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On the investment radar - Russia, Rates, Recession

7 months ago

This has been an extraordinary year so far, as the global economy buckles under multiple strains, from supply chain issues in China, to rising food prices, and the spill over from the Russian invasion of Ukraine.

With the war leading to higher commodity prices, food insecurity, exacerbating inflation, and contributing to interest rate hikes. As a result, the outlook has many downside risks, and recession fears are mounting.

We discuss what's the outlook for the rest of the year in this action-packed podcast: Russia, rates and recession.

While delving into what's coming up for equities and bonds. And of course, we cover the big question: has inflation peaked?

Seamus Lyons CFA, Senior Investment Manager and Chris Iggo, CIO Core Investments at AXA Investment Managers discuss what’s on their investment radar. Hosted by Louise Somers, Investment Specialist.




This year has been an extraordinary year so far as the global economy buckles under multiple strains from supply chain issues in China, to rising food prices, particularly in the poorest countries and the spillover from the Russian invasion of Ukraine. Global growth is slowing, but not stopping yet. It is expected to slow to 2.9% for 2022 and the Chinese and Russian economies, though, are certainly shrinking. The war is leading to higher commodity prices, food insecurity, exacerbating inflation, and contributing to tighter financial conditions. As a result, the outlook has many downside risks.

Today we will discuss and be delving into what's happening this year in more detail, asking opinions on what's coming up for equities and bonds, and of course the big question has inflation peaked?

Could you to put this year into context for us?

Yes, it’s certainly been a pretty interesting year so far. Markets got off to a pretty tough start in January as investors began to realise that interest rate rises were soon going to be a thing. In February, then not long afterwards we had the Russian invasion of Ukraine, and this is the largest conflict in Europe since the Second World War and also one of the key economic impacts that this conflict has been on energy and commodity markets.

Russia, as we know, is one of the largest exporters of energy in the world. And Europe is heavily reliant on Russian gas and Ukraine is often referred to as the bread basket of the world. They are a massive producer of food ingredients, wheat being one of the most known and this has done nothing to help an already spiraling inflation picture. And we're experiencing the highest levels inflation globally in over 40 years. The latest CPI print in the US is over 8.6% that showed inflation was rising in many core areas, such as services as well as the other headline areas of food and energy as well. This in turn has been forcing the hands of banks to get this issue under control, though, as such we're now seeing rises across the globe. The US Federal Reserve (Fed) has already raised rates a number of times, the most recent being a whopping 75 basis points. The first of its kind since 1994.

And let's not forget about Covid which still lingering in certain places. China Zero covered policy has resulted in lockdowns in many of its key cities. This is hampering economic activity and also having an impact on the global supply chains. As Chinese factories and ports are shut down for extended periods, so all of this has been weighing on markets and on economic growth as investors fret over the growing prospects of a hard landing or recession. We’ve seen some big falls in stock markets in the US is after its worst start since the days of Richard Nixon presidency. And bonds traditionally, a safe haven when you see equities do so badly, they've also endured a tough year so far as well so yes, it's a pretty interesting start to the year.

One of the top questions on investors’ minds is, have equities taken enough beating?

Good question. One that's on most investors’ minds at the moment. Well, let's start with looking how much equities have actually been beaten down this year. The S&P is down. Basically, the US is down over 20% as we speak, that is correction territory. The Nasdaq's down or at least it was down over 30%. Europe stands a little bit less, about 15% on the year-to-date basis. Very bad returns across most of the equity markets, so there is already a lot of bad news and recession risk already priced in by the market. But if we look to previous bear markets if this is what we're going to have we have seen much larger falls in the past as well.

Indeed, if there is a recession and those fears play out, ultimately equities can fall further. But you know, there are certain areas within equity markets that have taken large hit in the last year as well. Gold stocks certainly midcap growth stocks, China had a difficult time. These are areas that have been very, very badly hit. There are areas that look a bit more attractive as well, that probably won't be under so much pressure in the future. Sentiment and positioning remain very pessimistic right now but given the falls that we've seen this year and particularly more recently where you know we've had a difficult June as well; one could argue that equities have entered an oversold territory at the moment, and we might be in for hopefully a bit more of a stable period.

Is it too soon to call an end to the worst bond market collapse in at least half a century?

Good question. I would say probably the worst is behind us. If you look at any of the global bond markets indices, the drawdown that we've seen from last year's highs is the worst on record, and if you look at average prices in the bond market, they're very, very low. So, you take a typical corporate bond index like in the US. The average price of bonds is around $0.90 in the dollar at the moment, and they've only been lower on a few occasions, including you know, quite big crises like the global financial crisis in 2008. From a purely evaluation point of view, I think we have seen the worst. Now there are still headwinds. Of course, we don't know if inflation has peaked yet. We don't know if it's priced in in terms of monetary tightening. And there is always the possibility that yields could go higher and therefore we have some more losses from bond portfolios.

But I suspect we're near the end of that correction. Yields are at their highest level for many years now, and the speed and the extent of the correction in bond yields. There's certainly been something that I haven't seen before even in other previous bond bear markets, like in in 1994, but we need some good news. We need some news around inflation. Looking out and the central banks sending a message that they think enough is already priced in in terms of what they need to do to control inflation. So, the next three months or so will be very important. The risk is that you know, with oil prices still elevated and the war in Ukraine having an impact on global food prices, inflation continues to surprise to the upside, and that may mean the market has to price in even more monetary tightening. That's the worst-case scenario. But I do think that if you take a 6-to-12-month view, with most bond markets you will get positive returns going forward.

Inflation has been reaching dizzying heights. Do you think that inflation has peaked?

Well, it's difficult to know. I think at the moment a lot of the inflation that we're experiencing has been driven by global energy prices. They were already rising as we came out of the Covid pandemic. Given the strength of the recovery and then the war, obviously in Ukraine added to that. But beyond energy, we've had all these supply chain issues that you mentioned in your introduction, and we're starting to see inflation broadening out throughout the economy so as businesses face increased costs of input, they're then having to raise their own prices.

And this is something that is very worrying for central banks and hence we've had a much more aggressive attitude from the central banks in the last three months, including the ECB bringing forward its first interest rate hike in July. And the Fed, being quite aggressive already in terms of raising rates, one thing I would watch. We are starting to hear stories about inventories starting to build, especially in the retail sector and that lead into some price discounting so maybe there are some early signs that the dynamics of inflation are starting to ease back some of the year over year. Comparisons should also start to come down I think in Q3, but at the same time as we're seeing in the UK at the moment, this is causing disruption and claims for higher wages, so we have to watch that wage price spiral. But I would say probably at a headline level we're fairly close to the peak in inflation, I'm just not sure how quickly or how far it will come down in the coming months.

What effect has inflation had on the bond markets?

Oh, it's had a disastrous effect. Inflation didn’t surprise us all. But the extent to which inflation rose surprised most people at the end of last year and in early 2022. It was a complete 180-degree reversal in monetary policy, so for the previous two years central banks were concerned with making sure the markets were functioning during the pandemic cut interest rates to very low levels did more QE, and so on, and now they've had to fully reverse that. So, we're starting to see the end of QE or start to see rates rise almost everywhere apart from Japan. And this is something which has been a shock to bond investors because bond yields, as you know, are the forward expectation of interest rates. So, if interest rates are going to be higher, bond yields have to go up and as bond yields go up, prices go down.

And as I mentioned, we've seen the biggest drawdown in in over 40 years in most bond sectors there has been some differentiation. The longest duration for the very long dated bonds have been the worst hit. Short duration, that is, bonds that mature in you know the one-to-three-year timeframe, have held their value better and also inflation-linked bonds which are very popular instruments, particularly in the pension world, have done well because part of their return is derived from the actual inflation rate, so again with inflation picking up, this is a sector of the bond market that's performed better than others.

The thing that worries me at the moment is the credit side. The corporate bond market, where part of the return is reflective of the credit risk that investors are taking when they're lending money to corporates. If we are going to go through a period of weaker economic growth then there could be some credit difficulties and that may show up in wider credit spreads than we have at the moment, even though they have widened. Corporate bonds may struggle a little bit more the saving grace I think, is that underlying government bond yields will stabilise or may even start to move down again.

The war in the Ukraine lockdowns in China, supply chain disruptions, and the risk of stagflation are hammering global growth without oversight of a global recession. Do you think this is a possibility?

Yes, it's certainly fair to say that recession risks are increasing, so you know you look at most strategists and investors out there, they've been very busy rewriting their forecasts increasing the probability of a recession, the longer inflation stays elevated at these levels the more this risk increases. You mentioned that the conflict in Ukraine has been over 100 days now and there's no signs of that conflict abating anytime soon either, so as long as these things remain in place, definitely recession risks grow. We're already beginning to see some signs of global growth slowing. Some of the recent hard data that came out has definitely been showing like a weakening trend. Forward looking indicators like PMI’s are beginning to weaken somewhat. Consumer confidence is also very low, so the Fed doesn't have an easy task on its hands. In trying to generate a soft landing and also history is not on their side either. The previous areas where inflation has been this high, they've generally resulted in recessions following a period of rate rises so yes, the probability is definitely increasing.

The Fed has just had its most aggressive hike since 1994. Is the Fed kicking an economy that’s down?

Well, first of all, I wouldn't say the economy is actually down, it's still in a pretty strong position. The earnings cycle even more recently has been very strong. The consumer is still in good shape, so the economy, at least where we are today, is in a good position. But, saying that the Fed does have a big task on their hands, and they need do something about it and they've been very clear that they will go into restrictive mode if necessary to get inflation under control. This is exactly what they did in 1994, when they did another big rate rise of 75 basis points.

It does also mean that the hope for soft landing that they talked about becomes obviously more difficult task as time goes on and inflation remains as elevated. Then we think that the likelihood of a recession, being defined as two quarters of consecutive negative growth, is definitely growing and it is very high but at the same time it's not a given. The tightening that's been done by the Federal Reserve so they may not need to go as far as markets are predicting. The recession is not a foregone conclusion. You know a lot of economic outcomes remain open, and on that one we are probably less bearish than maybe some others in terms of recession being a likelihood.

The ECB reported its intention to increase rates for the first time in 11 years as it tries to control soaring inflation in the eurozone. This triggered a substantial market reaction and an emergency ECB meeting. Could you provide some details about what's been happening?

I think the ECB is a tricky institution because it's got a very large governing Council tries to run monetary policy by consensus, and we've seen in the past that that's led to some problems and it's worked well when there's been strong leadership, like when Mario Draghi was in charge. But at the moment when they're faced with this inflation problem that they haven't had for a very long time, it's even more difficult. And remember, they're starting off from a position where interest rates are negative.

The deposit rate is minus 50 basis points, so you know they've got a job on their hands just to get back to 0, and that's the first kind of hurdle really because negative interest rates is not doing anything to help. The European economy will have to go further than that in time because inflation is just as much a problem in Europe as it is everywhere else. But getting from -0.5% to say 2%, which is what the market has priced in for European interest rates, is going to be an interesting journey because as interest rates go up, it reawakens all those concerns about fiscal stability in Europe.

And particularly for countries like Italy, which has a very high government debt to GDP ratio close to 150% as low growth and some stretch. Moral issues that are presently being discussed but never really being dealt with. If interest rates are going up, that means the Italian Government has to pay more to service its debt. That means it has less money to spend on other things, and questions will be raised about the sustainability of Italian debt. The last time that this was an issue, Draghi said we would do whatever it takes to save the euro. This time round you know you can't play the same hand twice.

I don't think because they can't do a big round of further bond purchases when they're trying to control inflation, so they're trying to do something much more technical, they call it that anti-fragmentation plan, where they would try to support bond markets like in Italy and Spain and Portugal and Greece. But it's not clear at the moment how exactly that will work and therefore investors are putting a little bit more of a risk premium on some of those sovereign bond assets. I think we'll see a very volatile period over the course of the next three months as the ECB starts to raise interest rates.

Do you think that the ECB will Be able to counter the current bond market panic?

Well, ultimately it will because we can revert to buying bonds and intervening in the markets, but that would water down its anti-inflationary policy. And if you think about the Fed, it definitely wants to control inflation and ideally would like to achieve a soft landing. My view is that at some point the Fed will reverse its interest rate hikes pretty quickly if it sees the economy tanking. As long as patient is under control, but the ECB is much more challenging, they want to control inflation, but they don't want the euro to break up either, so that's a balancing act. Ultimately, they have the power to intervene in the markets and buy government bonds and that should in extreme counter the effects of any speculative attacks on sovereign bond markets.

Global equities and bonds have suffered YTD losses not seen in decades as inflation hit’s a 40-year high. What’s coming next?

Seamus Lyons: It very much depends on the path of inflation from here. If the picture does not begin to improve, then we're likely to see more of the same in terms of weak equity markets, weak bond markets as the Fed and other central banks have no choice but to ramp up rates even quicker and by further and obviously the possibility of a recession becomes more distinct reality then.

But you know, we also have a lot of recession risk and weaker growth already priced in by markets. And there is certainly more room for markets to fall further. Our view probably is that equity markets will be more range bound in the coming months as investors wait for or clarity on the inflation story. But at the same time, we're likely to see volatility levels remain pretty high as investors fret what is going to be a very uncertain invite.

Chris Iggo: I fully agree with Seamus that it's the profile of inflation over the next 6 to 12 months that is the most important, but I think we have to think about investor behavior as well. We've suffered big losses in both bond markets and equity markets, and investors tend to literally project that this is going to carry on and attach a lot of bad news and the world changed and we're never going to make money.

Again, this always happens in bear markets, but it won't last forever. There will be a recovery and valuations are getting much more attractive. People still need to invest their cash and their savings and central banks will complete their hiking cycle at some point. And I think we have to be careful about making comparisons to the 70s and stagflation because there are so many reasons why today is different to that. Yes, there are concerns about the geopolitical environment, there are supply concerns about how companies will manage their supply chains going forward. And there's bigger concerns about climate risk and water scarcity and things like that, but most of the time markets go up and people make money and we're going through a transition period at the moment.

I think at this time next year things will probably look a bit better. In the meantime, it's about inflation and it's about the messaging from central banks. It's about how companies deal with this changed environment profits are going to get hit because costs are rising, but I don't think it's like 2008 when the whole system was broken, I think it's much more like probably 2018, which was the last time the Fed tightened monetary policy. But as soon as they started to pivot and started to talk about reducing rates, markets improved.

What’s the Architas outlook for assets for the second half of 2022?

Given the falls that we've already seen in equity and bond markets this year, in our view, a lot of the bad news and recession risk is already priced in by the market. We've just recently upgraded our view on equities from an underweight where we've been positioned since early March back to a neutral stance. With a preference for US equities and Asian equities relative to Europe. We expect the eurozone to struggle a bit more as the conflict in Ukraine rages on, with the effect of elevated energy and commodity prices which will particularly impact that region and economic growth prospects more.

Where we've got a bit more optimistic on in recent weeks has been Chinese equities. It really has been a hard 18 months for the market. With one issue after another weighing on things, but we believe now you're seeing the easing of lockdowns and the regulatory risks facing the technology companies are beginning to ease also. We think the future market prospects are a bit brighter and indeed as well in the event of actually a global recession. If it did happen, China is one of the few places that has the firepower to deliver more stimulus.

Looking at fixed income, we've been quite underweight here for a long time, but given the very dramatic moves we’ve seen in yields this year we've actually recently moved back to a neutral in most of the bond areas. Certainly, in the US where you got yield of above 3%, there's also an opportunity cost to be underweight that market because the carry now is attractive as it's been for many years.

Probably one area within bonds where we aren't as optimistic is in the eurozone or the yields there. They're still low on an absolute basis, so you don't have that same level of carry. Also, we probably expect a bit more hawkish behavior from the ECB in the coming months because they're a little bit behind the Fed, in terms of dealing with the issue of inflation, so we probably expect a bit more hawkish behavior from the ECB, and so for that reason we remain underweight to eurozone government bonds.

Finally, there is one area in bonds that we do like, which is high yield. This asset class now offers a very attractive level of yield. We had big moves in the yield curve, which had spreads. Widening spreads now widen over 500 basis points in high yield so the overall yield market very, very attractive. We think there is a good risk reward there and it’s an area where we've been allocating more capital to. 

Overall, probably not as a negative outlook as we would have had a month or two ago. We think there's a lot in the price, and maybe this Summer could be a bit more of an interesting period for markets.

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