need to be instigated by the central bank. Market pricing of the growth cycle usually moves a little ahead of the economic cycle given economic data is released with a lag and investors look to the future. Are we close to a point where the negative trend ends, and the market can start to price in incremental improvement in the growth outlook?

Much has changed over the last few years, but some lessons shouldn’t be given up too easily – don’t fight the central banks. Bear market rallies may occur but for as long as central banks are actively tightening to slow economies, the market will struggle to sustainably price an improving outlook for growth and the current risk-off environment for growth-sensitive assets will persist.

A slowing growth environment has historically been supportive for the US dollar and this most recent period has been no exception. Rising rates and a superior growth outlook in the US relative to other developed market (DM) economies has also supported dollar appreciation. The dollar has appreciated nearly 7 per cent in real effective terms over the last quarter, taking the year-to-date change to over 12 per cent (Figure 30) and the level to the highest seen since November 1985.

Figure 30. JP Morgan real effective exchange rate changes in 2022
Figure 30. JP Morgan real effective exchange rate changes in 2022
Source: Aviva Investors, Macrobond as at 3 October 2022

It is unsurprising then, that investors are questioning how much further this trend can run. With the outlook for the dollar so tightly tied to the rates and risk outlook, the current environment of dollar strength is expected to continue for as long as the Fed’s active tightening stance persists.

The recent tightening in financial conditions has been sharp (Figure 31) with all the drivers moving in the same direction: rates rising, credit spreads widening, equities falling and the dollar appreciating. Only when the trend in inflation is clearly reversed will central banks look for looser financial conditions.

Figure 31. US financial conditions
Figure 31. US financial conditions
Source: Aviva Investors, Macrobond as at 3 October 2022

Aside from the broad trend of dollar strength, currencies with less hawkish central banks and deteriorating terms-of-trade have been more at risk, e.g. sterling, yen, won and yuan; a handful of emerging markets also have wide trade deficits and problematic fiscal metrics.

However, many EM currencies benefit from high commodity prices, and have raised interest rates to quell inflation and stabilise exchange rates – as such, EM FX may outperform many G10 currencies, especially when carry is taken into consideration, even as the USD remains ‘king’.

It goes somewhat against the grain for central banks to be actively seeking to tighten financial conditions further in a ‘below trend and declining’ growth environment.

This time it’s different. With central banks actively trying to create a growth slowdown, rather than reacting to one, the relationship between fixed income and risk assets has flipped. Over the last 20 years the growth cycle and growth-sensitive assets have driven rates; now rates are in the driving seat.

Figure 32 shows the rolling correlation between US treasury return and US equities which has now turned positive. In the bottom panel we split correlation according to the return environment for equities and we can see that not only has the correlation turned positive, but it is more positive in periods of declining equity markets.

Figure 32. US Treasury total return corr to SPXT - Wkly chgs, 1y rolling window
Figure 32. US Treasury total return corr to SPXT
Source: Aviva Investors, Macrobond as at 3 October 2022

Looking forward there is no doubt that central banks are closer to the end of their hiking cycles than the beginning. Real yields may yet need to move higher still to sustainably bring inflation back under control, and the reliance on current inflation as an indicator for when the job is done makes it more likely than not that the more aggressive central banks overtighten.

Given current levels of yields in major economies, the outlook for fixed income from here over the longer term is likely positive but timing entry will be tricky and highly sensitive to depth and breadth of inflationary pressures.

With so much of the outlook determined by inflation and the subsequent policy response, it is unsurprising that market volatility has been elevated.

Fiscal policy complicates matters, for bond markets and for monetary authorities dedicated to reining in inflation

As we have seen in the UK in late September, fiscal policy has the potential to have very significant ramifications for market pricing and monetary policy decisions. Divergences in fiscal policy could create opportunities for relative value plays going forward. Playing these divergences will also help reduce the need to perfectly time the rotation from short to long bonds.

Slowing and below-trend growth alongside the absence of any meaningful ‘central bank puts’, rising real rates, and heightened uncertainty due to geopolitical risks have resulted in a challenging environment for equities.

Our view is that this negative environment is likely to persist over the next six months. Moreover, despite being able to pass on many input and labour costs, earnings per share (EPS) estimates continue to trend down (Figure 33). As our title suggests, the bottom will likely be reached only when PMIs and leading indicators durably improve from low levels, inflation and employment soften enough to allow central banks to assuage rather than induce “pain”, as Jay Powell terms it.

Figure 33. Equity earnings trends are heading downhill rapidly - (Avg of 3, 6, 12m changes)
Figure 33. Equity earnings trends are heading downhill rapidly
Sources: Thompson/Reuters DataStream, MSCI, Aviva Investors as at 3 October 2022

That said, on a structural, multi-year view, equities are likely to produce positive, perhaps even excess-to-cash returns, as long as a deep recession or financial crisis is avoided.

A similar logic applies to corporate bond spreads: they are strongly correlated to the shape of yield curves (a proxy for monetary stances), as well as real yields, commodities and growth.

None of these are supportive, and unlikely to change near-term. Inverted yield curves and restrictiveness in lending, as well as capital markets that have sporadically shut down, usually portend a rise in High Yield defaults (Figure 34).

Figure 34. US HY default rate regression model - Annual default rate
Figure 34. US HY default rate regression model
Source: Bloomberg, Federal Reserve, Moody’s; Aviva Investors as at 3 October 2022

There are good reasons to be hopeful that coming recessions will avoid the huge, multiyear spikes in defaults seen in the GFC and dot-com crash, but credit deterioration leads us to expect some further HY underperformance of cash. Junk spreads usually peak around 1000bps as a recession of unknown duration and magnitude hits and we anticipate further spread-widening relative to investment grade (IG), where shorter duration bonds should be better at holding their value.

The asset allocation table applies the above considerations to further reduce equity exposure, which has been steadily reduced from +3 during the reopening period of 2020-21, and now sits at zero, with Europe underperforming. Government bonds and HY are underweights, with IG and higher grade EM, along with cash and (hedged) UK equities preferred, alongside a heavy long dollar overlay.

Figure 35. Asset allocation
Figure 35. Asset allocation
The weights in the Asset Allocation table only apply to a model portfolio without mandate constraints. Our House View asset allocation provides a comprehensive and forward-looking framework for discussion among the investment teams. Source: Aviva Investors as at 3 October 2022

Read more of the House View

Executive Summary

A summary of our outlook for economies and markets.

Key investment themes and risks

The five key themes and risks which our House View team expect to drive financial markets.

Macro forecasts: charts and commentary

Our round-up of major economies; featuring charts and commentary.

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