The third week of June proved to be challenging, confirming that capital markets are at a turning point. Central banks around the globe are now following words with actions. The Federal Reserve (Fed) recently not only took the biggest interest rate step since 1994 with a 75 basis point increase, but also sharply adjusted its interest rate targets for 2022 to 2024 upward. The year-end targets are now 3.4% (2022), 3.8% (2023) and 3.4% (2024). One may wonder to what extent it makes sense at all to issue a target for 2023 and 2024, but the direction is clearly defined, namely to fight inflation by all means. The big surprise, however, was the Swiss National Bank’s (SNB) decision to raise interest rates by 50 basis points. The move was not expected by the markets and seems extraordinary, as the SNB is front-running the European Central Bank (ECB). The ECB is aiming to hike rates for the first time in eleven years at its next meeting in July, but ECB President Christine Lagarde is struggling to take a decision due to rising spreads in the European periphery. Financial markets are already pricing in the ECB’s interest rate turnaround, and expectations point to rapidly rising rates in the United States and Europe.
In May, the US inflation rate was again above 8%, even though goods inflation has been falling for two months. This is the first indication that global supply chains are beginning to re-synchronize. Services inflation, on the other hand, has continued to rise, triggered by rising wages in the sector. Here, the recipe or solution is obvious. To return to equilibrium, the demand momentum must be slowed down sharply. As a consequence the Fed must destroy demand, so to speak, which will probably materialize in lower economic growth.
A strong US dollar, rising interest rates and slowing economic momentum – this is an almost perfect storm for the now upcoming reporting season, which starts at the end of July in the US and in Europe. High energy costs are likely to take their toll. Analysts are still expecting almost double-digit earnings growth. Although the stock market no longer expects this kind of momentum, no profit recession has been priced in yet either. There will literally be a “day of reckoning”. In this context, corporate guidance is likely to be indicative for the second half of 2022, but also for 2023, where earnings growth of 8% is clearly too high in our view. Volatility at the single stock level is likely to be enormous, as it was in the first corporate reporting season in 2022.
In recent weeks, the growth/inflation mix has deteriorated again. This has increased the risk of a recession in the coming twelve to 18 months, at least in the United States. Low-record consumer sentiment and less fiscal stimulus, as Covid-19 aid is expiring, are further slowing growth. High energy and food prices act as an additional tax for a large part of the population. This means there is less money to support consumption and economic growth. In the US and Europe, growth forecasts are therefore being revised downward, while China's economy output is already below potential this year.
In this market environment, the time has not yet come to build up risk, either on the equity or the bond side. We are sticking to our strategy of not buying the market setback, despite a 20% correction. Rising interest rates have not caused the equity risk premium to rise across assets, despite a P/E compression of 15-20%. In the coming months, we will focus primarily on selection, both in equities and bonds.
On the equity side, we upgrade the emerging markets (EM) from ”unattractive“ to ”neutral“. In the harsh market environment of recent months, emerging market equities have lost significant ground against the global equity index. However, much negativity now seems to be priced in, opening up potential for improvement. Meanwhile, we are abandoning our preference for Latin American stocks as political risks have increased significantly recently, for example in Columbia. The focus now shifts to the second quarter earnings season.
Central banks have long underestimated the rise in inflation. Now they face the challenge of tightening monetary policy without choking off the economy. The balancing act is particularly delicate for the ECB, which has to prevent another debt crisis in the currency area. On the bond side, we continue to favor subordinated bonds, with a preference for AT1 bonds.
Publisher: LGT Bank (Switzerland) Ltd., Glärnischstrasse 36, CH-8027 Zurich
Author: Thomas Wille, Chief Investment Officer, Email: firstname.lastname@example.org
Editor: Alessandro Fezzi, E-Mail: email@example.com
Source: LGT Bank (Switzerland) Ltd.
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