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The rise in inflation continues to dominate the policy setting, and with that, the cyclical outlook in all DM countries. Yet, there is considerable dispersion in the current position in the cycle as well as the inflation outlook across countries. The possible outcomes range from a ‘soft landing’ to stagflation, to inflationary recessions.
Markets have turned on a dime several times in the past few years. From the depression of the Covid-induced lockdowns, to the euphoria surrounding the reopening of economies and the unleashing of consumer demand, to worries about the sharp rise in inflation, followed by the risk of recession in response to monetary tightening. Investors have now become sufficiently worried about a (US) recession that they anticipate the Fed to ‘pivot’ as soon as early 2023 and begin easing interest rates again. The latest Fed statements were interpreted as indeed supporting the idea that the recent ‘jumbo’ rate hikes would end soon. As the turn of the monetary policy cycle has thus come into sight, Treasury yields declined again, US stocks rebounded and the US dollar eased off.
The depth and the duration of any recession will likely hinge on the prospects for inflation and the appropriate policy reaction. Given the multitude of factors that have impacted price growth over the past 12-18 months (some outside the purview of central bank policy), the future trajectory of inflation remains shrouded in uncertainty. While the shocks from food and energy prices will likely begin to fade, the impact of services price growth is taking over as the principal driver. Consumption-driven price growth may well soften as the economy (employment) weakens in response to tighter monetary policy. But with solid wage growth and a decent buffer from elevated household savings, this can take time. In the meantime, the supply side remains vulnerable to geopolitical and pandemic-related risks.
The features of slowing growth and rising inflation are now in place across all DM economies. However, there is considerable dispersion in outcomes. Inflation is still moderate in Switzerland and Japan but at a multiple of target-level in the UK and the eurozone. Policy action thus has farthest to run in the latter. The key counter-examples are Japan and China where central banks are either on hold or in easing mode. Growth remains still robust in commodity exporters such as Canada and Australia and is weakest in the UK and Switzerland. The US is in recession technically, but a debate rages when and if the economy will officially enter a recession.
Market Strategy: The MSCI ACWI reported another loss during the May-July period, with a return of -1.9% (-4,8% ex-US). The US and Japan were the only outperformers (though still incurring negative returns), while all other countries underperformed, with EMs and Australia reporting the weakest outcomes. Yet, despite the gloomy economic outlook across the majority of economies, markets have barely altered their expectations for corporate earnings over the next year when the downswing will likely be most pronounced. There thus remains considerable downside for the market as a whole.
In our country allocation we favour exposure to countries with the best cyclical prospects and the most attractive valuations. Thus, we upgrade Japan to overweight as its economy does not face the headwind of domestic monetary tightening, even if its exports will encounter slowing global demand. However, equities will be helped by a weak yen and attractive valuations. In the face of the global slowdown, we are sceptical of significant support for commodities from the demand side, even though energy prices may continue to be supported by tight supply given the sanctions on Russian exports. As a result, we downgrade Australia to neutral, but retain an overweight to Canada, which also offers more attractive valuations. On the other hand, we believe that UK valuations are not sufficiently attractive to compensate for the highest inflation record in the asset class combined with the darkest cyclical outlook. We also retain our underweight to the Eurozone as monetary tightening, energy disruptions and the resulting rationing will weigh on activity. In addition, the ECB remains constrained in its fight against inflation by the union’s fragmentation risks. We remain overweight US equities as labor market strength points to a resilient economy. We also think that the Fed has become more nimble in its policy conduct and will try to mitigate too sharp a slowdown. Valuations have become more attractive.
*This publication reflects asset performance up to 30 July, 2022, and macro events and data releases up to 10 August, 2022, unless indicated otherwise.
The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.
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