UPDATE OF OUR INVESTMENT THEMES FOR SEPTEMBER 2022

Start of a new bull, or pause in the old bear?

Stock markets have recovered a little, now what?

A summer mini-rally in stocks

The summer months have seen stock markets recover nearly half of the ground lost since the start of 2022. The US S&P 500 index has recovered from a 23% year-to-date fall in mid-June to just -12% by late August. In euro terms, the MSCI World index is today only just over 1% below its 2022 starting level once dividends are included.

Reasons for pessimism abound: however, economic recession worries continue to loom large as high inflation rates hold back corporate and consumer spending, particularly in Europe where sky-high energy costs weigh heavily. The US, Europe and China all have their own economic difficulties, with no major bloc able to act to power the global growth motor.

False hope or start of a true market rally? Are we likely to see a resumption of falling stock markets later this year, or is the recent mini-rally the start of better times ahead for stocks? Is all the bad news already priced in?

Which indicators to watch for hints of market direction?

Certain factors support stocks at the moment: financial conditions have improved, and investors are already very pessimistic, usually a good contrarian buying signal. The peak in US inflation is likely already past, with many forward indicators pointing to lower inflation over the months ahead. Lower inflation prints may allow the US Federal Reserve to scale back further interest rate hikes before year-end, allowing financial conditions to loosen and support risk assets.

US inflation remains the key market driver: the direction and speed of the path of US inflation remains the key to financial markets. A disappointingly slow decline or even a stubbornly high inflation rate would drive fears of a deeper recession, higher bond yields and the risk of a bigger fall in corporate earnings. In contrast, a speedy decline in inflation thanks to weaker housing, goods and petrol prices could allow real bond yields to fall, and also improve the chances that US corporate earnings remain robust. This would benefit stock, bond and credit markets.

Themes: energy efficiency/conservation, food & water security, focus on income

The current energy crisis is forcing households and companies to embrace measures to reduce energy consumption in the short term. Record energy prices will further spur investment in low/zero-carbon energy generation and infrastructure, plus energy efficiency investments related to heating, lighting, transportation and production of goods and services. This fits neatly with our circular economy investment theme, focused on minimising resource and energy usage, improving durability of products and reducing waste. The energy crisis also indirectly impacts our food & water security subtheme, given the energy-intensive nature of production of nitrogen-based fertilisers. Higher energy prices are thus forcing up the cost of food, while widespread droughts over this summer have underlined the need to prioritise water security for drinking and for agriculture.

The recent rise in both short- and long-term interest rates, combined with the fall this year in stock, bond and credit markets, offer a long-awaited opportunity to invest at higher bond and dividend yields, at a time when high inflation continues to erode the value of low-yielding bank deposits.

Economic Outlook and Interest Rates

Looking for some relief

Economic indicators stabilise

There are lots of reasons to be pessimistic about the global economy: growth is slowing sharply in the US, Europe and China for different reasons. Europe is increasingly likely to enter an economic recession due to record high gas and electricity prices. We will monitor whether the rate of fall in leading economic indicators decelerates. In the past, this has often been a trigger for investor risk appetite to return. We have seen encouraging signs from business surveys and consumer confidence in the US. However, in Europe, any macro improvement should occur somewhat later. 

Inflation is still key

Inflation rates have been very high almost everywhere, pressuring household budgets and resulting in weaker consumption. European industry is cutting back on production in response to very high energy prices, constituting a big drag on economic growth. In the US, we have seen a peak in inflation. Recent data show that consumer price inflation (CPI) has fallen since March for most core inflation measures. While inflation should trend downwards, we think it will remain solidly above target throughout 2023. In the eurozone, second quarter inflation averaged 8.0% before reaching 9.1% in August. We do not expect a peak until it approaches 10% in late autumn. The normalisation process thereafter should be slow and highly dependent on the evolution of energy prices. Inflation should stay above the ECB’s target until late 2023.

Looking for stabilisation in interest rates

The peak in US inflation should be confirmed over the coming weeks. In the US, we see a terminal Fed Funds rate at 3.50%, to be reached by the end of the year. We no longer envisage rate cuts in late 2023. In the eurozone, we foresee the deposit rate at 1.50% by year-end and at 2.25% by Q4 2023. Bond yields have risen over the summer. We maintain our 12-month target for the 10-year yield at 3.25% in the US and 1.75% in Germany. The current levels suggest limited upside for bond yields. The difference between short and long-term maturities is quite small and therefore we prefer short-term maturities. We have a preference for higher quality corporate bonds. Companies show strong balance sheets thanks to debt reduction and refinancing during this low yield environment.

Risk aversion took the USD to record levels

The value of the euro (EUR/USD) has been hovering at around 1 in recent weeks. The growing risk of a European gas crisis owing to disruptions in Russian exports is weighing on the demand for the euro. The dollar’s safe haven status is another key factor. Both the interest rate differential and long-term fair value estimates (purchasing power parity) suggest that once risk aversion stabilises, the euro should appreciate gradually. We were formerly too ambitious in our expectations for a re-appreciating euro. Our new 12-month EUR/USD target is USD1.08 per 1 euro (previously USD1.12).