Signs of disinflation are starting to appear, but may take time to materialise
Recent growth data and earnings have been better-than-feared
The outlook for risk assets is starting to improve, but risks remain
Just as investors moved towards extreme bearishness, and recession fears jumped into the end of the second quarter, a few encouraging data points in July have led markets to stabilize. Whether THE lows are in is too soon to answer, but some technical improvements are starting to bring confidence to brave “buy-the-dip” investors. Another bout of volatility cannot be excluded, but perspectives for the second half of the year appear more constructive.
The growth backdrop remains fragile, but so far data is holding up. Europe is more at risk than the US, and growth expectations have dipped for the Old Continent in light of the looming energy crisis, but markets seem more focused on the US holding up, which would be helpful for earnings. So far, consumption is proving more resilient than expected, despite higher prices. In addition, signs of coming disinflation are starting to appear, reassuring markets that the worst may be behind us in terms of inflation. Indeed, commodities have fallen sharply since their highs, retailers have excess inventory they need to clear, car & travel prices are coming down, and the housing market is starting to cool. Together, these point to an alleviation in prices into the end of the year, even if the fall is gradual.
In the meantime, hawkish rhetoric continues, with rate hikes coming from virtually all central banks except for the Bank of Japan. However, the European Central Bank admitted it needs to be data-dependent, and watch out for energy shortages, and the Federal Reserve is likely towards the end of the aggressive part of its hiking cycle. Markets are hoping July inflation data will allow the Fed to acknowledge growth in August – possibly at Jackson Hole – and reduce the pace of tightening.
Today, investor sentiment has become so bad that it is almost good. Indeed, positioning is so bearish that most of the selling has likely already occurred. Moreover, somewhat less-bad-than-feared earnings results are helping to ease some growth concerns, which should help sentiment. As such, we maintain our current equity allocation, waiting for further indication that improvements are coming before diving back into risk assets more firmly. We believe that tech will continue to lead the way up as markets recover over the coming months, though likely not in a straight line. Cyclicals such as energy may need more proof that growth is holding up for further outperformance, but the ongoing high oil price suggests downside should prove limited.
Our fixed income positioning has not changed. Yields have likely seen the bulk of their move, even if another spike is possible. Still, as growth fears may not fade for some time and we are likely past peak hawkishness and peak inflation, we maintain a more balanced allocation between sovereign debt and credit. We favour investment grade credit for now, as high yield spreads are more at risk of further widening, though opportunities are arising in the space.
The strength of the dollar has been a hurdle for emerging markets and for corporate results. While the dollar is unlikely to relinquish its crown in the short term, it may not rise much from here, likely retreating on improved risk appetite and reduced interest rate differentials with the euro. Cryptocurrencies also appear to be past the worst, with a stabilization across the major currencies assuaging fears of a total collapse of the asset class.
The recent stabilisation in equity markets and the improved breadth we have seen in the recent
rebound are encouraging signals that we may be closer to a bottom for risk assets. While it is still
too early to dive back in, the outlook for equities into the end of the year continues to improve.
Indeed, earnings have been better-than-feared so far, and consumption is holding up, despite
risks to the outlook. At this point, any disinflationary signals will prove supportive of
markets, as they suggest the aggressive part of the Fed’s hiking cycle is closer to the end. In
addition, resilient economic data will be needed for a sustained recovery in investor sentiment.
For now, we remain cautious and maintain current allocations. We expect technology to
continue its recent outperformance and lead the rebound into the end of the year. Defensives
should continue to do well, but cyclicals should recover with risk appetite on better-thanexpected
earnings and growth data. Europe is likely to remain under pressure compared to the
US given energy risks and the ongoing conflict in the Ukraine. Emerging markets remain tied to
China, where the outlook is gradually improving.
Fixed IncomeMarkets are starting to believe we are close to peak inflation fears, peak hawkishness, and peak
tightening fears, suggesting the big part of the move higher in yields should be behind us. As
such, we have a more balanced allocation between sovereigns and credit, even if another
spike in yields could happen. IG credit is proving more resilient than high yield given ongoing
growth concerns, maintaining our preference for investment grade over high yield, even if we
believe the US and the world will avoid a recession in 2022 and risk appetite will gradually
recover over the coming quarters.
Even though we are likely near a peak for the dollar, the greenback is unlikely to retreat much
as growth and interest rate differentials remain supportive for USD versus other major
currencies, and haven flows would pick up if grows slows too much. Still, an improvement in
risk appetite should bring some support to the euro, as a lot of bad news is already baked in in
terms of growth and energy risks. Sterling should recover as the UK political landscape becomes
clearer, though a hard-line Brexiteer PM could weigh on confidence, while JPY may not weaken
much from here as the Bank of Japan is holding steady. Emerging markets have been mixed, but
a stabilisation in RMB should help.
CommoditiesCommodity prices continue to fall, as concerns about growth and demand continue to weigh on
prices. Encouragingly, this should help reassure investors about coming disinflationary forces,
though it may still take time to materialise. Oil may not retreat much as supply remains tight
and the war in Ukraine seems unlikely to end anytime soon. Gold remains under pressure as
the dollar strengthened further and real yields climb, though we may be closer to a peak in
USD, suggesting a potential stabilisation for the shiny metal.
Cryptocurrencies finally started catching a bid, with recent lows holding and major cryptos
pushing towards recent resistance levels. Improving sentiment towards the technology
sector and towards equities in general should continue to support cryptos, though another bout
of volatility cannot be excluded in the short term. It might take time for mass adoption to resume
more broadly, but a stabilisation in the market is a good start.