Global markets not out of the woods yet

November 22, 2022 09:36
Photo: Reuters

Looking toward the balance of 2022, one thing is clear: we are not out of the woods yet. Both the global economy and global investment markets continue to be waylaid by familiar risks. That does not mean investors have to wander the woods with no trail markers. In the US, for example, even if the Federal Reserve's inflation-fighting pushes the economy into recession, the combination of resilient labor markets and household balance sheets points to any such downturn being mild and relatively short-lived.

Stay attuned to value opportunities

There is no question this has been a confounding and challenging year for markets, and there is still a way to go before we emerge from the murk of bearishness into the light of "normalcy". In the meantime, we see glimmers of incremental economic progress and asset allocation opportunities that can help investors stay on the path toward their long-term objectives.

However, investors seeking to put this bear market behind them are not out of the woods yet, as hopes have diminished that inflation might peak quickly, that the US Federal Reserve would pivot, and that the global economy could emerge unscathed. Meanwhile, there are further risks ahead: softer earnings, a likely weaker employment picture and demand destruction that undermines the ability for the consumer to continue to be the hero. Therefore, it is crucial to position portfolios to keep pace with inflation, cope with hawkish monetary policy and cautiously take advantage of longer-term trends.

Portfolio themes to keep any eye on

Watching inflation data these days is like waiting for a fever to break: Until prices peak, there is little hope for relief. With that in mind, remaining focused on asset classes that typically perform better in an inflationary environment — namely, farmland, real estate and infrastructure is key. Returns on these real assets have historically exhibited a positive correlation to inflation while offering portfolio diversification and relatively low volatility.

Meanwhile, the overheated US economy continues to detox from its pandemic-driven, stimulus-fueled state. There is little doubt market volatility will persist as these economic factors play out. In 2022 alone, there have been four bear market rallies, each one stronger and longer than the one before it. The question is: when does the bear break through and become a bull? The key data signals there is likely more rockiness ahead as corporate earnings deteriorate.

With macro risks elevated, it is preferable to be generally defensive when it comes to equities. Over the near term, markets are likely to be driven by inflation concerns, central bank policy, and earnings, which are not looking great. Slowing economic growth and ongoing geopolitical concerns also make it tough to be bullish toward equities.

Geographically, US stocks, especially large caps, are preferred over non-US developed and emerging markets given the relative economic resilience of the US and ongoing dollar strength, with a particular emphasis on dividend growers, as they tend to be more defensive, they can weather volatility and provide income. Growth stocks that offer compelling fundamentals, solid pricing power and reasonable valuations are also favored, while private equity also presents many opportunities. Some investments may suffer from the lagged effect of market repricing, current vintages may be worth a look, especially if the world manages to avoid a hard landing.

Direct real estate is also an option

Inflation consternation drives market gyrations, and it is indisputable that the direction of global investment markets continues to hinge on the expectations for and reality of inflation. For proof, look no further than the July jolt versus the September swoon. While we anticipate inflation data to remain a potential source of volatility, we remain confident that the 9.1% year-over-year increase observed in June's U.S. Consumer Price Index will ultimately prove to be the peak.

However, even as the rate of growth moderates, current pricing levels may prove sticky, and opportunity knocks for commercial real estate. Adding exposure to direct real assets, particularly farmland, has been one of our highest-conviction investment views in 2022. We believe investors can benefit from increasing their exposure to residential areas of the commercial real estate universe, especially rental markets. The relatively excessive cost of home ownership should continue to translate into stronger demand for rentals as well as resiliency in the level of cash rents.

When the rate market sneezes (as it has this year), other asset classes are at risk of catching a cold; and commercial real estate is no exception. However strong real estate fundamentals may help to provide natural immunity to higher financing costs and any potential negative valuation adjustments, particularly in the U.S. rental housing sector. Below-average vacancies in 43 of the top 50 U.S. cities continue to enable landlords to increase rents to offset higher operating costs. On the demand side, elevated home prices and the 30-year fixed rate mortgage's ascent to 7% means that the cost to rent has never been more attractive. While macro headwinds will continue to impact markets into 2023, U.S. apartments and single-family rentals may be a source of shelter from inflation-induced volatility due to low vacancies and strong renter dynamics.

Exercise caution when investing outside the U.S.

Today's ultra-cheap non-U.S. equity valuations may be alluring to investors, bringing to mind Oscar Wilde's famous quip, "I can resist everything except temptation." Yet investors must beware the impulse to jump right in when assessing non-U.S. stocks based on their current equity risk premiums. Across regions, we see far more headwinds than tailwinds to justify establishing or adding to non-U.S. equity allocations.

In Europe, the energy crisis and war in Ukraine are the most obvious disruptors of economic activity. Germany has nationalized a major power company and plans to ration energy to stretch reserves, which will limit industrial output. Additionally, the European Central Bank has just started raising rates, putting it far behind both the Bank of England and the U.S. Federal Reserve, especially after another aggressive U.S. hike. These factors outweigh the positives of bolstered energy reserves and fiscal stimulus, which will help consumers but likely continue to exacerbate inflation. A de-escalation of the war, new sources of energy being brought online and the possibility of a milder-than-expected winter could help turn the tide.

Elsewhere, The Bank of Japan reaffirmed its outlier dove status among central banks last week through its yield curve control policy. It purchased JPY 2 trillion of bonds to put a ceiling on rates and bring liquidity to the benchmark 10-year government bond, which had recently gone untraded for two days. This has driven the yen precipitously lower, adding inflationary pressure in a country that needs to import basics like food and energy. To counter this, Japan intervened to prop up its currency for the first time in 24 years. A move toward policy normalization within Japan, and separately, diminished U.S. inflation and less aggressive Fed hikes could help.

Meanwhile, China, the largest emerging market and the world's second-largest economy overall, is perpetuating its untenable zero-Covid policy, dragging down domestic growth and global economic recovery. The continued potential of shutdowns in major production zones such as Shanghai adds to uncertainty and the risk of further economic pain. The region would benefit from more clarity on China's policy intentions and evidence of economic progress. Elsewhere, nascent bright spots in Latin America, notably Brazil (which sends nearly half of its crude oil exports to China), could foster confidence in the region's valuations.

Stay defensive

The risks causing elevated volatility, especially inflation, are likely to persist, but we are not anticipating a deep or prolonged recession. Preparing for the inflation fever to break is more than a short-term investment play, as it is impossible to predict exactly when inflation will finally peak. As such, real asset categories that have historically proven less volatile, weathered high-inflation periods well and provided diversification benefits are favored.

Nevertheless, we emphasize that investors should be wary of value traps. Current readings of our data-driven Bear Market Tracker signal that equities is unlikely to find their bearings and begin to move closer to bull market territory in the near to medium term, so we maintain a somewhat bearish view toward equities.

While bear traps in the woods may be easy for the human eye to spot, value traps in investment portfolios can be less obvious. Relying too much on what appear to be attractive short-term valuations can ensnare investors in ways that greatly diminish long-term outcomes. Therefore, we suggest a mostly defensive stance overall and see better opportunities in credit markets moving forward.

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Chief Investment Officer, Nuveen