By Stuart Paterson
Few could have imagined just how different the last two years have been to one another.
In the 12 months to July 2021, equity markets soared, spurred by vast government and central bank stimulus, the gradual retreat of Covid-19, and expectations for a strong reopening-led recovery in economic activity.
One year later, investors have endured an environment the likes of which many have not experienced before. Developed market equities posted their worst half of the year in over 50 years and there has been no reprieve within the relative safety of bonds, which in some cases have seen double-digit declines, a phenomenon not seen for centuries. There has been virtually nowhere to hide in such an indiscriminate sell-off, with only commodities delivering positive returns among major asset classes.
It’s hard to avoid such grim news as of late,
but it’s important to put things into context.
The recent bout of volatility has been prompted by central banks playing catch-up to increased inflationary pressures. The “front-loading” of the monetary tightening cycle has now contributed to a very apparent slowdown in growth. This
can be seen most notably in the US housing market, while there is also broader weakness
in manufacturing and retail.
At least in the eyes of the Fed, this was a harsh but necessary course of action to put the brakes on demand and counter inflation.
Markets have now gone some way to pricing in a growth slowdown. Cyclical industrial commodities that are more sensitive to changes in economic activity have recently seen substantial draw-downs. Market-based measures of inflation expectations have also started to roll over, so much so the bond market expects the Fed to start cutting rates next year, albeit after a short but sharp rising cycle in the coming months. This is despite Fed chairman Jerome Powell’s hawkish stance increasing further – recently citing one percentage-point rises are not off the table due to the strength of the economy. This is noteworthy as it is the first time in eight months or so the bond market is not aligning with central bank guidance.
These forces have fuelled a vociferous debate as to whether the US economy is imminently heading for a recession. We still believe any recession will likely be short-lived and may be technical in nature (as defined by two consecutive quarters of negative GDP growth). We acknowledge the headwinds facing the economy and particularly the consumer in the face of a surge in the cost of living, but corporate and household fundamentals are, on balance, still in decent shape.
The truth is that a “proper” recession should involve the labour market, given the importance of consumer spending to the overall economy. Should employment hold up, so too should the consumer and thereby the economy. Despite the doom and gloom, US employers added more jobs in June than forecast and the unemployment rate remains near a five-decade low at 3.6%. At least where the labour market is concerned, there is yet little sign the US economy is entering a recession.
We should also remember the post-pandemic recovery somewhat blurs the conclusions that can be made about the economy. The slowdown in demand for real goods and industrial production would normally be consistent with a recessionary environment, yet this is perhaps more reflective of a shift in spending patterns back towards services. This can be seen by strong demand for travel and leisure activities despite broader concerns for the consumer.
With that all being said, what should investors do? Consistent with a tightening of financial conditions perhaps as intended by central banks, 2022 has brought about a revaluation of all major asset classes as seen by higher bond yields, wider credit spreads, and lower equity multiples. Arguably, the opportunity set has now improved. Identifying inflection points in markets is nigh on impossible and often the best thing is to do nothing, yet portfolios must now be adjusted towards assets that can perform throughout an inflationary period.
Equities continue to be our asset class of choice in such an environment as they provide investors with a claim on a firm’s assets that are used to provide goods and services in the real economy. Just as share prices can become so high they are no longer tied to company fundamentals, so too can panic selling lead to investors becoming unduly pessimistic about the long-term prospects of a business. In the case of the latter, this means there are opportunities to identify undervalued assets.
This is where active stock selection is of increasing importance as companies navigate this challenging backdrop with varying degrees of success.
Stuart Paterson is executive director of
Julius Baer International.