MonthlyFlow - July 2022

  • Markets remain laser-focused on inflation and ensuing tightening risks to growth

  • A slowdown is starting but a recession should be avoided in the US and the global economy

  • The short term might remain volatile, but longer-term entry points are starting to emerge

Investors are almost entirely focused on inflation and on central bank tightening expectations, and the ensuing risk to global growth. Markets have seesawed between inflation and growth fears for months, with the latter taking over in recent weeks as cracks are starting to appear in the US economy and the Fed reaffirmed its commitment to bring inflation down, even if growth slows sharply as a result. Given the starting point for the US economy, we believe that growth will hold up even as it slows, and that the US can avoid a recession over the coming quarters. Nonetheless, growth fears are likely to linger for some time, leading to negative headlines. Encouragingly though, some disinflationary signals are appearing, including high retail inventories and a slowing housing market. These should, over time, ease concerns over persistently high inflation pressuring central bankers to continue to tighten aggressively. Still, inflation will take time to cool, suggesting the Fed will remain hawkish into the summer.

 

In the short term, however, investor sentiment remains fragile, and we cannot exclude another correction in the coming weeks. While markets are pricing in a growth scare, any deterioration in sentiment or indication that inflation is not coming down as expected could send markets lower again, closer to recession pricing. Interestingly, the bond market is closer to pricing in a recession as the yield curve continues to flirt with inversion and high yields spreads have broken above 500 basis points.

 

For now, we maintain an allocation to cash as a cushion to further volatility and as dry powder to seize attractive entry points for the longer term. We believe it is still too early to dive back into equity markets, as growth fears can last and inflation will likely come down only slowly, suggesting downside risks are not over. However, entry points are starting to emerge, for those with a longer investment horizon. The technology sector has started to recover in recent weeks, often outperforming, which should continue as tightening fears gradually abate (from their current peak), leading the way for a broader rebound. Cyclicals such as energy have suffered from growth fears but should recover as growth holds up.

 

On the bond side, we may still have another spike in yields in the coming weeks, especially with few inflation-related data points to offer any relief, but we believe that the bulk of the move is behind us. As such, we have a more balanced allocation between sovereigns and credit. There remains some risk to high yield spreads, which could widen further if growth fears worsen in the coming months, and we maintain a preference for investment grade credit. If Fed hawkishness and Fed tightening expectations are at a peak, the US dollar should be close to peaking as well, though concerns about the euro, the yen and sterling suggest the greenback should remain somewhat underpinned in any case. A softer dollar and falling commodities would help alleviate concerns for a number of investors, especially in terms of inflation.

 

Looking ahead, we remain constructive on the second half of the year. A cooling in the economy and in inflation should gradually materialize, if slowly, suggesting we are at peak tightening worries. Growth worries may take longer to fade, but if growth holds up – in the US in particular – and earnings do as well, investor sentiment should recover into the end of the year, lifting risk assets.

 


Equities

Even if we see another leg down, we believe that sentiment should gradually improve over the summer and into the end of the year. While a more severe slowdown is a risk, markets are already pricing in a serious growth scare, even if earnings expectations have not come down as sharply. Valuations are no longer rich, though not all sectors and regions can be called cheap. Still, they offer more interesting entry levels for the longer-term, in our view.

For now, we remain cautious and maintain higher cash allocations. We believe that technology will continue its recent outperformance and lead the rebound – when it materialises – into the end of the year. We believe that defensives will continue to do well in a more fragile risk appetite environment. With more pronounced growth concerns in Europe, and even more so in the UK, the US should do better, as earnings should prove more resilient there as well. Emerging markets remain tied to China, where the outlook is significantly improving. A truce in the regulatory crackdown and a commitment to boost growth post lockdowns has helped the market outperform, which could continue.


Fixed Income

Growth worries have hit the bond market as well, helping yields to decorrelate from equities. Indeed, we may be at peak hawkishness, peak tightening expectations and peak inflation fears for markets, suggesting the worst is behind us for yields. Still, another spike in yields cannot be excluded, especially with few inflation data points on the horizon. Overall, we have a more balanced allocation between sovereigns and credit. IG credit is proving relatively resilient, but high yield spreads could continue to widen, reinforcing our preference for investment grade over high yield, even if we believe the US and the world will avoid a recession in 2022.

 

Currencies

While a peak in Fed hawkishness, in inflation fears and in tightening expectations could see the dollar retreat, pressure on other major currencies due to growth concerns (EUR, GBP) or central bank actions (JPY) suggest the dollar will not drop too sharply. If global growth fears gather steam, then safe haven flows could find their way into dollars as well. If, however, risk appetite picks up again, the euro should regain some ground. Overall, we do not expect the dollar to give up its crown, even if it does come down from here. Emerging markets have held up better than anticipated in the dollar rush, especially as the RMB has started to stabilise, albeit at a weaker level.



Commodities

Commodities have retreated across the board, as growth fears impact demand expectations. Oil remains an exception as supply is still the overarching challenge, but food and industrial commodities could see further pressure as growth concerns persist. Gold has failed to break higher as climbing real yields remain an obstacle for the shiny metal. Oil could move higher again as China reopens more and supply stays constrained, even as Biden tries a rapprochement with Saudi Arabia. As long as the Ukraine conflict persist, prices are unlikely to retreat much.

 


Crypto

Major cryptocurrencies are near this year’s lows, as the sell-off has been sharp and broad-based. However, despite the Terra/Luna crash and some funds closing to redemptions, the correction has been orderly, and the market remains stable, an encouraging sign. Still, it may take some time for sentiment toward crypto to recover, delaying the broader adoption, but it should not derail it. Fed tightening and risk-off sentiment are not helping at the moment, but crypto correlation to stocks should prove supportive over the second part of the year.

 

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