As bond markets move away from recession calls, equities take over
There may be more pain ahead, but we should be getting closer to a bottom
We remain constructive for the year, but the upsidecould take some time to materialize
While inflation remains the most-watched driver for investors, markets have moved on from peak inflation fears to growth fears. Moreover, the three main concerns that have been weighing on markets remain in place: Federal Reserve tightening, zero-Covid policy in China and the war in Ukraine. However, while a hard landing has been discussed for some time, recession fears jumped following the Bank of England’s “stagflation” comment and disappointing earnings from consumer-related companies.
Interestingly, just as the bond market stopped pricing in a recession –pricing out the interest rate cuts expected for 2024 –,equity markets have started pricing in a growth scare or recession-like environment, dropping through resistance levels to new lows for the year. Encouragingly though, the positive correlation between stocks and bonds that has been exacerbating pain in portfolios since the beginning of the year is finally reversing, with the traditional inverse relationship taking hold again in recent weeks. Additionally, Shanghai appears to be gradually exiting from lockdown, suggesting the worst is behind us in terms of supply chain and production disruptions, and therefore prices.
Nonetheless, inflation will likely only come down slowly, suggesting the Fed will need to see a few more months of disinflation to feel comfortable lifting its foot off the tightening pedal. Additionally, China appears unlikely to move away from its zero-Covid policy, and the Russia-Ukraine war is set to persist. As such, negative headlines should still be expected over the coming months, though with such a bearish outlook already priced in, sentiment cannot fall much further from here.
In this context, we believe it is too late to take risk off the table, especially with equity markets already down around 20% across most indices. However, we may not have reached the bottom yet, suggesting it might be too early to jump back in. Still, while a few more weeks of pain are expected, long-term entry points are starting to appear, with battered sectors like tech starting to look less rich in terms of valuations. Moreover, if growth holds up, cyclical sectors should do well.
On the bond side, sovereign yields have retreated from recent highs, as growth concerns increase. Financial conditions have already tightened sharply, even though credit spreads have continued to prove resilient and below long-term averages. As we are probably close to peaks in terms of sovereign yields, we keep a more balanced allocation between credit and sovereigns.
The dollar has been in a win/win situation with interest rate differentials supporting the currency on one hand and weakness in other major currencies lifting the green back on the other, an environment that could last, though any acknowledgment from the Fed that it is keeping an eye on growth could see USD retreat.
While there could be more volatility in the weeks ahead, we remain constructive for the second half of the year. We believe the Fed is focused on a soft landing beyond just bringing inflation down, suggesting a more balanced approach after the summer. In the meantime, US growth remains solid, even if some signs of slowdown are emerging. Still, a US recession is not our base case at this point. For now though, we remain cautious and hold higher cash levels.
Risk assets remain under significant pressure, breaking through lows, with only short-lived bounces in between. Growth fears have added to inflation fears, leading to questions about the earnings outlook. However, sentiment is becoming overly negative, and we should slowly be nearing a bottom, though a number of ugly weeks are still likely ahead of us. Still, the second half of the year should see improvements in inflation and Chinese lockdowns as well as a still-solid outlook for US growth.
As such, long-term entry points are starting to appear, but caution remains the name of the game for now. We believe that the US will perform better than Europe given growth risks to the Old Continent and the ongoing Ukraine conflict, with food and energy prices weighing on the consumer. We continue to see a divergence between commodity exporters and importers across emerging markets, with those tied to China still at risk of slowing growth. However, sentiment there seems to be improving, which could lead to a bounce later in the year.
Bonds are finally decorrelating from equities again, with yields falling on growth concerns as investor sentiment drops further. While we think the worst is behind us for yields, another spike cannot be excluded so we remain prudent, though we are balancing the sovereign and credit allocations more. We may be past “peak hawkishness” for the Fed, but it is not yet ready to lift its foot off the tightening pedal and other central banks are joining the fray, though markets are pricing in such an aggressive hiking cycle already that it would take a lot to surprise markets going forward. Credit, especially IG credit, continues to prove resilient, reinforcing our preference for credit risk over duration risk as we do not expect an imminent US recession.
King dollar remains in high demand, even as it has started softening in recent weeks. While the ECB is joining the tightening train, the Bank of Japan isn’t budging, suggesting few hurdles to the dollar for now, especially as Chinese and European growth concerns persist. However, any improvement in risk appetite should support the euro, and any acknowledgment of growth by the Fed could see the dollar retreat, eventually. Emerging markets remain split between commodity importers and exporters, with China adding to volatility across the region with the RMB’s recent weakness.
Growth concerns have seeped into commodity markets as well, with most growth-related commodities softening on concerns about China and its extended Shanghai lockdown, and US tightening. Oil remains spared, stuck in a range as investors weigh the ongoing war in Ukraine and the risks of supply disruptions with lower demand from China. However, even if the conflict eases, oil prices are unlikely to retreat much. Gold has recovered somewhat as the dollar eases, but tighter monetary policy remains an obstacle to much higher prices.
The market sell-off did not spare cryptocurrencies, which came under renewed pressure in May, before stabilising at lower levels. While liquidity removal and risk-off sentiment are likely to keep cryptos under pressure in the short term, their correlation to stocks, and tech in particular, should prove supportive over the second part of the year. Broad adoption should resume once sentiment stabilises, which should bring longer-term support. Moreover, the growing adoption of blockchain-based innovations should add to demand over time.