Investment Strategy Focus: September 2022

Summary

1. What will drive risk-on (stocks higher) or risk-off (stocks lower) behaviour? The direction and speed of US inflation momentum (lower/faster better for risk); the direction of financial conditions (looser is positive); and stabilising economic activity (watch PMI surveys). Still too early to upgrade  stocks or credit, in our view.
2. High energy prices depress growth: energy  costs continue to exert a heavy economic toll in Europe. If natural gas and electricity prices  remain at current levels for an extended period, we would expect European financial markets to suffer from weaker earnings. We upgrade crude oil to positive, downgrade base metals to neutral.
3. The US dollar is a key swing factor for risk: an even higher US dollar would depress stocks, emerging markets and commodities. In contrast, if the US dollar peaks now and begins to decline (if the Federal Reserve softens inflation-fighting policies), this could be positive for markets. We adjust our 12-month euro forecast to USD1.08.
4. Did you know? Lows in US consumer sentiment are a good predictor for US stocks: when US consumer sentiment has plunged to a low in the past, US stocks then have rallied over the next 6-12 months. Peak economic pessimism today could suggest better times ahead…
5. Key idea in focus - Infrastructure still an attractive asset class: holding up well in 2022 (especially in euros). Infrastructure delivers stable income growth and benefits from strong institutional demand for real assets. We favour exposure to global infrastructure funds.

Markets Outlook

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

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. Japanese stocks have even recovered to nearly flat for this year, while UK stocks remain above January levels. 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: to be clear, 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?

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. US 2-year and 5-year inflation swaps have eased back to 3%. 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, raise the potential for US corporate earnings to remain robust and could drive a substantial loosening in financial conditions, boosting stock, bond and credit markets.

Investment Conclusion

The likely downward path in US inflation (i.e. US inflation swaps fall to 3%) over the remainder of this year and into 2023 should encourage investors. However, much uncertainty around future US Fed Funds rates remains, holding bond and credit markets back. It still feels too early to take a positive stance on either stocks or corporate credit. Watch inflation expectations, real bond yields and the US dollar for hints to market direction.

The Macro Picture

Focus on US inflation and economic indicators

Negative factors are plentiful and obvious: economic growth is slowing sharply in the US, Europe and China for different reasons. Europe in particular is ever more likely to experience some sort of economic recession due to record-high gas and electricity prices. So global growth is weak. The key will be to monitor whether the rate of fall in the leading indicators slows (second derivative). This has often been a trigger for risk appetite to come back.

Inflation rates have been very high almost everywhere, putting a lot of pressure on households who then consume less as a result of the rise in prices. European industry is also cutting back on production because of the very high energy prices. So that is a big drag on economic growth.

Higher rates: in addition, central banks such as the ECB in Europe and the US Federal Reserve are raising interest rates, in order to slow inflation. But this comes at a price.

Some signs of resilience: European economic activity remains surprisingly resilient. But this can only persist if energy prices ease back further in the near term.

Three factors we follow very closely: firstly, we believe the US inflation rate has peaked, but how quickly is it going to decline in the months ahead? Components such as housing, goods and even petrol prices are all falling quite quickly, suggesting that inflation should fall. We await confirmation that US inflation is declining relatively quickly.

Secondly, European energy prices continue to surge in the lead-up to the 3-day Nord Stream 1 Russia-Europe gas pipeline shutdown. Will limited natural gas exports from Russia to Europe continue? This is our assumption, and we can expect European energy prices to decline. The peak in inflation will come with some delay, probably in November.

Thirdly, the US dollar has been incredibly strong over the last few months. This puts pressure on the global economy and on global markets, particularly on developing economies. Any inflection in trend to a weaker US dollar would tend to boost financial markets. This, in turn, will rely on a signal from the Federal Reserve that they will slow or even stop tightening monetary policy.

Investment Conclusion

Growth is slowing sharply in the main regions. Europe is likely to experience a temporary recession due to record-high gas and electricity prices. The key will be to monitor whether the rate of fall in the leading indicators slows. US inflation has probably peaked and the eurozone should follow around November. This should take some pressure off central banks and will be key for financial markets.

Focus: are peak energy prices behind us?

Europe suffers record gas, electricity prices

Russia continues to restrict natural gas exports to Europe: since end-2021, Russian piped gas exports to European Union (EU) countries have been cut by 70% (as at August 2022). Gazprom continues to restrict gas exports to certain countries including France, keeping the benchmark Dutch natural gas price at record levels, circa 5 times the average level in August 2021.

But almost balanced by increased gas imports elsewhere: we should note that total gas flows to the EU have only fallen by 5% versus October 2021 levels. This has been achieved through increased imports from other countries, largely in the form of Liquefied Natural Gas (LNG) shipments from Qatar and the US.

EU gas storage levels have exceeded the targeted 80% level: most European countries (except for the Netherlands) have already exceeded the EU 80% target for natural gas storage set for 1 November. If Russian gas flows are not completely shut off, then Europe can still navigate winter without the need to ration gas.

Oil prices ease back. Note that crude oil prices have returned close to their pre-Ukraine conflict levels, while retail petrol and diesel prices have registered substantial declines of late. Lower oil prices will help to calm inflation in time, and will take off some of the energy-related pressure on households and companies. Key here will be a continued effort to reduce oil and gas demand across the board, with restrictions in particular on energy-intensive production of aluminium and nitrogen fertilisers.

Investment Conclusion

There are clear signs of reductions in gas and oil product demand in the US and in Europe, due to today’s abnormally high energy prices. More demand adjustment should be made in coming months to ensure that Europe can get through winter without imposing gas and electricity rationing. We upgrade our crude oil view to positive within commodities (base metals downgraded to neutral), and see the current environment as still positive for both oil & gas and low carbon/renewable energy producers.

Bond, Credit and FX Outlook

Uncertainty around rates remains high

All about central banks: following the recent Fed member speeches and more precisely the comments by Jerome Powell at Jackson Hole, our scenario is for a “lower-for-longer” terminal fed funds rate. The peak in inflation should be confirmed over the coming weeks and should help the Fed to stop hiking at 3.5% by December 2022 which is a less restrictive level than in previous tightening cycles. The rate would stay there throughout 2023. Given the extreme  inflationary pressures, we think the debate for the ECB is biased towards higher-than-expected policy rates. We expect 1.5% for the ECB policy rate at the end of this year and 2.25% at the end of 2023.

The upside for bond yields is limited. We keep our 12-month target for the 10-year yield at 3.25% in the US and 1.75% in Germany. The difference between short and longer-term maturities are such that we prefer short- to medium-term maturity bonds.

Preference for higher quality corporates. Corporate fundamentals are probably at their peak. Companies keep strong balance sheets thanks to debt reductions and refinancing during the low yield environment. The risk of default is thus relatively limited for investment grade companies despite the fall in economic activity. Too early to return to high yield corporates.

Risk aversion has led the USD to record levels. The value of one euro (EURUSD) is hovering at around 1 in recent weeks. Risks of a European gas crisis linked to a disruption in Russian exports have risen a lot of late. This has been weighing on the demand for the euro. The safe haven reputation of the USD has been 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 gradually move higher. Our initial targets look too ambitious. We thus revise our 12-month target from USD1.12 to USD1.08 (value of one euro).

Investment Conclusion

We maintain our 12-month target for 10-year bond yields at 3.25% in the US and 1.75% in Germany. Given the shrinking difference between short- and longer-term maturities, we prefer short-/medium-term bonds. We prefer US investment-grade corporates. Interest rate differentials and long-term fair value estimates (purchasing power parity) suggest that, once risk aversion stabilises, the euro should gradually move higher.

Equities Outlook

New bull market or end of bear market rally?

Inflation is ultimately the key. 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 -23% year-to-date in mid-June to -12% for the year so far by late August. Japanese stocks have even recovered to nearly flat for this year. For this recovery to be sustained, US inflation needs to ease steadily to year-end.

Real yields stabilise: stock market valuations have recovered a little on the modest retracement in US and European real yields. But a sustained move lower in the US 10-year real yield is required to support average or above-average P/E valuations.

Regional allocation: still like the UK, Japan

Currency weakness has been a boon for the UK stock market (helped by strong Oil & Gas and defensive sectors) and also for Japanese stocks, given its strong export bias. We continue to favour these two markets.

Energy still in focus: both the global Oil & Gas sector, and Renewable/Energy Conservation/Efficiency stocks.

Statistics suggest no new S&P 500 low

Historically speaking, the 15 bear markets in US stocks since 1958 have never seen new lows established, once 50% or more of the bear market drop has been recovered (as today). On average, following a 50% recovery from bear market, the S&P 500 has gained 7% over the next 3 months, 11% over 6 months and 19% over 12 months.

Depressed consumer sentiment could be a contrarian buy signal for US stocks

Each time that US consumer sentiment has sunk to lows and then rebounded, US stocks have subsequently performed strongly over the following 12 months. This is thus a good contrarian indicator, delivering double-digit returns over 12 months each of the 6 times that we have seen this type of setup since the 1970s.

This remains a good reminder that some of the best buying opportunities arise when everyone is already very pessimistic.

Investment Conclusion

The direction in US inflation, financial conditions and real yields will guide our view on stocks over the next few months – we retain a neutral stance for now. Unless we see lower inflation and real yields and looser financial conditions, stock markets should trade sideways or even decline to new lows, given the pressure on 2023 earnings estimates. In Europe, any sustained fall in record energy prices could prompt a rally in unloved European equities, following heavy outflows so far this year.