The first half of this year has delivered several adverse shocks that dramatically raised inflation and significantly weighed on growth.
Markets have undergone a hawkish repricing as investors weigh the possibility of lower growth in a new era of quantitative tightening. This is further complicated by the potential consequences of higher interest rates with unprecedented levels of public and private sector debt in the system.
Given these dynamics, are markets accurately pricing recession risk, or is the reaction overblown?
Equity return can be thought of as the sum of the change in valuation, the change in forward earnings estimates, and dividends. Analysts suggests that the year-to-date decline in the S&P 500 Index was almost entirely driven by valuation compression. Meanwhile, both forward earnings estimates and dividends increased.
When combined with an assumed fading of shocks that reduce inflation, these strong fundamentals and the healthy private sector were anticipated to deliver above-potential growth in H2 2022.
However, as said by Goldman Sachs, the recent rally seen in global equities since mid-June is a bear market rally rather than an inflection point marking the start of a new bull market, largely a reflection of growing confidence that inflation is reaching a peak and that the interest rate raising is closer to an end than previously feared.
Despite this, reality has reasserted itself over the last month with markets unable to escape a tricky macro backdrop characterized by central banks speeding up rate hikes into what is a deepening economic slowdown. In the last couple of weeks alone, economists have raised their forecasts for ECB rate hikes and cut their GDP numbers to signal a deeper upcoming recession.
Indeed, analysts predict further weakness of the market before a decisive trough is establish, and there could be three different explanatory reasons: inflation, economic growth, and valuations.
First, inflation rates may be close to a peak, but the levels of inflations may stay elevated for some time, putting upward pressure on rates relative to current market pricing. The so-called soft-landing scenario for the economy presents a narrow path to be reached, that requires policymaker to slowdown GDP growth below-potential pace, re-balance supply and demand in the labour market, impeding wage growth to impact inflation rates.
Second, the economic growth is likely to weaken. Strong private-sector balances may help to moderate any economic downturn but most of the turmoil that industries are facing stem from profound supply-driven issues, not demand. And mostly, it is not clear as peak in interest rates alone will provide lasting solution.
Contemporarily, labour and commodities may contribute to weaker growth and lower profit margins, and even though there could be chance of a relatively shallow recessions compared with those in the recent past, there is still a greater than even chance that investors will price more recessionary risk as interest rates continue to rise.
The last explanatory factor is that valuations are not at extremes: inflations is just one of the triggering factors, but most importantly, central bank-induced tightening in financial conditions explained most of the valuation compression and much of the sell-off. Notably absent was any meaningful attribution to changes in expectations of earnings and dividends.
It appears clear as the market have entered a new regime of higher macro and market volatility, a by-product of multiple, concomitant, and complex factors.
Opportunities remain to achieve an orderly macroeconomic adjustment that leads to sound financial outcomes. However, it is believed that investors should factor in the implications of investing in a new market regime, even by shifting their investment strategy.
Over the last 20 years there has been a close relationship between interest rates and equity valuations, whereby higher rates lead to lower price to earnings ratios. Hence, the fact that central banks are still in the early stages of their hiking cycle suggests a high probability that PE ratios have further to fall.
In addition to higher base rates, the pace of quantitative tightening is also speeding up, with forecast of higher sovereign yields ahead. In Europe, the ten-year bond yields may rise to 2% or more later this year, which will be consistent with a further fall in Europe’s PE ratio to around 10x or so.
There is an additional expectation that the European economy will slow over the next couple of quarters and this should put pressure on corporate profits which have been resilient so far this year.
Looking forward, models are flagging large downside risks to earnings estimates for the next 12 to 18 months. To provide some additional context, there is consensus suggesting that companies could face the largest year on year drop in corporate margins since the global financial crisis.
Above all, investors should remind as when markets become more volatile and weakness takes over from strength, panic is not an investing strategy.
Conversely, investors should adopt a more defensive stance in favour of industries with inelastic demand including healthcare, insurance, utilities, telecoms, and energy. Investment strategy should embrace a value investing approach, evaluating the fundamentals of stocks offering high and secure cash return yield, whether that be driven by dividends, buybacks, or both.
In terms of portfolio construction, high inflation and volatility have put pressure on the traditional 60/40 portfolio, breaking down the diversifying nature of the relationship between stocks and bonds.
This may require considering new sources of return and diversification with greater dynamic adaptability, including illiquid alternatives for example.
Professionals advise that a backdrop of uncertainty marked by lower economic growth and recessionary headwinds may warrant investors to have extra cash on hand. Higher interest rates finally make some shorter-duration strategies more appealing right now with extra cash into money market accounts where they can earn a yield.
Elevated macro volatility also means that market dynamics are likely to evolve at a faster speed than witnessed in the last decade. However, investors will need to be nimbler to navigate frequent macro and policy shifts, adopting well thought strategy, also evaluating the possibility to shift from the short termism of public equity markets to in private equity ones, a longer investment horizon that could off-set near future instabilities and potential losses.
The coming months are likely to be subject to continued volatility in stock prices, even if the year’s lows are most likely in the rear-view mirror.
In the meantime, the emphasis is on the importance of diversification, across and within asset classes, as well as the power of periodic rebalancing.
Sources: Goldman Sachs, JP Morgan, Neuberger Berman, BlackRock
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information presented is not intended to constitute an investment recommendation for, or advice to, any specific person. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. The information in these materials may change at any time and without notice.
