#Market Strategy — 18.07.2022

2022 Mid-year Outlook: Pains Before Gains

Investment Navigator - Asia, Summer Edition, 2022

Prashant BHAYANI CIO Asia, Grace TAM Chief Investment Advisor, Hong Kong & Dannel LOW Investment Specialist at BNP Paribas Wealth Management


  • Market concerns have shifted from inflation shock to recession risk. The financial and economic indicators suggest a 35% probability of a US recession in the next 12 months.
  • Potential “pains” include (1) corporate earnings downgrades; (2) still plenty of room for investor to reduce equity positioning given still heavy exposure; and (3) highly leveraged high yield companies could be under pressure with fast surging borrowing costs.
  • Potential “gains” after “pains” are the Fed pivot and more clarity on political and policy directions after China’s 20th Party Congress held in autumn this year.

How large is the recession risk?

Market concerns have recently shifted from inflation shock to recession risk as central banks remain hawkish and tighten aggressively when economic growth is already slowing significantly. US 1Q GDP growth is -1.2% (qoq saar). The Atlanta Fed GDPNow forecast (a nowcasting model) is currently at -1.9%. This indicates that a technical recession (defined as two consecutive quarters of negative growth) may already be underway.

The traditional definition of a recession by NBER (National Bureau of Economic Research) is that a significant decline in economy activity is spread across the economy and that lasts more than a few months. For now, there are still no broad-based weaknesses, especially the US job market remains very strong (a lagging indicator though).

There is no doubt that the risk of a true recession is rising. Different indicators are showing different probability of a US recession. On average, the financial and economic indicators currently suggest a 35% probability of a US recession in the next 12 months. 

The Probability of A US Recession

How much recession risk has the market priced in?

Despite a 21% drawdown YTD in the S&P 500, it seems that the market has yet to fully priced in a US recession scenario as average drawdown over the past 9 recessions since 1950s was 34%. The drawdown so far represents a 65% probability of a US recession. Moreover, investment grade bond spreads and yield curve are still pricing a much lower probability of a recession.

Why more “pains” are likely in the summer months?

Firstly, consensus earnings estimates look too optimistic with 2022 earnings growth forecast for US still at +9.5% amid rising risk of a hard landing. The average earnings drawdown of S&P 500 in the past 9 recessions is -17%. We could see significant downgrades in earnings forecasts during/after the upcoming earnings reporting season if results (a lagging indicator) do not beat consensus. A downward trend in earnings revisions usually does not bode well for equity market.   

Secondly, despite the very bearish/fear investor sentiment according to different sentiment/survey indicators, investors’ positioning remains heavy on equities. While there has been notable outflows in credit with cumulative flows of investment grade, high yield and EM bonds down over 40% from the 2021 peak, equities barely see any net outflows amid sharp corrections in returns YTD. 

Read Investment Navigator June 2022 - Equities Depend on The Good, Bad, & The Ugly and Why High-Quality Bonds Are Worth a Look

S&P 500’s earnings drawdown
Significant outflows
High yield spread

Thirdly, if earnings growth is set to fall, companies in particular high yield corporates with high leverage could be under pressure amid surging borrowing costs and tightening financial conditions. High yield spreads have been widening but they are still not consistent with the levels seen in past recessions.

What are the potential “gains” after “pains”?

The Fed pivot - Don’t fight the Fed! So the market believes that when the Fed makes a dovish pivot, we could see a relief rally in risk assets. However, the bar for a Fed pivot is high as they had been behind the curve and their major concern is that the elevated inflation could become entrenched. In the near term, the Fed would still want to sacrifice growth to restore price stability as they can only affect the demand side of the inflation equation but cannot do much on the supply side.

What could trigger a Fed pivot?

1) A sustained decline in headline inflation – We believe US inflation may have peaked/will peak soon. While prices in the services sector continue to pick up, food and commodities prices are falling. There are more signs of easing in supply chains disruptions. Long-term inflation expectations are also falling.

2) A “credit event” with systemic threat – This is hard to predict, but a fast tightening cycle may trigger a major financial accident, giving the Fed no option but to ease. 

3) Significant rise in unemployment rate – This is less likely in the near term as the US job market remains very tight, while the problem of lack of labour supply should ease gradually with fading impacts from the pandemic.

We expect the Fed to hike another 75bp in July and 50bp in September. As the Fed funds rate would exceed the neutral rate by then and inflation is expected to decline, we expect a slower pace of tightening with 25bp hikes in November and December, respectively. Hence, the policy rate will reach 3.5% by end-2022. This is our terminal rate forecast for this cycle as the Fed may need to cut rates in 2H 2023 as the focus would be shifting to avoid a recession.

More clarity after China’s Party Congress -  The 20th Party Congress (held every 5 years) that will be held in autumn this year will announce major leadership changes. More certainty on political and policy directions should benefit Chinese assets.

Some relaxation in Covid restrictions, re-opening of economy,  easing measures and potential completion of regulatory crackdown have lifted investor sentiment. For now, we prefer to play China via A-shares which are more domestically-driven as offshore Chinese equities are more vulnerable to a volatile global equity markets. We expect some consolidation in A-shares in the near term after a strong rebound in June, while corrections are buying opportunities.   

STRATEGY: Quality & Protection

  • As we expect market volatility to stay high in the near term, investors should consider bringing Quality and Protection to their portfolios. Instead of holding too much cash which offers negative real returns, investors can focus on income and alternative strategies.
  • We stay defensive in the short term and remain neutral in equities (downgraded from positive since February 2022 against consensus views) and upgraded US governments bonds to neutral from negative recently. We favour short-to-medium duration investment grade bonds which offer the highest yields since 2018 (4-5%) and quality stocks with pricing power and sustainable dividend yields.
  • It is important to build satellite allocations from private equity, private real estate and hedge funds  in order to diversify and lower overall portfolio volatility as they tend to have lower correlation with traditional asset classes. (For further details, please refer to our Investment Navigator – Asia Edition in May 2022 “Diversification is the Only Free Lunch: Alternatives in a Volatile Market” )

Asset Allocation for July 2022

Overview of our CIO Asset Allocation for July 2022