Updated: Aug 9
GDP, Rates, Policy
SAA and TAA
Base, Bear, Bull Cases
Inflation and Recession
Welcome to another edition of our quarterly “Navigating Global Capital Markets”. As we enter Q3 of 2022, heavy losses have accumulated in global equities and fixed income markets. On one hand, the recovery from the impact of COVID-19 still moving forward. On the other hand, global inflationary pressures from unprecedented monetary policy incentives to fight the global pandemic, which have been further exacerbated by the four-month long Russia/Ukraine war and the Chinese zero COVID policy, have rattled the world.
As a result, over 80 central banks have turned hawkish in 2022 (figure 1), with the U.S. Federal Reserve so far raising the target range for fed funds by 1.50% (0.75% in the last meeting alone) to finish the 1H2022 at 1.75%.
The high inflation/high interest rates combo resulted in rising U.S mortgage rates, which together with fiscal restraint, a strong USD, depressed consumer sentiment and financial market losses in equities and fixed income, have been raising the expectations that a global economic deceleration could turn into a recession.
Looking ahead, valuations are obviously much more attractive than they have been during the last 12 months or so. Nevertheless, the risk of global economic deceleration, and even a recession, has been much more real.
When Navigating Global Capital Markets, we must first attempt to understand where we are and what is the investment landscape, to try to figure out where we are going. In this quarterly publication our focus is to give you an insight on our thinking and positioning ahead of expected events and conditions. For such, we rely on the Growth and Inflation Matrix together with an assessment of employment, monetary and fiscal policy conditions to guide us towards rational instead of emotional thinking.
I hope you enjoy reading this publication as much as I enjoyed putting it together and please let us know if you have any questions or comments.
Warm regards, LeoC.
Market volatility has picked up of late as investors assess the outlook for global growth, inflation, and policies (monetary + fiscal). The first half of the year was marked by the impact of the conflict between Russia and Ukraine, surging energy prices and hawkish central banks beginning to fight inflationary pressures without triggering a global recession. This macroeconomic environment left investors with no place to hide, with equities and fixed income undergoing significant drawdowns, and unsure on how to best put their money to work for them.
For the second half of the year, all eyes will be on inflation expectations and probabilities of recession. There is a growing danger that the U.S. (and other countries) could slip into recession later this year. Proprietary data and analysis from our independent partners and our own Brazen Research and Analysis Group (BRAG), show decelerating economic growth and inflation as early as August 2022. A macro/market regime where economic growth is decelerating while inflation either accelerates or decelerates is typically very volatile and full of surprises.
Higher energy and food prices are the equivalent of a tax on the consumer; rising interest rates means that positive equity returns must be supported by earnings growth; and sticky inflation will force the Fed to push interest rates higher and increase the cost of capital. It is crucial to understand whether these key risks will cause a shallow slowdown, to the likes of a technical recession, or push major economies into full‑blown recessions, dragging down corporate earnings and the profit cycle. If inflation has already peaked, a material repricing of the inflation consensus would provide a relief rally for markets and some breathing room for the Fed.
GDP and its components
While U.S. real GDP declined 1.6% during Q1 (figure 2), recent data suggests a small rebound during Q2 with the Omicron variant subsiding and spending picking up in economic sectors battered by the pandemic such as the consumer discretionary (travel, restaurants, leisure, and entertainment).
Unfortunately, higher interest rates are starting to have an impact on the housing sector as benchmark 30-year mortgages rates have increased dramatically from just under 3.0% in early 2021 to over 6.0% recently (figure 3).
Higher interest rates have also lifted the value of the U.S. dollar against a basket of trade-weighted foreign currencies by more than 7% this year. As such, the U.S. trade balance is set to be a further drag on GDP.
Lastly, with U.S. fiscal policy incentives – such as stimulus checks, benefits, and credits – set to either completely disappear or at a very minimum significantly decline, we are still projecting year on year economic growth deceleration not only in the U.S., but also for most of world (figure 4).
Strategic Allocation as of 06/15/21 and Tactical Allocation as of 07/06/2022
Our theme for 2022 has been about trimming equity overweight, which is totally different than overweighting or switching preference for fixed income. Our focus still on adding portfolio resilience and downside protection, but with inflation most likely peaking sometime during the second half of 2022, we see opportunities in sectors that have been hurt by the Fed’s lateness to raise interest rates.
For Q3, while reducing the overall risk sensitivity of the strategies by decreasing allocation to growth, high beta and low-grade credits, we are also emphasizing the value style by adding dividend-focused instruments to the portfolio.
While we expect real GDP growth to slow down, a recession is not our base case. We believe the YTD sell off in equities and bonds has contributed to tighter financial conditions and a cooling down of the economy. A material repricing of the inflation consensus would provide a relief rally for markets and some breathing room for the Fed. However, despite recent data showing some accumulation in inventory, a cooling of house prices, decelerating wage growth and auto prices, risks to the peak inflation thesis from geopolitical tensions and zero-COVID policy disruption, remain elevated.