What our House View means for asset allocation and portfolio construction.
- High inflation and China’s policy errors have added to the mix of slowing growth and more aggressive central bank tightening
- Recession risk is rising, yet central banks are focused on fighting inflation, leading to higherreal yields, flatter yield curves, and tighter financial conditions – and extraordinary volatility
- Valuations have become more attractive, but the macro environment remains challenging for credit and equities, and skewed toward downside risks
- We remain in a strong dollar environment, especially against the euro, yen and Asian FX, where central banks are out-of-sync with the Fed; other EM currencies are building up carry
Economies and markets have experienced a sequence of shocks in recent months, as several of our House View risks have materialised.
Demand for goods has slowed a little, but remains robust. Meanwhile, demand for services has rebounded before supply chains and labour markets had fully healed, adding to the upward inflation impulse.
The Russian invasion of Ukraine has exacerbated the energy price shock, and added risk premia to energy prices more generally. It has also disrupted some agricultural and fertiliser markets, creating a global food crisis in some areas.
Multiple shocks and large risks have increased volatility in financial markets
China’s property market remains in recession, while a failure to provide effective vaccines alongside rigid adherence to Zero COVID Policy has damaged growth and disrupted supply chains further, stoking prices.
Inflation peaks have been pushed later and higher, forcing central banks to respond. The balance for them has shifted from supporting growth to trying to tame inflation. After the extended period of ultra-loose monetary policy, the change to an aggressive synchronised hiking cycle (Figure 1) has been stark.
Figure 1. A synchronised global hiking cycle
Rate hikes have been and are likely to continue to be larger and faster than the last two hiking cycles. Advanced economies and Asia remain in the early stages of the hiking cycle, while Eastern Europe and Latin America are arguably nearer the end of the tightening phase.
The economic slowdown is now sharper, and a global hard landing is a growing risk, especially with China’s policy errors all too likely to continue. Financial conditions (Figure 1) have tightened rapidly but are unlikely to have peaked. Further tightening will weigh on activity and may cause negative feedback loops. Commodities may deliver an actual supply shock (particularly European gas disruption), rather than just a price shock that reduces real disposable incomes.
Rate hikes have moved into higher gear, but it is too early to position for a pause or reversal
Finally, discretionary spending negative wealth effects may make households more conservative in consumption and businesses less willing to invest.
The higher and more volatile inflation regime is driving a higher and more volatile regime in rates markets.
Central banks continue to focus on inflation even as recession risks grow, with many delivering significant hikes over the last quarter and with more expected (Figure 2). The ECB and the BoJ are yet to participate, but the ECB has clearly signalled the start of policy normalisation very soon. The market is currently pricing around 150bps of hikes in the euro zone this year which would take the policy rate to 1 per cent.
This anticipated rapid pace of normalisation as well as some clumsy messaging by the ECB led to a marked increase in fragmentation fears, with the spread between the yield on 10-year Italian government bonds to German peaking at just over 240bps in June. The ECB used an ad-hoc meeting to introduce an anti-fragmentation tool (with details to follow in late July), highlighting the precarious position central banks are in, needing to tighten policy rapidly whilst trying to maintain economic and financial stability.
Figure 2. Goldman Sachs financial condition indices
As markets are now much closer to fully pricing rate-hiking cycles, investors have just begun to think about the potential cutting cycle that could follow as recession risks grow. However, with central banks focused on inflation, positioning now for any such a turn in policy direction feels premature.
Additional fiscal support remains an upside risk to both the growth and inflation outlook. Significant uncertainty around both economic outcomes and policy reactions means high levels of volatility within the rates market is likely to continue.
BoJ policy and Japanese rates stand in stark contrast to the rest of the G10. Policy divergence has driven a roughly 17 per cent depreciation of the yen versus the US dollar and a nearly 13 per cent depreciation in real effective exchange rate terms.
The strong momentum for higher real yields is likely to continue creating a challenging backdrop for risk assets
While still low by international standards, inflation in Japan is now high relative to its own history and pressure on the currency shows no signs of abating. The extent to which the BoJ can maintain such a significant divergence in policy is being called into question and we prefer to underweight Japanese government bonds.
Financial conditions need to tighten further to bring inflation under control. In the first quarter of this year the move higher in real yields was predominantly driven by the move in nominal yields.
Over the last quarter we have seen real yields move more convincingly higher, driven by both higher nominals and declining breakevens (Figure 3). As inflation measures peak and recession risks grow, moves in real yields are likely to continue to be driven by both nominal and breakevens, generating more momentum in real yields.
A strong upward move in real yields is likely to be a challenging environment for risk assets.
Credit remains challenged and is more strongly correlated to risk assets than changes in rates (Figure 4). The previous negative correlation of spreads and yields is unlikely to resume until central bank tightening is decisively finished, and flat yield curves have historically been associated with elevated credit spreads. While fundamentals are currently supportive, the credit market remains exposed to a rising real rate environment and should a recession materialise – and with it, increased defaults and downgrades – then a further significant correction is likely.
Figure 3. Real yields driving financial conditions tighter
Figure 4. US HY credit correlation to US 2y & global equity
For currencies, risk aversion and rate differentials have been important drivers of dollar strength, particularly against the euro and yen, and we expect them to continue.
Although the ECB is now on the cusp of hiking rates, they will not keep pace with the Fed; the yen (see above), Asia FX and the overvalued CNH are more vulnerable. The DXY Dollar Index has strengthened considerably since the Global Financial Crisis, but it is unlikely to turn until the rate-hiking cycle has run its course, and the index is still 15 per cent below its 2000-01 peak.
The Fed and risk aversion benefit the dollar, but EM central banks have moved aggressively and some currencies have already weakened substantially
In other G10 countries, faster hikes should provide some protection for countries like Australia, Canada, Norway, Sweden and Switzerland – but euro weakness will weigh on the dollar crosses.
For emerging markets, rate hikes have belatedly rebuilt a real rate cushion in many countries (Figure 5). High carry and favourable terms of trade movements have helped Latin America deliver decent returns, and Central and Eastern European currencies (excepting basket cases like Russia and Turkey) are also being aided by hawkish central banks, though high inflation equates to low real rates, and the G10 rate hikes remain a headwind.
Figure 5. Many emerging markets have hiked aggressively and built a sizeable real rate premium
2y real govt bond spread to US
However, what is helpful for getting currencies and inflation under control is not a benign environment for risky assets, and that includes equities.
Historically, there has been a negative relationship between real rates and forward price-earnings ratios. Post GFC this relationship weakened but it looks to be re-established now, with the de-rating this year consistent with the rise in real rates (Figure 6).
Markets are moving back to a pre-GFC regime of higher real rates and lower P/Es
Since mid-2021, our view on equities has evolved from considerably overweight, to a more moderate position and our preference currently is to be only modestly overweight.
As noted above, the sell-off in equities this year has driven valuations down to more attractive levels. Moreover, while the risks of recession have clearly increased, the strength of household and corporate balance sheets should mean that any such recession is relatively mild. So while there remain significant challenges for equity markets over the coming months (e.g. see below on margin pressures), we have not moved to outright defensive.
Figure 6. Rising real rates look likely to depress P/Es
Forward P/E and real rates
As real rates and credit spreads rise, together with inflation and wages, margin compression is likely unless sputtering demand picks up again: very strong trailing and projected earnings are vulnerable. We favour those firms and sectors with pricing power, but in many cases, there is a struggle to keep up with rising costs and other expenses.
Long-term valuations are better, but margins and earnings are at risk in this stage of the cycle
Our positive structural outlook is reflected in our actual allocation and informed by quantitative signals that suggest negative sentiment is already pervasive, but we are tilted towards sectors that are defensive or have already priced in a large chance of recession. High P/E countries and sectors may need to compress more, given the above considerations: tech and growth look to be challenged. Europe has re-priced downwards but remains an underweight.
Finally, as with credit spreads, if the risk of hard landing rises or seems imminent, drawdowns can continue. Eventually, there will be a turn in inflation and an improvement in growth projections instead of the steady negative revisions, which can set up an environment for a concurrent bond and equity rally (as in 1995 and 2019) but we are probably several quarters away from such a prospect.