Q&A: How to navigate the turbulent months ahead – US

Why have the financial markets been particularly volatile lately?

Keith Wade, chief economist and strategist: “What we saw this year was the end of a long era of low inflation. A number of factors have pushed inflation higher recently – not least Russia’s invasion of Ukraine and China’s Covid-19 lockdowns. There has been a lot of attention paid to inflation in the UK lately, but this is not just a British problem.

“The important point about high inflation is that it is a good indicator that a recession is imminent. It depresses household incomes and is usually followed by tighter monetary policy from central banks. This makes borrowing more expensive and thus has a dampening effect on economic growth.

“We have not seen inflation fall from such levels without a drop in GDP in the order of 2% to 3%.

“There are signs that inflation is slowing down in certain areas. For example, energy and food prices have come off their peaks while congestion at Chinese ports is easing, which should alleviate logistics bottlenecks.

“But service sector inflation is still rising and labor markets remain very strong, particularly in the US and UK. This is partly due to lower labor force participation rates compared to pre-Covid times, early retirement of those of working age and a higher number of long-term sick people.

“We believe the US Federal Reserve (Fed) is unlikely to halt its rate hike cycle until there are signs of a slowdown in the labor market. This could happen fairly soon and we forecast US rates to hit 4.25% by the end of the year before pausing to see the impact.

“The good news is that markets are expecting the Fed to manage inflation. Long-term inflation expectations are stable below 3%. This should mean that wage demands ease as people do not anticipate a prolonged period of high inflation.

“Meanwhile in the UK we’ve had a particularly volatile couple of weeks following the 23 September mini-budget. The announced fiscal measures would have been worth around 12% of UK GDP by 2026/27. That’s a significant amount and the news was accompanied by few details on how it would be funded, prompting a sell-off in UK government bonds. Some of these measures have now been scrapped and a new chancellor is in office.

“In markets, another reaction to the mini-budget has been the fall in sterling, which in turn is further fueling inflation as commodities such as oil are traded in dollars.

“All of this means that interest rates in the US, Europe and the UK are expected to continue to rise. Our UK interest rate forecasts may not be as high as market expectations (see chart). Some of the work to slow the economy has already been done by the UK mortgage market, where interest rates have already risen rapidly.”

How has this affected the credit and equity markets?

Julien Houdain, Head of Credit – Europe: “The surge in inflation has obviously had a strong impact on interest rate expectations. At the start of the year, markets were expecting US interest rates to rise by 1% or 1.5%; Now let’s look at rates that are closer to 4.5% or 5%.

“US inflation is certainly the most important data point driving markets right now as it indicates where rates are likely to go. The US recently released its latest CPI inflation data, which remains elevated at 8.2% and will drive price action for the next month.”

“We have seen credit markets react very quickly to the prospect of dovish central banks from April to June this year, with credit spreads widening (ie bond prices falling). What is happening now is that the rest of the market is catching up.”

Alex Tedder, Head of Global & Thematic Equities: “What’s happened so far in stocks is that we’re in a bear market and we’re probably about three quarters through it. Markets have depreciated, but corporate earnings expectations have yet to fall.

“The downgrade came because companies’ future cash flows are worth less with higher interest rates. But the prospect of a recession has not yet been fully factored into market expectations for corporate earnings.

“We are only at the beginning of the Q3 corporate earnings season, so we will see downgrades. But surely the projections for 2023 earnings are way over the top. The earnings estimate has quite a bit more downside to go before we bottom the market.”

Where is a multi-asset investor?

Remi Olu-Pitan, Head of Multi-Asset Growth and Income: “Neither credit nor stocks were attractive options this year. For a multi-asset investor, cash was the place to be and patience was the most important attribute. Even commodities haven’t been an option lately; Inflation helps commodities, but they don’t do well in recessions when demand falls.”

“Again, it’s all about US inflation. We need to know when we will achieve stability on the interest rate front. And that will help us determine if stocks look cheap enough.”

How can investors position themselves in this environment?

Julien: “The good news is that loans offer attractive rewards. Credit has rarely been this cheap and the opportunity has existed since June as credit has priced in this slowdown ahead of other asset classes.

“Fixed income investing is about getting your money back and collecting a coupon along the way. Yields currently offer good investor protection. It’s possible to build a diversified portfolio with an average investment-grade rating that yields close to 8%, and that’s a daily liquidity fund.

“Nevertheless, it’s important to be selective and understand the difference between cyclical and structural impacts. Certain companies, for example in the telecoms sector, have accumulated high levels of leverage, which has not been perceived as a problem in a low interest rate environment. Telecoms is often seen as a defensive sector, but for some companies in the sector, that won’t be the case if they have to refinance that debt at a 5% interest rate, compared to the much lower levels that have prevailed over the past decade. This is a structural effect.”

Alex: “With equities, quality is crucial in the current environment. Companies with good cash flows, solid business models and the ability to raise prices to offset inflation will do best.”

draw: “From a multi-asset perspective, I think we’re past the first phase of this market reboot, which was just about moving to cash. That was a “macro” phase.

“We will now enter the second phase, which will be more ‘micro’. It will be about identifying those companies that can deliver profits and avoid defaults. It may also provide a good entry point into commodities for those who do not already have exposure.

“Phase one was a tough environment for investors, but phase two could be pretty good.”

What are the chances for 2023?

Alex: “There are still long-term structural investment opportunities in markets that have not changed as a result of the current turmoil. In fact, they have become more urgent, as we can see in terms of the need for security – be it energy security, food, cyber, etc. Investment themes such as the energy transition are becoming increasingly important.

“But especially for next year I would highlight Japan. The weak yen and low inflation have made the economy very competitive.

“And in terms of sectors, banks look attractive. The rising interest rate dynamic is positive for them because they can revalue loans. There are some unique issues in European investment banking, but mainstream European retail banks are much more conservatively run today than they were before 2008 and we find them attractive.”

Julien: “I would also agree with the European banks from a credit perspective. As a sector, they have experienced major crises before and those that remain are more resilient as a result. In addition, the European Central Bank has taken measures to contain potential problems – such as its plan to support peripheral markets – and to ensure financial stability.”

draw: “I still think patience is the watchword, but it’s certainly true that ratings have improved. Investors can slowly rebuild their portfolios and take advantage of these valuations, starting with corporate bonds, followed by equities.”