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While recession looms, will risk-taking resume?

  • 25 October 2022 (5 min read)

So far in 2022, the key dynamic in markets has been the relentless tightening in financial conditions. Central banks globally - with the exception of China and Japan – are attempting to bring inflation lower, which has lead to elevated volatility across asset classes.

For the reminder of the year the focus is increasingly shifting to calibrating the impact of tighter financial conditions on global growth. Our central case is that the US economy enters a mild recession in 2023, with the Eurozone in recessionary mode by end of this year. The dynamics in emerging markets are more complex and are largely differentiated by region, and country.

Valuations are attractive across most asset classes. On rates, levels are now consistent with positive real interest rates, once inflation starts to decline. Credit spreads are attractive, with the risk of moving wider, as the growth outlook deteriorates. A worsening macroeconomic backdrop merits prudence and dictates careful bottom-up credit selection. While overall sentiment remains poor in the wake of losses in 2022, cheaper markets may encourage more risk taking in early 2023.

In our October webinar - Where will the Fed take us? – we explore today’s macroeconomic dynamics in more detail, across the US, Eurozone, and China, and also look at our asset class views, with David Page, Head of AXA IM’s Macro Research and Ecaterina Bigos, CIO Core Investments, Asia Ex-Japan.

AXA IM: Implications for asset classes, at-a-glance

  • Rates and inflation: It’s difficult to call the peak in yields given the central bank bearishness and continued upside surprises on inflation. However, signs of slower growth, downgrades to the global outlook and increased signs of financial market stress should see peak central bank hawkishness arrive sooner
  • Curves: Short-end offers attractive yield levels today, with much priced in in terms of central bank hikes. Curves are very flat or inverted, and further moves in this direction might be limited, especially in the US
  • Credit: Sentiment towards credit weakened at the end of Q3 as fears continued to grow over the impact of a global economic slowdown on corporate cash-flow and balance sheets. Underlying fundamentals are still resilient, however higher rates and slow growth are negatives
  • Emerging markets: Debt continues to face headwinds from higher US yields, a stronger dollar and the effect of inflation and energy prices on balance of payments. Macro fortunes remain mixed with oil producers clearly continuing to benefit from higher prices, while importers suffer pressure through terms of trade
  • Equities: The macro backdrop remains challenging given that we are yet to see significant earnings downgrades. Prices have adjusted a lot from their 2021 highs and total return performance on many equity indices is consistent with past recessions. The recent increase in real yields has been another challenge on equity multiples. Downside risks remain in the near term from earnings pressure going into 2023


Readying for recession in the US

The Federal Reserve’s 2022 policy stance continues to be the centre focus – both domestically and overseas – in terms of its impact largely on financial conditions and growth across markets.

Our central case is a mild recession in 2023 in the US. This outlook reflects falling real incomes, contracting corporate profits, tighter financial conditions and high inventories. Supply chains are loosening while demand slows, with the theme of an inventory shortage shifting to an overhang.

Globally, inflation has been primarily driven by external factors - supply chain disruptions, significant disruption to energy and food prices. While markets may no longer use the term “transitory” sparingly, it is expected for these inflationary pressures to decelerate with drop in oil price unless additional shocks emerge.

Headline inflation should continue to come down and do so quite quickly. However, core inflation pressures remain uncomfortably high and are likely to be more persistent. We see inflation taking until end-2024 to get back to the Fed’s 2% inflation target. We forecast inflation to average 8.2% in 2022 and 5.2% in 2023.

Going hand in hand - anchoring inflation requires achieving a looser labour market, which requires slower growth. Slowing growth without recession, requires sustained below-trend output growth, a rebalancing of the labour market via sharply lower job openings with only a moderate rise in unemployment, and large, consistent, and broad decline in inflation. A very fine balance.

David believes the emerging slowdown in household consumption will persist over the coming quarters, leading to slower domestic sales in the US in the final quarter of 2022 and into early 2023. At the same time, business investment is likely to slow. Despite a certain amount of easing in supply costs, elevated costs in terms of energy, unit labour costs and financing are weighing on corporate profits.

“Where these start to slow, we normally see a softening in investment spend,” said David.

In David’s view, even if the Fed keeps a closer eye on the labour market, to indicate when to recalibrate its monetary policy, there is a policy dilemma: the use of forward-acting tools to slow the economy yet only using backward-looking measures such as labour market data to calibrate with.

“This a recipe for over-tightening and we think the abrupt shift in financial conditions is telling us to expect a mild recession,” he added. The only question is, when?

Risks running high in Europe

For European economies, recession will hit sooner than in the US, AXA IM believes.

A key driver, explained Ecaterina, is the gas crisis. Business and consumer surveys paint an increasingly negative picture of the economy, with economic activity slowing down. We have lowered our Eurozone growth outlook to include a more distinct contraction in Q4 this year and Q1 2023.

We forecast 2022 GDP at 3%, with growth deterioration in next two quarters by 1.6%, recessionary by Q4, possibly as early as Q3. We forecast a modest rebound after the winter but a gas storage rebuild, tight policy mix, and elevated inflation will prevent the level of growth rebounding to current levels by end 2023.

“Risks are skewed to the upside in Europe,” said Ecaterina. “In aggregate, we expect inflation to be above 8.5% by the end of this year, and to average 5.5% in 2023.” We expect the European Central Bank (ECB) to hike its deposit facility rate by another 75 basis points (bps) to 1.5% in October, wary about inflation being "far too high above target", even as wage developments remain moderate.

Any further fiscal policy response could add extra fuel to existing inflationary pressure, added Ecaterina, putting pressure on ECB to move faster and sharper.

Asia and emerging markets: Racing against the Fed

Closer to home, China's economy remains the focal point – its economic output will lag the rest of Asia which is expected to be 5.3%, for the first time since 1990, according to the World Bank. COVID-19 management, the property sector downturn, and macro policy have been at the centre of China’s growth dynamic this year.

After a brief recovery from its Q2 shutdown, the economy has lost momentum as the government continues its dynamic zero-COVID-19 policy, leading to smaller-scale lockdowns in several cities. The drag from China’s property sector continues, prompting support measures from both the government and People's Bank of China (PBOC) - all providing some positive signs, however not sufficient to revive the sector.

More broadly, the authorities have also restarted cyclical policy easing - with inflation subdued, it gives the PBOC room for increasing policy support. With less than four months to go by year end, timing is tight for Beijing to meaningfully revive growth for 2022.

Elsewhere emerging markets have continued to see a new phase of volatility as market stress is evolving following the ever-tighter Fed policy. The dynamics differ by region, and country.

In general, Ecaterina said commodity-exporting economies look in better shape fiscally, in line with elevated commodity prices in 2022 to date, hurting oil importers and manufacturing economies. 

Notably, emerging market central banks have hiked policy rates earlier and faster than their advanced peers. “This is bringing them closer to the end of their hiking cycle amid growth concerns,” added Ecaterina.

However, attention is now shifting to their currencies, driven by the hawkish Fed, since the depreciation of the emerging market FX adds uncertainty to external debt, explained Ecaterina, plus puts upward pressure on inflation for importers.  “This has led to intervention by some EM central banks and, in turn, a depletion in reserves.”

At the same time, she added, emerging market nations must consider the need to offer sufficient yield to foreign investors to limit capital outflows.

Taking selective steps towards positive returns

The overarching message is that higher carry and a potential peak in rates raise the probability of positive returns in Q4.

Valuations are attractive across most asset classes. Current bond prices should help investors identify opportunities for attractive total returns, with higher yields providing a better cushion, particularly in the shorter part of the curve. Credit spreads are at risk of moving wider given the potential for weaker growth. And a worsening macro backdrop merits a prudent approach via careful bottom-up credit selection.

Investor sentiment remains poor in the wake of the losses already incurred in 2022, however cheap markets may encourage more risk taking towards year end.


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