Pause and assess
- Any indication of a pause in hikes, especially from the Fed, should boost markets further
- Sentiment is extremely negative, which could support the upward move
- Softness in labor and inflation data would be key for investor sentiment
After a horrendous September and a tough start to October, markets have staged a strong rebound over the past few weeks. The consensus remains overarchingly negative, and most expect this to be “just another bear market rally”. However, the conditions do seem to be aligning for a rally into the end of the year. Indeed, we are seeing a growing number of indications that growth is slowing, and inflation is cooling, which should allow the Federal Reserve to “pause & assess” after the most aggressive monetary tightening cycle of the past 40 years.
While many have been talking about a Fed pivot, the term is, in our view, misleading. A pivot suggests a 180 degree turn in policy, which is not happening anytime soon. In fact, the Fed has been clear about staying higher for longer, working hard to push back against interest rate cuts that markets have priced in for the end of 2023. Still, that is a year away, and in the meantime, monetary policy is set to remain restrictive. Nonetheless, we are likely close to the end of the more aggressive part of the tightening cycle, and any indication of a pause in 2023 would be welcome by investors, as they have had to continuously adjust hiking forecasts throughout 2022.
The European Central Bank did a dovish hike in October, as did a number of other central banks, indicating that the pace of tightening is likely to slow as central bankers assess the impact of the hikes that have already been carried out to date. Many Fed speakers have started to indicate the same. The European growth and inflation backdrop remains very different from the US, suggesting the Fed needs to see more softening in the labor market and in hard inflation data to be able to take its foot off the table with some confidence their hard work will not be reversed.
For now, we believe that the recent rebound has legs. Plenty of questions remain for 2023 and there are some key risks to continued upside over the coming quarters, but, markets are currently pricing enough tightening and softness in earnings to see markets continue their recovery into December, especially if disinflation signals continue. The earnings seasons has been better than feared so far, despite some big misses from big tech, and investors already expect further downgrades to the 2023 earnings outlook. With such negative expectations and such bearish positioning, the bar is lower for upside surprises over the coming weeks.
We maintain a balanced allocation with a decent exposure to equities, as we believe this rebound can continue, even if it is not in a straight line. We still hold a healthy cash allocation as a cushion for further volatility and as dry powder for clearer skies over the medium-term. We expect the tech sector to hold up, as shown by some resilience across the sector despite big name misses. Yields and the dollar may finally be peaking, which should also support sentiment into the end of the year. With the latest spike in yields likely showing the peak for now, we continue to rebalance between credit and sovereigns. Caution remains de mise as the Fed is unlikely to turn dovish overnight, but a slowdown in the pace of tightening around the world should provide a catalyst for further upside.
October ended with a strong rally across equity markets, with indications from central bankers that they are thinking about taking their foot off the tightening pedal boosting sentiment. Abounding signals that disinflation is happening, and that growth is starting to slow have helped as well. Coupled with ongoing expectations that this rally will fizzle and that markets have further downside that have brought extreme bearish positioning, we believe this bounce can continue into the end of the year.
Defensives have been leading the way, which may continue given the fragile growth backdrop and uncertainty about the outlook for 2023. Tech as a whole has held up well considering the big misses we saw from some big tech, and further drops in yields should bring support to the sector. The European growth backdrop remains a concern, and earnings should suffer in 2023, suggesting it will underperform the US. President Xi’s consolidation of power has scared investors, as the growth backdrop remains poor and the regulatory crackdown and the zero-Covid policy may be not over.
The latest spike in yields was quick and violent, but the peak should finally be in, especially as central banks are indicating more and more that the most aggressive part of the tightening cycle is arriving to its end. This doesn’t mean cuts are coming, but that a pause to assess the impact on growth is likely. In this context, we continue to rebalance between credit and sovereign debt, as spreads could still widen on growth fears. Within credit, we maintain a preference for investment grade over high yield, as growth fears are not behind us, though any strong rebound in equity markets should lift the higher beta high yield segment with it.
The dollar remains king, underpinned by strong fundamentals. In addition to historically high levels of US real rates, a stronger growth backdrop should maintain inflows to the US economy and, as a result, bring underlying support for the dollar. Although EUR and GBP have recovered from oversold levels, further upside potential remains limited as both currencies continue to be affected by worries about recession and the ongoing energy crisis. We expect the Japanese yen to remain under pressure as the Bank of Japan sticks with its accommodative stance and intervention may not be a match for interest rate differentials.
The recent decline in the dollar has helped commodity prices generally, but we don't see much support for the trend as global demand is unlikely to increase significantly given growth concerns and liquidity constraints. Still, we remain optimistic about oil as OPEC+ acts to maintain high prices, oil producers as a whole have limited spare capacity. Regarding gold, it may be too soon to get excited, but the yellow metal is starting to appear alluring given the risk of stagflationary climate on the horizon.
The cryptocurrency market has fared well recently, recovering over October. However, as long as the market continues to face liquidity withdrawal, a robust rally is unlikely to occur. The good news, though, is that the strong correlation between Bitcoin and other risk assets (notably Nasdaq) is coming down, which should support the asset class in the coming months. As investors begin to weigh diversification benefits in their portfolios, this could restrengthen crypto’s appeal and resume flows towards crypto assets.