Investors are getting more worried as they enter the second half of the year. More specifically, there are three burning questions on their minds.
Firstly, having gone through one of the worst yearly first halves ever, have global markets priced in the extreme consequences of an incredibly sharp and global reversal in the cost of money with ongoing rate hikes?
Secondly, after China’s strict zero-Covid policy where Shanghai went into an extended period of lockdown, is the worst over for the country and is there hope of some recovery for its domestic stock markets in the second half?
Lastly, after the positive correlation seen between bond and equity prices over the past few months, can investors secure the resilience of their portfolios while leaving room for opportunities for positive returns, at least in some pockets of the global markets?
Jean-Louis Nakamura, chief investment officer of Lombard Odier, says: “Facing those interrogations, we have persistently advised to exercise caution and favoured portfolios’ resilience over attempts of dip buying.”
“After de-risking our conviction multi-asset portfolios massively in late January and then again between mid-April and mid-May, we do not think the time had come yet to stand against a large wave of likely unfavourable developments over the next months,” he adds, reiterating that portfolio resilience remains a priority, with the most efficient hedges for 2H2022 potentially different from the successful ones in 1H2022.
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Amid geopolitical uncertainty, Nakamura believes that commodities may still offer some protection but their most cyclical components are at risk of surrendering their gains rapidly should the growth scare dominate ultimately.
Symmetrically, sovereign bond yields have started to regain their diversifying capacity as activity points increasingly to a recessionary outcome in the US and Europe.
While Nakamura recommends holding cash to keep overall risk under control, he also has his eyes on China A-shares as he thinks this might be one of few reserves for positive returns in 2H2022.
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The dreaded R-word
The way Nakamura sees it, if central banks were sincere in prioritising the fight against inflation, they would only stop the tightening of monetary and financial conditions either when price pressures calm down or if a further market capitulation threatens the overall stability of the financial system.
On July 13, the US government announced that inflation for June increased further to 9.1%, putting to rest any vestige of hope that the current bout of inflation is transitory. This latest economic data raised speculation that the US Federal Reserve Board would go for a 100 basis points (bps) hike instead of a more moderate 75 bps hike.
Nakamura is aware that both outcomes may take time to manifest but actual tighter liquidity and monetary conditions would only increase the depth of an incoming — if not already ongoing — recession, adding pressure for several emerging economies to restrict their financial conditions at a faster rate.
This would be at the risk of much of the outperformance several emerging economies were able to accumulate in the first half of the year when they celebrated the reopening of their economies and the boom in commodities exports.
While the reopening of economies has supported the purchasing managers’ index (PMI) for manufacturing and services even amid the Russia-Ukraine war and spike in energy and food prices, Nakamura notes that more granular economic data are deteriorating rapidly in many large economies.
Essentially, with rising prices, affordability and spending power have declined. “Ultimately, the synchronised carnage in both equities and bonds markets year to date have wiped out more than US$30 trillion of wealth in global markets, with — here again — unavoidable negative consequences for the demand from US consumers highly sensitive to financial and real estate wealth effects,” says Nakamura.
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He notes that the New York Fed has predicted an 80% probability for a hard landing, similar to the 1990 recession scenario, along with a more pessimistic outlook during the latest economic forecast released in March. The Atlanta Fed has also downgraded GDP growth estimates to –2.1% as at July 1, suggesting a possibility that after a surprise negative growth in the first quarter, the US economy could already be in a situation of “technical recession”.
“But if we have a second quarter that is also negative, the officially, at least from a technical point of view, the US economy will have entered into a recession. This is even if labour markets remain tight and do not show signs of rapid deterioration,” says Nakamura, adding that the US economy may surprise on the downside and may be closer to a technical recession.
Pricing in a recession
But the main question is: How far have markets priced in this recessionary outcome?
The way Nakamura sees it, markets could have already integrated the scenario of a global recession but may not have priced the risk of a prolonged period of economic contraction or a systemic financial crisis yet.
“As the reality of higher policy rates materialise and if tighter monetary conditions persist longer than expected, there is room for the multiples of stocks to contract further,” he adds.
Looking ahead, Nakamura quotes US Fed chairman Jerome Powell: “The path to a happy-ending scenario has become extremely narrow.” If inflation does not decelerate over the summer, excessively aggressive monetary conditions are expected to prevail till early 2023, potentially causing a global recession.
“The world will plunge into a recession that does not need to be severe to cause more harm to financial assets prices if central banks do not react to it fast enough, especially if labour markets — in a post-Covid context — do not deteriorate rapidly,” says Nakamura.
“Rather, more expansive refinancing conditions will put increasing pressure on the stability of the house of cards the global economy has become over the last 30 years,” he adds.
Investing outlook
Nakamura sees Singapore as “doing very well” and continues to be positive about its economy. However, he expects inflation to remain “sticky and strong” coming into the next year.
On July 14, the Monetary Authority of Singapore raised its inflation forecast for this year to 5%– 6% from the earlier 4.5%–5.5% range. To cope with the knock-on effects, Singapore’s central bank moved to strengthen the Singdollar yet again.
Nakamura warns that Singapore will not be immune to a general weakness in the global economy so this may be a challenge for the citystate to hit its economic goals amid the inflationary pressures.
Overall, Nakamura is keeping a cautious stance when it comes to investing amid such volatile market conditions. While Lombard Odier has raised a lot of cash in its portfolios from late January and again in late February, it is not eager to rush in and buy equities despite a true correction in the market.
“We believe that we are not in the same pattern as the previous tightening cycle, where at some point, central banks were realising that activities are decelerating, suggesting that they are already in the restrictive territory. We believe that not only central banks will take rates higher but they may stay longer,” says Nakamura.
He believes securing portfolio resilience trumps taking the opportunity to buy on dips, given strong uncertainty related to the Fed’s reaction in an environment of lower growth and persistently high inflation.
With that, the best hedges of 2H2022 might be different than 1H2022 as growth concerns prevail progressively over inflation.
While precious metals and energy may provide some protection against adverse geopolitical developments, more cyclical commodities, such as industrial metals, as well as value and cyclical stocks could end up surrendering part of their recent strong outperformance.
Meanwhile, emerging markets such as Brazil and Indonesia, which are exposed to commodities, or those that benefit from their reopenings, such as India and Asean, may also see lower returns in an environment of possible global recession, higher developed risk-free rates and capital repatriation flows.
However, Nakamura sees a potential rebound of China’s A-shares over the next few months as the market is more directly exposed to the shifts in domestic demand and more insulated from the volatility in developed markets.
“China’s onshore markets have rebounded significantly since late April, reflecting improving activity conditions and strengthening momentum in policy support. Even under our shallow recovery assumptions, we believe there is space for similar returns within the next few months, quite insulated from the volatility in global markets,” says Nakamura.
With that, the bulk of the appreciation of the US dollar is likely behind and the US Fed is expected not to reverse its current guidance as long as there is no danger of an ultimate capitulation in markets or the threat of a systemic financial crisis.
Photo: Bloomberg
