Manning the defences: Investment themes for the rest of 2022
WITH rates rising in most places amid fears of persistent inflation, and with a dangerous geopolitical situation feeding into an energy shock, the events of the past few months bear the hallmarks of a paradigm shift that calls for intense vigilance and a resolutely active investment approach.
Complicating asset allocation is the increasingly positive correlation between fixed income and equities (meaning both have delivered negative total returns year to date), as the market oscillates between concerns about inflation and growth.
So, for the moment, it is a matter of choosing the lesser of two evils. In our case, alongside an underweight in equities, this has involved raising our tactical stance on fixed income from underweight to neutral. Higher yields are starting to make safe-haven bonds more enticing as both inflation and economic growth slow, while the risk premium offered by equities has been sliding. At the same time, we believe macro hedge funds will continue to have a field day.
Economic slowdown and easing of bottlenecks
Economic sentiment continues to deteriorate, particularly in advanced economies. Purchasing manager indexes (PMI) suggest services activity globally remained below the 50 threshold dividing expansion from contraction in August, while the manufacturing PMI remained slightly above. But even in manufacturing, a decline in new orders points to contraction ahead.
The global slowdown has weighed on oil demand (-2 million barrels per day in the last 5 months), while supply has increased. As a result, the oil market remains in slight oversupply. This situation is likely to prevail for the rest of the year as advanced economies slow further and China is dragged down by its troubled property sector and zero-Covid policy.
As a result, commodity prices are likely to remain on the soft side. European gas is a notable exception and could contribute to keeping inflation high in the short term. But high energy prices increase the risk of recession, possibly resulting in a drop in the price of Brent oil towards US$80 per barrel in the short term.
We have decided to lower our forecast for world gross domestic product (GDP) growth to 2.9 per cent this year (from a previous estimate of 3.3 per cent) and to 2.7 per cent in 2023 (compared to 3 per cent), with the downturn in business activity also likely to lessen inflationary pressure.
We continue to expect a mild US recession towards the turn of the year, and we now expect real GDP growth of -0.8 per cent in 2023, compared with 1.3 per cent in 2022. As long as employment gains slow and inflation continues to come off the boil, we believe the US Federal Reserve will stop raising policy rates when its funds rate reaches 3-3.25 per cent.
We believe GDP in the euro area will decline from 2.9 per cent this year to zero in 2023. Faced with persistent inflation and a faltering economy, policy normalisation by the European Central Bank will be complicated, although it will have to act fast to tackle high inflation. We believe headline inflation could hit 10 per cent in the coming months.
We continue to forecast full-year GDP growth of 3.2 per cent in China this year. While there could be important news on economic strategy from the Communist Party Congress next month, we believe policy support is insufficient to fully offset the short-term pressures weighing on the Chinese economy.
We expect Japan’s moderate recovery to continue; our GDP forecast for this year is 1.5 per cent. Relatively weak inflation means the Bank of Japan could try to stick with ultra-dovish monetary policy, but severe yen weakness is testing the bank’s yield-curve control.
Investment themes for the rest of 2022
A number of the themes we developed at the start of the year have been showing their worth.
The general uncertainty caused by increased geopolitical strains, economic slowdown and persistently high inflation all mean the first of our 2022 themes – ‘It ain’t over ‘til it’s over’ – remains valid. This theme essentially means adopting a tactical, active management approach. This can involve exploiting divergent correlation trends between sectors. It also involves using structured products to exploit volatility discrepancies within and between asset classes in order to enhance yield and protect capital.
Likewise, The Great Resignation remains a valid theme, with labour-market tensions generally contributing to the pressure on companies. Underweight now on equities overall, active management continues to focus on fundamentally strong companies capable of providing consistent dividends and stable earnings throughout the economic cycle.
The risk that wage pressures add to the margin squeeze facing companies means that resilient, cash-rich companies across sectors continue to have our preference. As part of the ‘pricing power’ theme, essentially, companies with pricing power remain central to our asset allocation, such as equity sectors in life sciences and energy. The latter in particular is well positioned to grow shareholder returns while adapting to the energy transition.
Overall, with the market and economic backdrop becoming increasingly tough, one of the rare places to hide from market volatility has been macro hedge funds, whose potential we had signalled at the start of the year. Global macro strategies have been benefiting from economic and policy divergence as well as the uncertainties caused by geopolitical events. These strategies continue to generate decent alpha from sharp moves in equity, currency and fixed income via non-directional strategies and structured products. Our 2002 investment theme ‘Who pays the bill?’ has gained in salience as energy costs skyrocket, companies’ margins come under pressure and workers’ real incomes fall.
The asymmetry in the way that countries have dealt with recent crises has fed into the theme of ‘The slow unbundling’. An illustration is the way in which central banks in some emerging market countries moved much faster than the Fed to raise rates to try to head off inflation. While many emerging market (EM) countries are under severe pressure from the rise in the US dollar, there are nonetheless attractive carry opportunities in select EM currencies and bond markets as a result of this ‘unbundling’. With a lack of contagion from China’s real-estate crisis, there continues to be superior risk-adjusted return potential in investment-grade hard-currency corporate credits from Asia.
The writer is head of CIO office and macro research and CIO Asia, Pictet Wealth Management.
