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barometer of financial markets june investment outlook

June 2022
Marketing Material

Barometer: Pulling in our horns

Rising real interest rates and concerns about the prospects for the global economy weigh on our outlook for equities, prompting us to cut our allocation to underweight

01

Asset allocation: a war of nerves

Inflation. War. Covid. They’re each taking their toll on investors’ nerves. 

Russia’s attack on Ukraine continues to squeeze commodities, adding to the inflationary pressures that were building during the Covid pandemic and forcing central banks across the world to hike interest rates and drain liquidity from the global financial system. 

And Covid itself hasn’t gone away – not least in China, where the more authorities try to throttle a new infection wave, the more they throttle the economy. 

This pernicious combination of rising real interest rates and worries about how the global economy will cope with a shortage of fossil fuels and other commodities weighs heavily on the outlook for equities. As a result we have downgraded the asset class to underweight, and upgraded cash to overweight – we await confirmation that inflation and bond yields have peaked before re-allocating to fixed income.


Fig. 1 - Monthly asset allocation grid
June 2022
Barometer grid June 2022
Source: Pictet Asset Management

Although equity valuation multiples have shrunk significantly – down 30 per cent from September 2020 on a price-earnings  basis – they’re still not attractive enough to compensate for the risks. For instance, market projections for corporate earnings haven’t sufficiently factored in the prospect of recession. At the same time, profit margins are being squeezed by rising input costs. 

As for bonds, performance is likely to track inflation expectations and national growth prospects. 

Though the risks are on the downside, our business cycle indicators are only just managing to stay neutral, though there are warning signs of stagflation across the major regions. We have revised down our expectations for global growth for 2022 to 2.9 per cent from 3.4 per cent last month and inflation is revised up to 7.3 per cent from 6.8 per cent. 

We have reduced our growth projections for the US economy, revising down our GDP growth forecast for the current year to 3.0 per cent from 4.0 per cent as our leading indicator slipped into negative territory for the first time since August 2020, reflecting the fact that rising mortgage rates are starting to take a bite out of the housing market. On the plus side, retail sales have held up and household balance sheets remain in good shape.

The downward revision to US GDP projections have been more significant than those for the euro zone during the past month. 

While the US Federal Reserve has set the hawkish tempo, other central banks, especially the European Central Bank, have started to catch up. Although regional inflation is set to peak in May, wage growth could be a spanner in the works. There are signs of significant pay increases in some sectors in France and Germany. If that starts to pick up the peak in inflation could be delayed. 

Lockdowns have sent the Chinese economy into a deep slump. Retail sales, industrial production and fixed asset investment have all come under pressure. We have cut our 2022 full-year growth forecast for the economy to 4.2 per cent now considerably below the official target of 5.5 percent which always looked ambitious. We are however optimistic about a strong recovery in the second half as the economically key regions start to open up again.

Fig. 2 - Shrinkage
G5* central bank assets, % change year on year
AA - liquidity
*Federal Reserve, European Central Bank, Bank of Japan, Bank of England and People's Bank of China. Source: Refinitiv, Pictet Asset Management. Data covering period 31.05.2007-29.04.2022.

Our liquidity readings show central banks are removing stimulus at the fastest pace ever – there has been a USD600 billion drain over the past three months.1 Our  liquidity indicator is at its most negative for the US and our readings for the euro zone and emerging Asia ex-China also show a marked retrenchment. 

We believe that the US is half way through its monetary tightening cycle – including both Fed rate hikes and the central bank's quantitative tightening programme. The Fed is increasingly caught between the frying pan and the fire – forced to choose between tightening and causing a recession or failing to tighten sufficiently and allowing inflation to become entrenched. We think the former scenario is more likely. So far, however, the contraction of Fed liquidity is being partly offset by an increase in private sector lending.

China is an exception to the wider rule of contracting liquidity. Central bank policy easing is beginning to have an effect and excess liquidity – money supply in excess of what is needed to maintain current economic conditions – has jumped.

For the first time since the summer of 2011, both bonds and equities look reasonably attractive on our valuation metrics. Commodities, on the other hand, remain at their most expensive in 20 years. Emerging market local currency government bonds are positive while valuations for US dollar and euro denominated high yield credit are improving as their yield spreads have widened. Meanwhile, real estate now looks cheap.

Our technical indicators show that the trend for equities has turned negative for the first time since March 2020, with a broad weakening of momentum across developed markets, which dampens the outlook over the coming six to 12 months, though over the short term there’s the chance of a rebound. 

Bond trends remain negative, though are starting to show signs of stabilising. Investor sentiment and positioning surveys show that appetite for risk remains at very depressed levels. Investors have raised cash to highest level in two decades, rotated further into defensives and turned underweight equities and tech as per a widely followed fund manager survey. 

02

Equities regions and sectors: cyclical caution

The double-whammy of tightening financial conditions and slowing economic growth are bad news for equities in general and for cyclical stocks in particular. In downgrading equities to underweight, we acknowledge there are few places for investors to hide outside of the core defensive sectors – and, unsurprisingly, those havens have become expensive.

The outlook for corporate earnings is particularly worrying. Consensus analyst estimates for company profits over the next three years imply no recession over that period, which we believe is overly optimistic.

We’ve downgraded our 2022 global earnings per share growth forecasts to a below-consensus 8 per cent (down from 12 per cent a month ago), with risks skewed further to the downside as GDP growth estimates continue to be revised down.

Rising input costs are already biting into profit margins (see Fig. 3) while companies’ own guidance on earnings prospects is turning increasingly negative.

Surprisingly, despite their recent underperformance, cyclical stocks’ premium relative to defensive sectors is still only at neutral levels, suggesting a ‘soft landing’ for the economy or a swift return to trend GDP growth, neither of which is a certainty. This leaves ample room for cyclical stocks to continue underperforming, which is why we consider it prudent to trim our cyclical exposure further.

The financial sector, in particular, looks increasingly vulnerable. Until recently, it seemed that higher interest rates would boost banks’ lending margins and, in turn, their overall profitability. Now however, they appear more susceptible to weaker economic growth, and we believe financials will struggle at this stage of the cycle. Bond yields are unlikely to rise much further while banks’ profit margins are likely to have peaked. And even though financial stocks’ valuations are still attractive, they are not as low as they were a year ago.

Fig. 3 - Margin for error
Global  equity sectors 2022 net profit margin estimates, change over 3 months, ppts. 
Equities - margins
Source: Source: Refinitiv Datastream, IBES, Pictet Asset Management. Data as at 25.05.2022.

We see better potential in materials and healthcare. Companies in these industries are well-placed to defend their margins. Materials also benefit from being a ‘value’ sector, which we believe is likely to hold up better than growth over the near term. The high ‘quality’ attributes of healthcare, meanwhile, make it attractive in uncertain market conditions.

In contrast, despite our overall defensive tilt, we remain underweight utilities – by far the most expensive sector on our valuation scorecard. Utilities are often seen as  a bond proxy. Hence their strong outperformance in an environment of rising bond yield is highly unusual and, we believe, hard to sustain. Add in the introduction of windfall taxes in some countries – such as the UK – to combat the energy price spike and we believe a negative stance on utilities is warranted.

Regionally, we remain cautious on the prospects for US stocks, an expensive market and one heavily weighted towards beleaguered tech stocks. The picture appears brighter for equities in Europe, where the economy is at an earlier stage of the cycle and where fiscal policy is more accommodating. And, while prospects for the UK’s domestic economy look poor, its stock market should hold its own thanks to the global footprint of its listed firms as well as the market's distinctive sector composition – value sectors, whose prospects we believe are brighter, are well represented in UK equity indices. 

03

Fixed income and currencies: better outlook for Treasuries after tightening blitz

The Fed has been at the forefront of a global campaign to withdraw pandemic-era stimulus and control inflation.

But the central bank is walking a tight rope: tightening aggressively to rein in inflation but at the cost of a recession; or not tightening enough to support the economy but losing control of prices.

We think the central bank is keen on avoiding a repeat of a 1970s-style inflation and thus determined to continue raising interest rates aggressively throughout this year.

By our estimates, the Fed has already completed half of what we think is its planned tightening – a hike equivalent to 6 per cent that includes both interest rate rises and the unwinding of bond purchases; we expect it to hit that objective by early next year. 

By prioritising inflation, the Fed will find it difficult to ease policy if, as looks likely, the economy starts to weaken. This, in our view, raises the risk that stalling growth develops into a full-scale recession. Against this backdrop, we upgrade US Treasuries to overweight from neutral. US government bonds are attractive now as recent data suggests a peak in inflation (see Fig. 4).

Fig. 4 - Plateau in inflation expectations
US 5Y5Y forward inflation breakeven rate (%)
FI - breakeven
Source: Refinitiv, Pictet Asset Management, data covering period 30.12.2016 – 25.05.2022

US 10-year bond yields have fallen steadily in response to signs of easing inflationary pressures while those on US inflation-linked bonds have moved into positive territory.

Our models suggest fair value for US 10-year yields is at around 2.6 per cent, which incorporates our assumptions that the Fed will drain a total of USD2 trillion of liquidity and that the economy returns to trend growth in 2024.

While a looming slowdown in US GDP growth justifies an overweight in US Treasuries, the improvement we expect to see in China’s economic prospects has led us to reduce exposure in Chinese government bonds, which now look expensive.

Pushing against the global tide of tightening, China has started to ease fiscal and monetary policy, shifting to broad-based accommodation from targeted measures.

Its credit impulse, which represents the flow of private-sector credit, continues to improve and excess liquidity has rebounded sharply from negative levels.

This raises the prospect of a strong economic recovery once Beijing fully removes Covid restrictions. For these reasons, we downgrade Chinese government bonds to neutral from overweight.

The asset class has been the safe haven in volatile bond markets, with its positive year-to-date return comparing favourably with global bonds, which lost 10 per cent on average.

As a result, however, it has become among the most expensive government bonds in our valuation framework; the China-US bond yield differential has all but disappeared.

We also downgrade European high yield debt to negative from neutral. The asset class is vulnerable to tightening financial conditions and a deterioration in the region's growth, especially as the European Central Bank plays catch-up with the hawkish Fed.

Elsewhere, we remain neutral in emerging local currency, sovereign and corporate bonds.

In currencies, we continue to believe the dollar is about to succumb to a secular depreciation. The currency is trading at a 20-year high in trade-weighted terms, but on a purchasing power parity terms it is around 30 per cent overvalued.

The dollar is likely to struggle the most in the coming months against the Japanese yen, in which we are overweight. We upgrade the euro to neutral from underweight and the Swiss franc to overweight from neutral.

04

Global markets overview: equities claw back losses

Equities ended the May nearly flat after month-end buying was spurred by data showing a peak in US inflation and an easing of Covid restrictions in China.

The relief rally followed a historic sell-off in global stocks that saw them fall 17 per cent since January, marking the worst start of the year for the asset class in 100 years.

Signs of slower economic growth in the world’s biggest economy reduced inflation fears and fanned expectations that the Federal Reserve may become less aggressive in its monetary tightening campaign.

Fig. 5 - Peak yield
US 10-year Treasury yields, % 
 
Markets - bond yield
Source: Refinitiv Datastream, Pictet Asset Management. Data covering period 01.01.2021-25.05.2022.

European and Japanese stocks outperformed their US counterparts where a strong dollar and high valuation represented headwinds.

Commodity-heavy Latin American stocks were the best performers, with a gain of nearly 4 per cent in local currency terms.

Energy stocks continued to outshine the rest of the market, with the sector adding nearly 12 per cent in local currency terms, bring year-to-date gains to as much as 38 per cent.

Businesses that are sensitive to economic cycles, such as real estate and consumer discretionary, fell more than 3 per cent.

Utilities attracted defensive inflows to rise more than 2 per cent. Global bonds ended the month slightly down as the asset class stabilised towards the month end after registering the worst-ever start to the year with a year-to-date loss of 7 per cent.

European government bonds and credit fell across the board as yields and the euro climbed on European Central Bank governor Christine Lagarde's warning that the bank was likely to raise interest rates twice by end-September.

Emerging market local currency bonds rose 1.7 per cent, thanks to a weaker dollar.

The greenback lost more than 1 per cent amid shifting Fed policy expectations -- the move eased the currency off its 20-year high against a basket of currencies.

The yen was one of the beneficiaries of the dollar’s decline, rising nearly 0.9 per cent in the month, slightly retracing some of its recent losses. It had dropped 13 per cent against the dollar over the past couple of months. But the currency remains oversold with purchasing power parity measures indicating that it's trading at a 30 per cent discount to the greenback.

The Russian rouble rose more than 10 per cent, rallying alongside other commodity currencies to capitalise on higher energy prices.

05

In brief

Barometer june 2022

Asset allocation

We cut our equity allocation to underweight and balance this with an overweight on cash as we remain neutral on bonds.

Equities regions and sectors

We reduce exposure to cyclicals, downgrading the financial sector to negative.

Fixed income and currencies

We increase our allocation to US Treasury bonds to overweight from neutral, cut Chinese bonds to neutral from overweight, cut euro high yield to underweight from neutral, the euro currency is upgraded to neutral from underweight and the Chinese renminbi is cut to underweight from neutral.