First-half returns on equities and bonds were frankly disastrous. Furthermore, establishing a reliable scenario that can stand the test of the coming months will likely challenge many investors. On the one hand, central banks have ‘declared war’ on what looks to be higher-for-longer inflation; on the other, signs of slowing growth have fuelled expectations of an impending global recession.
Can we not just cancel the first half of 2022?
What is there to say about market returns? In the first half of 2022, the US Treasury bond market generated negative returns of almost 10% while eurozone government bonds fell by more than 12%. Segments across the credit market posted largely negative total returns.
As for equities, the MSCI AC World index lost 20.9% in US dollar terms as at 30 June – marking the worst first half of a calendar year since inception of this index 34 years ago. The month-to-date 0.3% rise (as at 6 July) looks timid.
Moreover, in the absence of strong investor convictions about the consequences of the US Federal Reserve’s stance on monetary policy, volatility has remained high in equities and even more so in government bonds.
In one month, investors’ expectations have undergone a sea change. The previous market narrative, according to which central banks would not need to raise policy rates by as much as had been expected because inflation would fall has given way to a much less favourable assumption for risky assets. Namely, the combination of slowing growth and persistent inflation.
A dual mandate? What dual mandate?
US Federal Reserve Chair Jerome Powell has appeared less and less confident about the economic outlook, telling Congress recently that a soft landing would be ‘very difficult’ and that a recession is ‘a possibility’.
Indeed, deteriorating business surveys, disappointing consumer spending and sharply lower consumer confidence have left the Federal Reserve of Atlanta’s GDPNow running growth estimate in negative territory in the second quarter – at -2.1% annualised on the basis of data available as at 1 July.
This indicator is not an official forecast. However, if it were confirmed in the first estimate of second quarter US GDP, due on 28 July, the US economy would be in a ‘technical’ recession after the 1.6% contraction in the first quarter of 2022.
Recession fears have caused futures market expectations of further Fed rate rises to recede. Yet the minutes of the Fed’s 14 June policy meeting, which concluded with a 75bp increase in the federal funds target rate, revealed that policymakers remain concerned about inflation and would continue to monitor inflation expectations.
There was concern among many meeting participants that ‘elevated inflation could become entrenched’ since inflationary pressures had failed to come down. The Fed’s message is becoming clearer: Monetary policy needs to become restrictive to cool the economy.
The implication would be that there is a possibility that the Fed will accept, or even seek, a period of sufficiently broad-based weakness in economic activity, including higher unemployment, so as to damp demand and slow inflation.
Most policymakers appear to believe that the risks to growth are tilted to the downside as a result of external factors such as the war in Ukraine and Covid restrictions in China. In addition, they evoke the risk that tightening financial conditions further could have a larger-than-expected impact on activity.
While the minutes reflect the Fed’s dual mandate – maximum employment and price stability – the general tone leaves us with the impression that the fight against inflation is now a high priority.
What does this mean for markets?
The combination of high inflation and limited growth is historically unfavourable for many asset classes. This explains investors’ nervousness as we enter the summer period.
However, since the start of the year, the rise in nominal and real bond yields has been the main driver of the decline in equity valuations and thus the sharp fall in markets. By contrast, the earnings outlook has remained quite resilient, particularly if we consider that equities should be pricing in recession risk.
While leading business indicators have already fallen, earnings expectations remain resilient. However, this could reverse, especially in the eurozone, and further penalise equities. The earnings season that is about to begin is likely to be decisive.
A rebound looks possible in the short term given the technical conditions, but it would likely be erratic. It could provide investors with opportunities to reduce, at relatively favourable levels, their exposure to equities (as we have done regularly since February).
In fixed income markets, the sharp widening of credit spreads in recent weeks is offering investors entry points (in particular in European investment-grade) as, in our view, it reflects an overly high expected default rate.