Things would get worse before they get better

May 23, 2022 11:05
Photo: Reuters

“The dominant concern in the market is that the economy could buckle when the central banks have no firepower – because their guns are trained on reducing inflation instead. In other words, tight monetary policy could take the place of the Fed put. “Stefan Kreuzkamp said.

Grit your teeth and get through it would probably be the shortest summary of our latest strategic outlook, as we expect things to get worse before they get better. This is because of the many challenges ahead, not all of which, we hope, will be long-term: supply constraints, China's Covid problems, inflation, slowing growth, tighter monetary policy, market volatility and the war in Ukraine. From an investor's point of view, the main concern is that central banks are starting to address rampant inflation with interest rate hikes just as the economic clouds are darkening. We put the probability of a recession in the U.S. in the next 18 months at around 40%. But inflation rates in the high single digits mean the market can no longer put its faith in its most reliable savior of the past 35 years: the so-called Fed put. This time the U.S. central bank is ill placed to bail the economy or financial markets out.

It might be argued that investors have been well aware of this for several months already. The fact that stocks, bonds and cryptocurrencies combined have lost over 30 trillion dollars1 since the beginning of the year has put them on notice. But the lack of a Fed put in the current environment of strong economic growth, record employment and rising corporate profits is quite different to its absence when the economy is really going downhill. In other words, the big stress test for the markets has not yet come. That is a sobering message for investors.

Moreover, a number of other stress tests seem set to be conducted in coming months. What happens if there is a sustained decline in energy supplies from Russia? What if China continues to subordinate everything to its fight against outbreaks of Covid? What if, in line with our expectations, inflation peaks in the second quarter but then stabilizes at close to 5%, rather than 3%? And what if, again contrary to our assumptions, war spreads to NATO territory?

There are many unanswered questions. And yet there are also developments that, in our view, point clearly to serious difficulties for the markets in the second half of this year. Margin pressure at companies is rising, financing conditions are getting worse, Covid stimulus packages are expiring, especially in the US, and consumers’ real purchasing power is falling, eroded by inflation. We therefore expect continued high volatility, especially in the equity markets, pressure on corporate bonds, and strain in emerging markets.

But the outlook may improve towards the end of the year if these risks do not escalate and investors begin to believe that the Fed can bring the economy in for a soft landing on what will be, admittedly, a very narrow runway. There would then be positive return potential for the majority of asset classes on a 12-month horizon. This would be based, too, on economic resilience and avoidance of recession: growth rates of 2.9% for the U.S., 2.8% for the Eurozone and 4.5% for China in 2022, and in 2023 only a mild slowdown in the U.S. and Eurozone, to 2.4% and 2.2%, respectively, while China improves slightly to 4.8%.

Inflation is expected to slow in the U.S. from 4.7% to 2.9% in the coming year and in the Eurozone from 8.0% to 3.3%. But for this to happen central banks will have to do their bit and tighten accordingly. We expect the Fed to raise interest rates steadily to 3.25-3.5% in the next twelve months, while the ECB will have reached a refinancing rate of just 1% by then. Unlike the Fed it will not yet have reduced its balance sheet during this period. Since our baseline scenario assumes no recession, we expect a slight steepening of the yield curve in the U.S., but no more big leaps in yield overall (we see the 10-year Treasury at 3.25% in 12-months time), while for Germany we expect a further flattening of the yield curve, with the 10-year Bund yield at 1.00% in June 2023.

Corporate bonds could initially face a further widening of risk premiums, but we see positive return potential over twelve months. The same is true for selected emerging market bonds, as the strain imposed by higher U.S. yields and a stronger dollar should have subsided by then. We see the dollar weakening a little from its current level to USD 1.10 against the Euro in twelve months.

In the near term the environment will remain difficult for equities. First quarter earnings were still surprisingly robust for the most part, and earnings estimates are still holding up very well. But we fear that there could be downgrades in the course of the year. A serious threat to equities, however, are developments on the bond side. In the U.S. yields on inflation-adjusted tenyear Treasuries (TIPS) have risen from minus 1.1% to plus 0.2%. This weighs on equities for two reasons: First, future profits are discounted at a higher interest rate, which hurts growth companies in particular. Secondly, equities no longer benefit from the "there is no alternative" mantra – and there is likely to be a shift from equities to bonds. But equities do benefit from the fact that, unlike bonds, they offer a certain degree of protection against inflation. And their valuation multiples for equities have already fallen significantly from recent highs. We could envisage a recovery here once volatility in the equity segment decreases again.

Rising interest rates are also leaving their mark on some alternative investment segments, though not as plainly as in the equity and bond markets. We currently prefer infrastructure projects to real estate, as the cash flows here are fixed for the longer term and mostly enjoy inflation protection. Gold is being hit by rising real interest rates. But the currently high geopolitical risk premium, inflation concerns and cryptocurrency turmoil might mean the yellow metal holds up well for now. Lastly, we expect structural undersupply in oil for the time being, which should keep the price of Brent at around $110 per barrel.

Economic slowdowns combined with continued high inflation rates, which also limit central banks’ room for maneuver, are thus the quite challenging environment for investors these days. But we think that if recessions in Europe and the US can be avoided, the outlook should improve significantly in twelve months’ time.

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Chief Investment Officer and Head of Investment Division of DWS