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Weathering the Storm
Rising fears of recession gripped global markets as the Fed responded to May’s higher CPI report by stepping up its efforts to bring intensifying inflation under control. The knock-on effects on prices and supply chain disruptions continued, driven by Russia’s invasion of Ukraine and renewed COVID lockdowns in China, intensifying inflation worries even as signs of weaker global growth emerged. This unpleasant combination of events led to a particularly brutal first half in global financial markets. Equity markets fell sharply during the second quarter, after experiencing smaller declines in the first quarter, pushing stocks into bear market territory. Declines in bonds were also substantial—the biggest drawdown since 1990—as the bond bear market continued to roar. With central banks turning ever-more hawkish in their quest to tame surging inflation, yields across the curve surged even higher after their brutal rise in Q1. So long as markets remain gripped by the dual headwinds of intense geopolitical tensions and stepped-up central bank hawkishness, we expect risky assets to remain under pressure.
Equities may continue to face downward pressure
The decline in stocks was driven primarily by the significant compression in earnings multiples. The forward P/E ratio on the MSCI World Index declined roughly 24%. Even the S&P 500 Index, which was trading at a premium to its 10-year average on forward earnings earlier in the year, is now at a discount. Amid the sharp interest rate hikes, markets have priced the higher policy rates into valuation multiples. Among international markets, the major EAFE components—Eurozone, UK, and Japan—all trade at valuations which are at a discount to their 10-year averages. Emerging market (EM) valuations have improved as well, with Latin American equities appearing particularly cheap—currently trading at a 56% discount to history. While stock multiples plunged spectacularly in the first half, they could still see continued downward pressure in the near term as inflation continues to run hot and central banks stay vigilant. Despite significant equity market drawdowns and improved valuation multiples, we remain cautious on equity markets due to the combination of heightened recession risk, hawkish central banks, and significant risk of earnings disappointment.
Select risk assets are more attractive than government bonds
With the ongoing deterioration in the global macro environment, we are cautious in the near-term outlook for riskier fixed income sectors. Nevertheless, some sectors have more attractive risk-reward profiles than government bonds. EM debt experienced a sharper drawdown during the first half of 2022 than U.S. stocks, falling 29% from last year’s peak. EM hard currency yields rose to about 7.5% by late June and are now above the peaks seen in March 2020 and November 2018, making them very attractive from a valuation perspective. However, spreads are likely to remain pressured as long as U.S. rates continue to be repriced upward. Even though most EM central banks are relatively more advanced in their hiking cycles, weaker EM currencies and higher energy prices increase the upside risk to EM inflation, which will put pressure on EM central banks to retain a hawkish stance for longer. U.S. corporate high yield bonds have held up better by comparison so far this year, with a decline of about 13%. Spreads on high yield debt have also risen but are still below their historical average. Therefore, the segment is not yet cheap and is not fully pricing in recession risk. U.S. companies are somewhat insulated from the war in Ukraine and the slowdown in China. While high yield debt is likely to benefit from the energy sector, which represents roughly 13% of the Bloomberg U.S. Corporate High Yield Index, consumer cyclicals (~21% of the index) could prove to be a headwind amid economic turbulence. Beyond the near-term yield volatility, bonds may consolidate in late summer on further visibility into the inflation and growth trajectory. Overall, we remain bearish on the outlook for sovereign debt over a longer-term horizon and we think yields are likely to rise over the next few years.
Commodities remain a good inflation hedge
We remain positive on commodities and continue to believe the bull market here is still young. Supply-demand imbalances are not likely to be easily remedied in the near term. Russia’s invasion of Ukraine has led to a negative supply shock across all commodities: oil, gas, coal, fertilizers, precious and industrial metals, and agriculture. With the war dragging on, and with Russian threats to cut energy supplies, supply constraints are likely to be persistent in the coming quarters. Although some signs of weakening in the developed economies may provide a modest offset, pandemic-weary consumers remain eager to travel. This should boost summer seasonal demand and be supportive for commodities. Real-time U.S. activity data on time spent outside the home, for example, are still approximately 4% below pre-pandemic levels, suggesting still-pent-up demand. Inventories across the commodity complex remain well below historical averages. Furthermore, planned reopening in China during the second half, following rolling COVID lockdowns in the second quarter, could provide additional support to commodities.
Bloomberg U.S. Corporate High Yield Index covers the USD-denominated, non-investment grade, fixed rate, taxable corporate bond market. Investors cannot invest directly in an index. MSCI World Index captures large and mid-cap representation across 23 Developed Markets (DM) countries. S&P 500 Index is an unmanaged index of 500 common stocks of large U.S. companies, weighted by market capitalization. Indices are unmanaged and are provided for informational purposes only. Investors cannot directly invest in an index. The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care.
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