- Elevated economic uncertainty, rising inflation, and investor expectations of a downshift in global growth from the stellar rebound of 2021 were already underway at the start of 2022.
- New shocks—Russia’s invasion of Ukraine and the reinstatement of COVID-related shutdowns in China— significantly worsened the trend of lower global growth and higher inflation this year.
- Increased inflation pressure has forced central banks to adopt even more aggressive rate hiking postures to recover lost credibility, creating a greater drag on growth.
- Meanwhile, the war in Ukraine is turning out to be a protracted conflict, proving to be a more persistent external shock than investors may have anticipated.
- Reinstatement of lockdowns in China has acted as an impediment to growth and another obstacle to sorting disruptions in global supply chains.
- Europe continues to bear the greatest exposure to both the Russia/ Ukraine conflict and to slower growth in China and thus carries the highest recession risk among major developed economies.
- The US economy is relatively more insulated and remains supported by a strong labor market for now. Nevertheless, headwinds including higher gasoline prices, negative real wage growth, and negative wealth effects from declining financial markets persist.
- Significant fiscal drag and signs that the previously red-hot housing market is slowing under the weight of higher mortgage rates and low affordability provide additional headwinds for the US.
- Central banks continue their attempts at walking a tightrope, looking to balance an intensifying inflation problem with increasing risks to growth stemming from multiples shocks and policy tightening.
- After initially misjudging the inflation problem as “transitory” and thus facing credibility challenges, central banks are likely to front-load rate hikes, increasing the risks of policy overtightening and economic downturn.
Market Outlook & Investment Strategy:
- Rising recession fears gripped global markets this quarter as an unpleasant combination of macro events led stocks into bear market territory and investors assumed a “risk off” stance across most asset segments.
- Declines in bonds (the flip side of higher rates) were also substantial with the bond bear market growling even louder. The Bloomberg Global Aggregate Index extended its losses, falling 15% from its January 2021 high, the biggest drawdown since 1990.
- The decline in stocks was driven primarily by the significant compression in earnings multiples.
- All major equity regions are now trading at a discount to their 10-year averages; however, multiples could see more downward pressure in the near term as inflation runs hot and central banks stay vigilant.
- Corporate earnings have been a key pillar of support for stocks during the recovery from the pandemic and analyst forecasts for 2022 are still upbeat. However, we see significant scope for earnings disappointments in the second half given tighter financial conditions and macro headwinds.
- US dollar strength and souring CEO confidence underscore the risks of downward revisions to US corporate earnings expectations.
- Commodities still stand out as a shining-star asset class and an attractive hedge in the current inflation-prone economic context.
- Beyond near-term volatility, bonds may consolidate as the summer unfolds, especially if investors gain visibility that the inflation rate is following growth lower.
- The tough macro environment argues for caution on fixed income risk assets. However, some bond segments exhibit very attractive value (emerging market debt), while others have yet to fully price in recession risk (US high yield debt).
- Despite significant equity market declines and improved valuations, we remain cautious on stocks due to the combination of heightened recession risk, hawkish central banks, and significant risk of corporate earnings downgrades.