During the first half of the year, markets were challenging however asset prices have rallied somewhat in July.
Driving the initial falls was worse than the inflation data we were expecting to see, but also a change in central banks’ reaction. This is forcing investors to reconsider the broader investment outlook.
Inflationary pressures are the highest observed in a generation. Unprecedented fiscal and monetary policy support over the past two years has led a rapid recovery back to pre-pandemic levels for many economies. However, stoked by post-pandemic supply chain disruption, the ongoing war in Ukraine, and Chinese adherence to zero-COVID, these additional inflationary headwinds have collectively served to roil the global economic and investment market outlook. Global equities, in US dollar terms, fell into a bear market (defined as a fall of 20% or more from a previous peak) during June. In bond markets, yields have risen sharply this year (prices falling), and a narrowing in the difference between yields across maturities has suggested a higher risk of recession ahead.
Pivotal to the significant market falls that we saw during the second quarter has been the reaction function of central banks. Central banks have not only raised interest rates aggressively, but they have increasingly signalled that they will only deviate from future hikes once inflationary forces have receded. As a result, the risk to the economic growth outlook from tighter monetary policy has narrowed the window whereby policy makers might hope to deliver a ‘soft-landing’.
Looking forward, there are still grounds to remain constructive. The recent round of quarterly corporate results delivered a resilient earnings picture for businesses, in aggregate. We expect end demand to soften and this is likely to result in earnings downgrades, however equity valuations have compressed at a remarkable rate as investors try to price in both the higher cost of financing and a softer outlook for earnings. In time, this may prove to be a good entry point for investors but for now the economic outlook, inflationary environment and central bank policy directions are difficult to call with strong conviction.
In the past, slowdowns have been made worse by the banking sector which had been found to be inadequately capitalised. As a result, banks (in the past) have aggressively withdrawn debt financing to corporates and individuals in the teeth of the slowdowns, thus amplifying the cycle. This time is certainly different as the lessons from the Global Financial Crisis (GFC) of 2008/09 have been learnt by regulators and banks are now forced to have (and, indeed, do have) rock solid balance sheets. This suggests that if a recession does materialise it should be fairly shallow, all else being equal.
Over the coming months, we should start to see headline inflation beginning to fall which, if allied with further evidence that economic growth is slowing, may allow central banks to reduce the hawkishness of their communications and this would be taken well by market participants.
There are, however, two wild cards. Firstly, following years of wage restraint, will a wage price spiral form in developed economies which elongates the inflationary environment and provokes even tougher interest rate responses from central banks? Secondly, the uncertainties surrounding the Russian invasion of Ukraine have made the forecasting of energy and food prices for this winter close to impossible. So while we hope that the coming economic downdraft should be benign relative to history, the probability that one can ascribe to this central scenario is lower than normal and demands a degree of circumspection.