Where do we stand on Markets at this point of the year…
[Invest. Pro.] Intended for Professional Clients in accordance with MIFID.
Article written on June 30th, 2022
How do you assess current market conditions?
Investors are currently facing exceptional economic and financial conditions. The major global inflationary shock, caused by an equally exceptional combination of structural and external factors, brings us into a period of great uncertainty:
- In China, the continuation of the Covid epidemic does not make it possible to envisage a rapid and definitive lifting of the constraints weighing on the economy. In addition, the real estate bubble continues to burst and considerably reduces growth prospects.
- In Europe, the war in Ukraine is a long-term one. The sanction mechanism, combined with shortages affecting agricultural production in particular, is generating pressure on all raw materials and exacerbating already strong inflationary pressures.
- In the United States, the very robust post-Covid recovery, fueled by massive support plans, triggered a reflation cycle. Widely desired a few months ago and maintained by very accommodating monetary conditions, the dynamic of rising prices is now out of control. A price/wage loop has indeed been set up and is fueled by the tensions mentioned above (supply shock, shortages, explosion in commodity prices, etc.).
After a period characterized by increasing globalization, structurally accommodating financial conditions, abundant liquidity and non-inflationary growth, we are now entering a major adjustment phase in global economic and financial conditions. Central banks must quickly correct excesses of the past, including the massive, immoderate responses to the Covid crisis in 2020, at the risk of losing all credibility.
From 1999 to 2021, we have experienced a structural downward trend in interest rates and a positive correlation between equity markets and treasury yields. This environment was particularly favorable to passive asset allocation strategies. In an inflationary world, the relationship between the evolution of equity markets and interest rates comes back to a less favorable pattern. Diversification between asset classes is considerably reduced. This new environment requires a dynamic exposure to the different asset classes and to each market to manage global risk.
Source: Seeyond, Bloomberg, as of June 24th, 2022
Moreover, Central Banks’ constant management of inflationary pressures should make the economic cycle more volatile. Markets will be more sensitive to changing macroeconomic conditions and less driven by liquidity.
We have now entered a transition phase which translates into a sudden and structural rise in interest rates and a significant adjustment in equity markets’ valuation. This adjustment will probably last several quarters. Recent trends in bond yields and equity markets have already partly factored in this new environment. Nevertheless, we believe that inflationary pressures will remain for several years and that the markets do not fully integrate this new environment yet. The decline in consumer purchasing power is considerable. Pressure on corporate margins should quickly become unsustainable as consumption slows. And unlike in past years, Central Banks will not intervene as quickly to avoid recession. The famous “FED Put” is gone.
What is your forecast or expectation of the market?
Unlike the previous years, we do not expect the markets to recover quickly enough to erase the recent fall in equities and the rise in bond yields in a few months. Our current views (cautious on equity and government bonds) are consistent with remaining risks and potential new market adjustments.
The structural level of volatility in interest rates and equity markets is adjusting upwards. Shorter and more violent cycles are to be expected, complexifying even more the forecasting exercise.
In the short term, we estimate that the equity markets will yet adjust by around 10% before finding valuation levels integrating the upcoming economic slowdown. Bond yields should stay close to current levels or tighten slightly further. Yield curves should flatten or even invert, especially in case of recession.
In the medium term, market developments will depend on the extent of this slowdown and inflation. This context itself will also depend on the evolution of the health situation in China and the war in Ukraine. The magnitude of the slowdown and the inflation dynamics will be the main market catalysts in the coming months. We estimate the probability of a global recession next year to be close to 50%.
If global economy were to go into recession – a scenario that is not yet integrated in market valuation - our models would most certainly lead us to further downgrade our view on global equity and to increase our assessment on sovereign bonds.
This article has been provided for information purposes only to professional clients as defined in the MiFID Directive. It must not be used for retail investors. The provision of this material or reference to specific sectors or markets in his article does not constitute investment advice or a recommendation or an offer to buy or sell any security. Investors should consider the investment objectives, risks, and expenses of any investment carefully before investing. Views expressed in this article as of the date indicated are subject to change and there can be no assurance that developments will transpire as may be forecasted in this article.