Can’t we just cancel the first half of 2022?
What about the profitability of the market? In the first half of 2022, the US Treasuries market returned almost 10% negative, while Eurozone government bonds fell by more than 12%. Credit market segments posted mostly negative total profitability.
As for stocks, the MSCI AC World index lost 20.9% in dollar terms as of June 30, marking the worst first half of a calendar year since the index was created 34 years ago. Growth since the beginning of the month by 0.3% (as of July 6) looks timid.
Moreover, due to the lack of firm conviction among investors regarding the implications of the US Federal Reserve’s stance on monetary policy, volatility remained high in equities and even more so in government bonds.
Investors’ expectations have changed a lot in one month. The previous market narrative that central banks would not need to raise rates as much as expected because inflation would fall has given way to a much less favorable assumption for risk assets. Namely, the combination of slowing growth and sustained inflation.
Dual mandate? What is the dual mandate?
US Federal Reserve Chairman Jerome Powell has appeared increasingly less confident about the economic outlook, recently telling Congress that a soft landing would be “very difficult” and that a recession was “a possibility.”
Indeed, due to deteriorating business surveys, disappointing consumer spending and a sharp decline in consumer confidence, the Atlanta Federal Reserve now estimates second quarter GDPN growth in negative territory at -2.1% y-o-y based on data available on 1 July.
This indicator is not an official forecast. However, if confirmed in the first estimate of second-quarter US GDP due on July 28, the US economy would be in a “technical” recession after contracting 1.6% in the first quarter of 2022.
Recession fears have led to lower futures market expectations for further Fed rate hikes. However, the minutes of the Fed’s June 14 policy meeting, which ended with a 75bp increase in the target federal funds rate, indicated that policymakers remain concerned about inflation and will continue to monitor inflation expectations.
Many participants in the meeting expressed concern that “high inflation may take hold” as inflationary pressures have not eased. The Fed’s message is becoming clearer: monetary policy must become tighter to cool the economy.
The implication is that the Fed is likely to agree to, or even seek, a period of broad enough weakness in economic activity, including higher unemployment, to dampen demand and slow inflation.
Most policymakers seem to believe that the risks to growth are tilted to the downside as a result of external factors such as the war in Ukraine and Covid restrictions in China. In addition, they entail the risk that further tightening of financial conditions may have a greater than expected impact on operations.
While the minutes reflect the Fed’s dual mandate – maximum employment and price stability – the overall tone leaves us with the impression that fighting inflation is now the top priority.
What does this mean for the markets?
The combination of high inflation and limited growth is historically unfavorable for many asset classes. This explains the nervousness of investors as we enter the summer period.
However, since the beginning of the year, the rise in nominal and real bond yields has been the main factor behind the decline in equity valuations and thus the sharp fall in markets. In contrast, the earnings outlook remains fairly robust, especially given that stocks must be priced against recessionary risk.
While leading business indicators have already fallen, earnings expectations remain stable. However, this could turn around, especially in the Eurozone, and punish stocks further. The earnings season, which is about to begin, is likely to be decisive.
A rebound looks possible in the short term given the technical conditions, but it is likely to be volatile. This could provide opportunities for investors to reduce their equity exposure to relatively favorable levels (as we have done regularly since February).
In fixed income markets, the sharp widening of credit spreads in recent weeks offers entry points for investors (particularly at European investment grade) as it reflects an excessively high expected default rate in our view.
Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience.
Any views expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. The opinions expressed in this podcast do not constitute investment advice in any way.
The value of investments and the returns they generate can go down as well as up, and it is possible that investors will not recover their initial outlays. Past performance is no guarantee of future performance.
Investments in emerging markets, specialized or constrained sectors are likely to be subject to higher-than-average volatility because of a high degree of concentration, greater uncertainty, because less information is available, less liquidity or because of greater sensitivity to changes in market conditions (social, political and economic conditions).
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