Recession delayed but not avoided

THE global economy has proven stronger than many feared. In the US, the labour market has refused to weaken, even in the face of sustained pressure from the Federal Reserve. In Europe, there have been positive economic surprises supported by warmer winter weather and falling energy prices.

Meanwhile in China, a rapid reopening from Covid has led to a flurry of activity, spurred by supportive monetary and fiscal policies.

It is clear that a global recession is not around the next corner, and near-term sentiment and growth outlooks are supportive. However, we are not out of the woods.

We still believe that a hard landing, in the form of a cyclical recession, is probable in the next 12 months, and markets appear to be too complacent of this risk. Earnings forecasts and credit spreads expect too much resilience and too fast a recovery, but this might not become clear until later in the year.

The very economic strength that has been behind the recent vigour of risk assets and sentiment will compel central banks to be more hawkish than they otherwise might. This will result in higher rates and for longer than assumed a few months ago.

The “higher for longer” rates along with the extensive monetary tightening seen in the past year will start to bite soon, and it is important to maintain a cautious stance. Credit markets are likely to come under pressure before equity markets in the coming growth slowdown. With lending standards tightening, and spreads now below their median averages of the post-financial crisis era, markets could be in for a shock if sentiment sours.

Emerging market equities more attractive

Emerging markets, spearheaded by China, appear to be a bright spot in the global economy. China is emerging from zero-Covid policy at startling speed, accompanied by a broad range of supportive policies. Many other emerging markets are also benefiting from falling inflation, peak monetary tightening, and attractive valuations. This may prove a potent mix.

The recent pause in Chinese equity markets’ rebound is likely to be temporary. Improving corporate earnings are expected to take over from cheap valuations as the main driver in the next stage of the rebound.

The 12-month forward price-to-earnings (PE) ratios have climbed nearly 40 per cent since the market bottomed in late October, approaching the levels at which recent historical rallies have peaked in terms of average rise in PE (48 per cent). But earnings per share – up 6 per cent since the rally began – still has a long way to go to catch up with the 25 per cent historical average peak increase.

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China’s consumer spending shows signs of strong rebound

Communications from the recent National Party Congress point to conservative growth targets with a focus on raising employment. Policy priorities appear to focus on raising household income and boosting consumption. I believe the consumption recovery will remain strong in the next few months, supported by savings and possibly policy easing. But the long-term sustainability of the recovery depends on households’ income expectations.

“Bad meaning bad’‘ or “bad meaning good”?

Inflation vs growth are two major drivers of market downside risk. When the market is worried about inflation, “good news’‘ often implies tighter rates and lower multiples in equities, that is, ‘good is bad’. When the world is worried about growth, then ‘‘bad growth is bad news’’.

For much of last year, central banks dictated the market narrative because inflation was the narrative, as it is again now. This matters even more for multi-asset investors as correlations change in these two worlds, with the inflation-driven world inducing positive correlations between bonds and equities, and causing portfolios to be a lot more volatile.

I expect a transition to a growth-driven market but the journey is unlikely to be smooth. If inflation becomes less of a risk and growth holds up, markets can rally. On the other hand, if inflation is still sticky and growth slows, markets will question the ability of central banks to act and the downside is greater.

This means investors need to be flexible and seek forms of return such as absolute return strategies that can navigate these waters even without these major drivers – especially as they can earn attractive cash rates on market-neutral positions.

The writer is head of multi-asset investment management (Asia), Fidelity International.