The financial outlook is particularly opaque – yes, some real value is starting to appear as markets fall, but while central banks continue to throttle demand, caution is needed for a while longer.
The first half of 2022 saw the worst start for US equities since 1970, with no single sector in positive territory except energy. The sell-off has been extraordinarily widespread, with government, corporate and junk bonds all showing negative returns, alongside bear markets in most equity markets. Two unlisted asset classes showed surprisingly strong positive returns – private equity and global real estate. US residential house prices rose by an extraordinary 20.4%1 in the year to May, while prime London rents climbed by the greatest extent in two decades.2 This was of little help to investors in listed markets where the past six months, especially for balanced mandates, have been among the most difficult on record.
The causes of the sell-off are not hard to find
The causes of the sell-off are not difficult to find; war, inflation and high valuations are all contributors. Most important, though, is central banks’ determination to tighten policy and bring demand back into balance with supply, which has been seriously damaged by the pandemic and the invasion of Ukraine. This will almost certainly trigger a recession – probably at the end of 2022 – as the price of bringing inflation back close to target by 2024.
Western central bankers are acting aggressively because they were slow to anticipate the problems last year. In mid-2021, consumers were flush with cash from stimulus cheques and enforced saving during the pandemic. They were prepared to spend liberally as economies reopened, while on the supply side delivery chains were seriously impaired by the pandemic and China’s prolonged COVID-19 restrictions. From microchips to car parts, manufacturers across the world were unable to meet demand, underpinning much of the inflation shock we face today. Better late than never, central bankers are now tightening interest rate policy, and rapidly. It is this that has most destabilised markets.
Inflation risks are still climbing, especially in the UK
Three factors add to today’s inflationary challenges. First, labour markets are exceptionally tight, with job openings exceeding the unemployed for the first time in recent history in the UK and at unprecedented levels in the USA. Second, the surge in European gas prices and a potential cessation of Russian gas exports to Europe risks further inflationary pressures and recession risks. Inflation in the euro zone was already running at 8.6% in June, the highest since the bloc was created in 1999. Third, UK inflation continues to climb, principally because sterling is weak, down 4% this year on a trade-weighted basis and 11% against the US dollar, and this has pushed up energy and import costs. Political turmoil and a rapidly widening trade deficit mean this is unlikely to be reversed quickly.
The first half of 2022 saw the worst start for US equities since 1970, with no single sector in positive territory except energy.
How likely is a ‘mild’ recession?
We forecast a US recession in late Q4 2022 or early 2023, but there is hope that it may be relatively mild. First, personal balance sheets are in good shape after the enforced saving of the pandemic years – we estimate there are USD$3tn of surplus savings compared to pre-COVID trends. Second, US and global banks are robust, in marked contrast to 2008. Last week all 33 major US banks passed the Federal Reserve’s stress tests. Third, labour markets are in rude health, so a deep recession, given unemployment rates at just 3.8% in the US and the UK, would be very unusual. In other words, expect a shallow, ‘jobful’ recession.
What does this mean for interest rates?
The outlook suggests three possible paths for interest rates (we focus on US interest rates for this section):
- The first, and most likely scenario, is a series of rapid rate increases that slow the economy and inflation, and, most importantly, cap inflation expectations. Under this outcome we see US rates peaking at around 3.25% in H1 2023.
- The second scenario sees inflation being much stickier – particularly if the energy crisis worsens. Rates move higher for longer (to around 4%) and a deeper recession is needed to squeeze prices back close to target.
- The third envisages a major market dislocation or financial crisis occurring as rates rise. Possible causes include widespread emerging world defaults, a collapse in the shadow banking system (China may be vulnerable) or a systemic failure that freezes the crypto ecosystem. In this case US rates peak at around 2.5% and then retreat.
For clients who remember the 1970s these rate increases may seem modest, considering that UK CPI is already at 9.1%. However, there are clear differences between then and now; in the 1970s inflation had been rising for longer and led to higher and more ingrained inflation expectations. The price of oil during the 1970s rose by a multiple of the rise seen over the past year, and the US economy was then almost three times more energy dependent (in terms of barrels of oil per unit of GDP). Finally, governments today are far more indebted now than they were in the 1970s – a material rise in interest rates today would likely result in a ruinous decline in government finances. A shallow recession, with rapid but limited rate rises, remains our base case.
For much of the past decade the rule of ‘don’t fight the Fed’ has meant staying fully invested to benefit from generous central bank policy – culminating in the extraordinary post-COVID equity rally of March 2020. Today, this phenomenon may reverse. If, as we have argued, central bankers genuinely want to tighten financial conditions and slow global demand, then the message for investors is clear – stay cautious for a while longer. Yes, we have seen substantial repricing of assets this year, with world equities declining more than 20%, but that was achieved by a contraction in valuations. By our measure, world equity PE multiples3 have fallen back from a peak of nearly 25 times to around 15.5 today (the 20-year average is 15.9 times). Corporate confidence is surprisingly robust, with share buy-backs continuing at record rates, but early signs of caution abound. Global corporate fundraising has cooled sharply, falling by 25% from the first half of 2021, while US equity fund raising fell to just USD$40bn, the lowest since 1999.4 Bond yields are also rallying on recession fears. All these signs indicate a heightened risk of profit warnings in the months ahead.
Our response has been to keep our underweight equity allocation for a little longer and retain a focus on defensive franchises and sustainable equity income. We do not intend to reduce equities dramatically from here. We note, for example, that declines in US equities of greater than 15% in the first half of the year have historically been followed by positive returns in the second half of the year. Across other assets, slower economic growth has led us to start reducing our aggressive underweight in government bonds. At the same time, we continue to overweight alternatives, which have produced standout returns over the past year. These exposures include gold and other inflation-linked assets, including infrastructure and renewables. Finally, we continue to keep precautionary positions in cash to provide funds for opportunistic purchases should any substantial sell-offs occur.
So caution today, but as the economic glass starts to clear there will be a host of opportunities. Equity yields in Europe are already mouth-watering, and the massive capital investment needed to create a low-carbon economy will provide a huge source of future earnings. Our thematic equity holdings should be the long-term winners and, as the world reopens for travel, our analysts will be hot on their trail.
1Case Schiller House Price Index June 2022
2Savills June 2022
3Global PE Multiple 1 year forward Factset
4Financial Times 2nd July 2022