Paul O’Connor, Head of Multi-Asset, explores the challenges facing markets for the remainder of 2022 and the looming likelihood of recession in the near future.
- Global inflation has triggered an interest rate shock, and ultimately a valuation shock in financial markets – as reflected in higher yields in government bonds, wider spreads in credit markets and lower equity price‑to‑earnings ratios.
- History shows that previous tightening cycles by central banks has often culminated in recessions. This is poignant, given the expected rate hikes by central banks and all‑time low levels of consumer confidence.
- Although most risk assets appear much cheaper than at the start of the year, it still seems too early to significantly rebuild exposures. They are likely to face continued valuation pressures from rising real yields, as well as headwinds associated with slowing growth.
The global backdrop has remained challenging for investors in Q2 as they struggle to price in the market impact of the war in Ukraine, coronavirus outbreaks in China and the continued upsurge in global inflation. But, just as in the early part of the year, the most assertive market theme in recent months has been the repricing of global interest rate expectations, which has dominated sentiment and performance across all asset classes.
Inflation shock | rate shock | valuation shock
The global inflation shock has triggered an interest rate shock and ultimately a valuation shock in financial markets. This is reflected in higher yields in government bonds, wider spreads in credit markets and lower equity price-to-earnings ratios. Investors have endured double-digit drawdowns this year in stocks, corporate credit, emerging market debt, government bonds and gold. There have been very few places to hide in this destructive, high volatility and highly correlated market environment.
While the scale of market moves seen this year might suggest that the resetting of global interest rate expectations is now well advanced, neither the economic data nor central bank messaging support this view. Inflation does seem to be close to peaking in the major economies, but this alone is unlikely to be enough to reverse the uptrend in interest rate expectations. With inflation at multi-decade highs in most economies, wage growth surging and unemployment at cyclical lows, big reversals in economic trends will probably be needed to endorse the view that interest rate expectations are high enough. Sustained relief on the interest rate front is likely to require a decisive easing of labour market imbalances to break the current momentum in wages and service sector inflation.
The speed and scale of the rethink on interest rates has been remarkable. Last September financial markets had not fully priced in a rate hike from the US Federal Reserve (Fed) for 2022; Today, they are indicating that rates will rise by more than 3% in 2022.1 The reappraisal of eurozone interest rates has been more recent, but also abrupt. At the start of March, the European Central Bank (ECB) was barely expected to raise policy rates this year; market pricing now suggests rates will have risen by about 1.75% by December, with more hikes beyond that – figure 1. As views on interest rates have evolved, most central banks outside Japan have brought quantitative easing programmes to an end and are pivoting towards quantitative tightening. This looks set to drain about US$3 trillion from global markets over the next 18 months2, reinforcing the monetary tightening from interest rates.
Figure 1: Market expectations for interest rates at the end of 2022
Source: Janus Henderson Investors, Bloomberg, as at 14 June 2022
This is going to hurt
It is hardly surprising that financial markets have been turbulent amid such a rapid change in the monetary policy regime. While central bank policies in the major economies have been market-friendly by design since the Global Financial Crisis (GFC), the focus has now clearly shifted towards prioritising the fight against inflation. As this battle intensifies, so does the risk that the response from monetary authorities will cause collateral damage in the real economy or in the financial markets.
Of course, history shows that many central banks’ tightening cycles have culminated in recessions. At face value, the basic data reveal that nearly 80% of US tightening cycles since World War II have ended this way – figure 2. Still, many of these were short and shallow slowdowns and not all are regarded as having been caused by central bank actions. In some cases, oil shocks or fiscal tightening were probably the primary causes of the slowdowns; for the recession of 2020, the pandemic takes the blame.
Figure 2: Historic probability of recession after rate hiking cycles end
Source: Janus Henderson Investors, Goldman Sachs, as at 17 April 2022 Note: Data based on all recession since 1945
Optimists can highlight that outside the US, fewer recessions have followed central bank tightening cycles. They might also note that ‘soft landings’ have become more common in recent years. However, this probably reflects the fact that the probability of recession seems sensitive to the economic conditions prevailing when the rate cycle begins. Whereas low inflation regimes, such as that experienced over the last few decades, have typically been associated with benign slowdowns, history warns that harder landings are more likely when rate cycles begin with overheated economies.
When core inflation was as high as it is now in the US and most other countries, 80% of tightening cycles in G10 economies have been followed by a recession. The labour market statistics are equally worrying. Since 1955, the US economy has always experienced a recession within two years from every quarter in which price inflation was above 5% and unemployment was below 5%, as they are today.3
So, the balance of evidence suggests a high risk of a recession next year. While the strength of consumer and corporate finances in most economies offers hope that a deep slump can be avoided, future developments in Russia, China and the commodity markets could tilt the probabilities less favourably. At the very least, a significant slowdown can be expected as interest rate hikes compound the current squeeze on consumer real incomes. It is ominous that some measures of consumer confidence in the UK and US have slumped to the lowest levels on record, below those seen in the six recessions since 1980.
Figure 3: Consumer confidence measures
Source: Janus Henderson Investors, Bloomberg, as at 14 June 2022 Note: Indices shown are the GfK UK Consumer Confidence Indicator and University of Michigan Consumer Sentiment Index
Recession only partly priced in
Weighed by such concerns, global equities have now fallen more than 20% from January’s peak. This is a sizeable decline for a sell-off outside of a recession and not too far from the 24% median decline seen during past recessions.4,5 While pullbacks outside recessions typically last three months, the current sell-off is now into its fifth.
Still, any sense that stocks have now priced in a lot of bad news has to be tempered by the recognition that the sell-off began with valuations unusually elevated, particularly among US mega-cap growth stocks. Valuations still look rich among the latter, while other stock markets now look priced for a slowdown but not fully priced for recession. In the corporate bond markets, credit spreads convey a similar message. Taking a cross-asset perspective, we see that equity valuations are consistent with real yields on government bonds. While this offers the promise that the equity derating will be complete once the central bank tightening cycle has been fully priced in, it also suggests that stocks will probably remain under pressure until that point has been reached.
While equity valuations have at least partially adjusted to this year’s challenging economic and policy environment, we see less evidence that earnings estimates and investor positioning has yet to catch up with the new reality. Consensus analyst estimates for corporate earnings for 2022 and 2023 have actually risen in recent months, despite economists persistently downgrading projections for gross domestic product (GDP) growth. Recessions typically see earnings growth contract by over 20%.6 Even if that outcome is avoided, current estimates of 8% global earnings growth for both 2022 and 2023 look optimistic if the world economy slows as we expect.
Fully invested bears
Indicators of investor positioning and sentiment are another way of judging what has been factored into markets. For equities, we see mixed signals here. Many indicators suggest that consensus sentiment regarding stocks is now at the sort of levels of bearishness that we would normally regard as being contrarian ‘buy’ signals. However, when we look at investor positioning, we see a different picture. Investors came into this year with high exposure to stocks and they have kept buying. Global investors have nearly withdrawn a net US$220bn from money market funds this year and have invested a net sum of nearly US$200bn into equities.7
So, even though equities, credit, and most other risk assets are now looking much cheaper than at the start of the year, it still seems too early to significantly rebuild exposures. It is hard to make the case for a sustained rally in risk appetite and risk assets until we have evidence that inflation has peaked, labour markets are cooling, and central banks are responding in a way that offers hope that they can defy the odds and deliver a soft landing. Until then, risk assets are likely to face continued valuation pressures from rising real yields as well as headwinds associated with slowing growth.
Despite the turbulence of the past few months, we have become more constructive on Chinese equities, which have already experienced a major bear market, a significant valuation derating and wholesale investor capitulation. We take encouragement from the growing evidence that last year’s broad-based regulatory clamp down has now largely run its course. We are getting less bearish on government bonds as yields move higher, taking a view that they should regain some of their risk-hedging characteristics as growth begins to slow.
Anything that accentuates the upward pressure on interest rates will probably be a source of downside risk for markets. The higher that interest rates need to go, the greater the risk of recession or some sort of financial accident. Developments in Russia and the commodity markets remain obvious sources of concern. In broad terms, there are probably two key paths to a more optimistic investing environment. The rougher one would be if markets sell off to the extent that most plausible adverse economic outcomes get fully priced in. The more constructive path would be if inflationary pressures eased surprisingly quickly, allowing investors to conclude that the interest rate cycle has been fully priced in. An easing of tensions in commodity markets could deliver such an outcome. A significant increase in the supply of labour could also take some pressure off central banks and financial markets.
1 Janus Henderson, Bloomberg Finance as at 12 June 2022. US0AFR Index (WIRP Implied Overnight Rate) Fed end 2022
2 BofA Global Research, 2 June 2022
3 National Bureau of Economic Research, as at 14 June 2022
4 Bloomberg. Global equities represented by MSCI World Index. Decline from 31 December 2021 to 13 June 2022.
5 Deutsche Bank Research, as at 14 June 2022
6 Deutsche Bank Research, as at 14 June 2022
7 BofA Global Research, EPFR Global, as at 8 June 2022