Equities Depend on The Good, Bad, & The Ugly and Why High-Quality Bonds Are Worth a Look
Prashant BHAYANI CIO Asia, Grace TAM Chief Investment Advisor, Hong Kong & Dannel LOW Investment Specialist at BNP Paribas Wealth Management
How should we think about the key topics?
Equity markets were volatile in May, reflecting consumers fear of rising inflation, in particular, oil and food prices. Covid restrictions in China and the ongoing Ukraine war also impacted sentiment.
- What is the probability of a recession?
- When will inflation finally peak?
- Are equity/bond markets becoming cheap enough?
- Is sentiment a short-term contrarian buy signal? Will equities eventually go lower over the coming months?
- How high will oil prices go?
- Where do we position as volatility creates opportunity? What are our key investment themes?
Are we going into a global recession?
Recession Fears? “Slowflation” not Recession.
• The Good: While we are definitely in a period of increasing “Slowflation” - lower growth and higher inflation, our forecasts are not predicting a recession in major economies. Our GDP forecasts for the US are 3.7% for 2022 and 2.5% for 2023; Eurozone 2.8% for 2022 and 2.7% for 2023; and China 4.8% for 2022 and 5.1% for 2023. China is the only major economy easing policy, however, the transmission mechanism has been slow and Covid-19 restrictions are now gradually ebbing.
• The Bad: Finally, when we examine market derived forecasts of US recession, they are increasing for 2023, up to 30%. This is not a low figure and we will continue to monitor, but also it is not indicative of a recession as a base case.
What about the US consumer?
The personal saving rate in the US at 4.4% is the lowest since 2008. However, credit card balances are being increased. Given the uncertainty of the pandemic and generous stimulus measures, deposits grew to roughly $3 trillion above normal levels. The excess saving level is still high at US$2.3 trillion. This suggests that despite a slowing demand growth influenced by the Fed actions, consumers do not need to reduce their spending as significantly as they did in prior recessions, when they were overstretched.
When will inflation peak?
The Good & Bad: Inflation is still proving stickier than expected with both US inflation and in particular, European inflation worsening at 8.1% vs 7.8% expectation in May. However, longer-term US inflation expectations are falling, and goods inflation could peak with large US retailers inventories bloated, which could lower goods inflation. As consumption shifts to services, this component is just starting to accelerate in inflation figures. More deterioration in fundamentals are needed to make the Federal Reserve start thinking about making a pause in their hiking campaign. This would help stabilise price-earnings ratio. It might take several more months into September before they can reassess the impact of tightening.
Are equity markets cheap enough?
The Good: The equity markets have corrected and the 2023 P/E earnings ratio of the S&P 500 is 16.6x, Euro Stoxx 50 12.1x, and CSI-300 13x. This partly reflects a more reasonable valuation especially in non-US markets. The “P”, or price, has corrected reflecting a growth slowdown. The decline of S&P 500 (-20%) in 4 months so far has been in line with previous non-recession corrections in terms of drawdown and duration, but we need a trigger for the market to form a bottom. Price-to- earnings ratio will stop falling when risks stop rising. Rising rates, inflation and oil prices have been the key risks in 2022 thus far.
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The Bad: We are moving to a growth scare from inflation fears. The current risk is the declining earnings per share (EPS) estimates which will not peak until PMIs bottom. The problem is with the “E” or earnings. For certain sectors, without pricing power, earnings look too rosy with consensus predicting 10.1% S&P 500 earnings growth for the year while growth is slowing with higher inflation. Only in the last four weeks analysts had started modestly reducing their forecasts. Margins may also come under pressure. We recommend to remain overweight high quality companies with pricing power and sectors like energy, healthcare, and financials.
Against the current macro backdrop, three key investment themes that we focus on are
2) Riding a new inflation regime; and
Short-term rally / longer-term volatility?
The Good: Despite the fact that investor sentiment has been bearish, signalling a near-term bounce which we saw in the last week of May 2022, investors are still net overweight equities. While being bearish, many have largely retained an overweight, selling only a fraction of their record inflows last year. Institutions and hedge funds are now positioned more cautiously.
The Bad: Sentiment indicators can predict short-term bottoms but a true bottom is when fundamentals are priced in. For global equities, it is important to focus on lead indicators. In this regard, US ISM new orders, at 55.1 are weakening and not yet pricing in a major slowdown or a recession (not our base case). Hence, there could be further downside or volatility for equities after the bounce. We expect more volatility in mid-July when US earnings season begins. We could be in an extended trading range market for the coming months. Longer-term investors and traders should buy steeper sell-offs.
What about Oil?
The Ugly: Oil continues its rebound with Brent trading above $115 per barrel. This is starting to lead to demand destruction with lower income consumers. In addition, prices are high, despite lower demand from China due to the Covid restrictions, and US’ strategic petroleum reserve release. However, the summer driving season in Northern hemisphere and hurricane season are approaching. This will be a key risk factor to monitor.
The Good: IF there is any truce in the Ukraine – Russia war (no signs presently), this could result in a $10-$15 premium in oil being priced out.
Our forecast is for oil to trade between $105 to $115 per barrel in the next 12 months.
The Good: THERE IS AN ALTERNATIVE
We remained neutral on credit as we had expected higher sovereign yields. This has now transpired and given the largest rise in yields in recent history.
We recently upgraded our government bond view from negative to neutral. In fact, we upgraded to neutral just as US Treasury yields peaked.
In that regard, high quality investment grade credit with the curve very steep out to 2-5 years is attractive with yields in USD of 3-5%. Euro yields are also more attractive with the recently more hawkish ECB. If we do have a bumpy slowdown and not a recession, credit spreads can start to widen, however, treasury yields will rally offsetting some capital loss. In addition, for investment grade credit, prospects of holding to maturity with low probability of default will provide attractive income for the first time since 2018.
We remain neutral on equities given the more balanced outcomes resulted from the good, bad and ugly factors and possible weakness during second quarter earnings season. We continue to favour quality stocks with pricing power and dividend yield and sectors like healthcare, energy, and financials. We encourage investors to monetise volatility via targeted solutions and to consider diversifying via alternatives in macro, distressed, and event driven strategies.
CONCLUSION / STRATEGY:
- We are in a period of increasing “Slowflation”. The forecast of a 2023 US recession has increased up to 30%. This figure is not low, but also it is not yet indicative of a recession either. Inflation is still proving stickier than expected, but it may be peaking soon, and may gradually decline over the summer.
- Oil continues its rebound with Brent trading above $115 per barrel, and is starting to lead to demand destruction with lower income consumers. IF there is any truce in the Ukraine – Russia war (no signs presently), this could result in a $10-$15 premium in oil being priced out. Our forecast is for oil to be trade between $105 to $115 per barrel in the next 12 months.
- We remained neutral on credit as we had expected higher sovereign yields. We recently upgraded our government bond view to neutral just about when US Treasury yields peaked. The prospect of holding a higher quality investment grade credit to maturity, with low probability of default while providing income, is looking attractive for the first time since 2018.
- We remain neutral on equities given the more balanced outcomes resulted from the good, bad and ugly factors and possible weakness during second quarter earnings season. We continue to favour quality stocks with pricing power and dividend yield and sectors like healthcare, energy, and financials. We encourage investors to monetise volatility via targeted solutions and to consider diversifying via alternatives in macro, distressed, and event driven hedge fund strategies.