<h1>Mid-year outlook: cooling or freezing?</h1>

Virginie Maisonneuve

Global CIO Equity

Equity strategy: navigating the narrow path of monetary policy normalisation in a synchronised global slowdown

Addressing the “great catch-up” in rates

As we look at the forces at play in the global economy, it appears we’re in the midst of a “great catch-up” unfolding at high speed. This is one of the most significant instances of monetary tightening in history, and it’s happening in the context of an economic slowdown – a highly unusual combination. Consider what we have witnessed in recent months:

• Major central banks have started to remove record amounts of liquidity by hiking rates and reducing asset-purchase programmes (known as quantitative easing).
• Inflation has soared – particularly energy and food prices – after staying at stubbornly low levels for decades. Central banks are single-minded in their focus on tamping it down.
• The global geopolitical “order” that prevailed for decades has begun to splinter, further fragmenting the global village. Russia's invasion of Ukraine and Covid-related supply-chain woes have prompted more countries and companies to “onshore” and rethink their global supply chains – not only to save on costs, but to build new partnerships.
• As markets process this information, yields on benchmark bonds have pushed higher and major equity indices have dropped significantly, ending a long run of strong performance.

Here at the mid-year point, we are watching QE withdrawal and rate increases in a world that is slowing, not growing – which is very atypical. Given this backdrop, the question for investors is: where is this great catch-up headed? Global trade as a share of GDP could fall further, pressured by a strong US dollar and difficulty sourcing goods. Interestingly, many companies in the US that have managed to repair their supply chains are now grappling with growing inventory levels as consumers pare back spending. This may indicate a slowdown in demand to come.

Could inflation soon peak? Consider M2, which measures US money supply and has historically been a good indicator of inflation and growth after a 12- to 18-month lag. This metric topped out in February 2021 (see Exhibit 2), which suggests that inflation could max out in the next six months. The probability of a strong, synchronised global economic slowdown is supported by M2 data and other indicators. (These include the high price of oil, falling manufacturing indices, rising interest rates and the reversal of the economic support packages put in place during the height of the pandemic.) The impact of slowing growth on corporate margins and earnings has yet to be reflected in many companies, and while valuations have already adjusted considerably, an upcoming “earnings recession” is still a possibility.

Solutions for positioning equity portfolios in this environment

The inflection point for equity markets could come when the expectations for US rate hikes shift from 50 basis-point “leaps” to 25 bps or zero. This may be the time when “bad news becomes good news” for the markets. Although the economic environment at that point might still be more challenging than it is now, the end of the tightening cycle could then be in sight. This would all take place in an environment where growth is more difficult to find and rates are higher than they have been for many years. With this in mind, we believe investors would benefit from a diversified portfolio anchored around a selected number of high-conviction strategies:

• Quality value stocks that have healthy dividends: these may earn a premium price from investors amid higher interest rates.
• Quality growth stocks with strong balance sheets after a strong derating: these names could be attractive, as their growth profile helps them stand out amid poor global growth and an economic slowdown.
• Energy security and food security: given the geopolitical uncertainties that have made these areas more vulnerable, these are solid thematic investments that can help investors reposition portfolios.
• “Impactful innovation” stocks, including artificial intelligence, cybersecurity and climate mitigation/adaptation names: this category should be considered a critical pillar for portfolios.
• China equities: these could be increasingly attractive, though volatility is likely to continue. China’s GDP growth of 4%-5% is notably higher than the world’s other major economies; its GDP is also high compared with many emerging economies. In addition, China is less exposed to the negative effects of a strong US dollar. Moreover, China’s central bank is now loosening – not tightening – its monetary policy.

Exhibit 2: falling US money supply suggests inflation may drop as well

The metric M2 – which measures an economy’s supply of money, including cash and checking deposits – has historically provided an indication of where inflation might be in 12-18 months. In the US, M2 has fallen notable since its February 2021 high, suggesting that inflation may soon be on its way down.

Source: Federal Reserve Bank of St Louis. Data as at 1 April 2022.

Next: Fixed-income strategy

Franck Dixmier

Global CIO Fixed Income

Fixed-income strategy: investing at an inflection point for growth and inflation

Growing recession risks may help bring down inflation somewhat

At the start of the year, we expected that the key market risk for 2022 would be whether major central banks could rein in historically high inflation without leading to a sharper-than-expected global downturn. So far, core government yield curves have been flat, which indicates that although we may not be in a recession, the market thinks this may be the tail end of a very short economic cycle. Fixed-income investors will want to keep a watching brief on which direction the following factors take as the remainder of the year unfolds:

• Growth: clouds have begun to gather on the global growth outlook, given increasing headwinds from tightening financial conditions and the squeeze in households’ real incomes. The geopolitical and supply-side implications of the invasion of Ukraine have intensified the downside risks.
• Inflation: as recession risks grow, we expect global inflationary pressures to ease up by the end of the year and into 2023. However, before inflation eases, it is likely to stay elevated in the near term given ongoing supply/demand imbalances and elevated commodity prices.
• Monetary policy: major central banks in developed markets are still inclined to maintain their hawkish policy stance in the face of historically high inflation data. The Fed is unlikely to change course until it sees clear evidence that inflation is coming down towards its target. Meanwhile, the European Central Bank is leaning towards bigger (and faster) rate hikes on the front end. We believe that, at least in the short term, the Fed will want to do what the markets expect – meaning the Fed funds rate will probably be near 2.75% by the end of 2022 (see Exhibit 3). However, we believe that the appetite for further tightening is likely to wane into 2023 as downside growth risks become more evident.

How to position fixed-income portfolios in this environment

Given all the uncertainty about which way the year will play out, we expect some near-term volatility in bond yields. However, we think we are at an inflection point for growth and inflation dynamics. Major central banks in developed nations may not yet be ready to pivot away from their hawkish policy stance, especially while current inflation remains at historic highs. But we think that as downside growth risks gather pace towards the end of this year and into the next, bond markets are likely to begin reassessing the extent of rate hikes in this cycle. Here are some strategies for fixed-income investors to consider:

• We may begin to see certain attractive longer-duration sovereign bonds in markets where rate hikes have been largely priced in, and where downside growth risks are set to become more apparent in the coming months. These markets include the US, Australia, New Zealand and Canada.
• Euro-area peripheral and semi-core bond markets don’t seem as well-positioned. In euro-area sovereign-bond markets, deteriorating fiscal metrics and a tighter ECB monetary policy stance suggests a further widening of spreads in peripheral markets, especially Italy.
• Among emerging markets (EM), selectivity is key. Geopolitical and supply-side pressures are sustaining underlying inflation, particularly in food prices, which represent a larger share of EM consumers’ inflation baskets. Among EM hard-currency bonds, high-yield spreads are wide. They may begin to come down as prices rises, which would make a compelling total return proposition for investors who already own these bonds.
• Among investment-grade bonds, corporate fundamentals are still reassuring, but downside growth risks support a defensive stance. Yet there may be opportunities for adding exposure to certain US high-yield names on any further spread widening, for the same reasons mentioned above. We also prefer US over euro spreads, and we favour entities with strong pricing power, such as global financials and US utilities.

Exhibit 3: in this economic cycle, a lot has already been priced into bond yields

Over the past decade, the US 5-year/5-year forward rate has tended to suggest a soft ceiling for 10-year yields. In mid-June 2022, the 5y5y rate sat around 3.30% – well above the Fed’s median long-run “dot-plot” projections of 2.5%.

Source: Bloomberg, Allianz Global Investors. Data as at 15 June 2022.

Next: Multi-asset strategy

Gregor Hirt

Global CIO Multi Asset

Multi-asset strategy: rapidly changing markets drive home the need for caution

Higher rates, higher costs and supply shocks add to companies’ stress

If the US economy continues to slow, the Fed’s decisive action to curb inflation seems likely to be the primary cause. But the broader global economy is also at a tenuous point, largely because of high inflation, supply-chain woes and uncertainty stemming from the invasion of Ukraine. Moreover, the world’s second-largest economy – China – has struggled with slowing growth and Covid-19 outbreaks, lowering interest rates even as other major economies are beginning to raise them.

Against this backdrop of uncertainty, investors have finally started to question high prices for both stocks and many bonds, as well as lofty earnings expectations for many companies. More specifically, investors want to know if companies are being too optimistic about the solidity of their profit margins in an environment of rising input prices, whether these are wages or energy prices. This reassessment of the economic situation is also starting to spill over into the credit market – not to a dramatic degree, but it may further stress companies’ margins by increasing refinancing costs.

Among our Multi Asset expert group, we have been cautious on equities for much of the year – particularly European and emerging-market equities, considering that the invasion of Ukraine may well have a more adverse impact on Europe. We have a slightly more constructive view of the UK and Japanese equity markets, although we have still reduced our exposure there. We have also been defensive with fixed-income markets in general.

All in all, we are entering a difficult period where still-worrying inflation rates will require most major central banks to reduce overall liquidity, even as higher yields, higher input prices and ongoing supply shocks affect companies’ margins.

Despite the selloffs, long-term opportunities can be found

Amid all these challenges, valuations have started to come down from what were too-rich levels. This may create opportunities for investors to re-enter the market at more attractive price points. We believe it may be wise to keep some cash on the sidelines for undervalued securities and select strategies.

• Commodity investments may help guard against rising inflation. In addition, as Exhibit 4 shows, gold may provide better diversification for equities than government bonds – at least for the time being. Commodity trading advisors are also benefiting from this environment, as they can short markets.
• The UK equity market has potential, thanks to its exposure to energy and healthcare, and its defensive bias.
• Alternative beta-type strategies, including long/short strategies, have experienced a renaissance this year.

Exhibit 4: with Treasuries now providing less diversification to US equities, gold is one potential substitute

US Treasuries have grown increasingly correlated to US equities, even as investors moved out of Treasuries amid concerns about rising inflation. As a result, Treasuries have become a less effective diversifier, particularly when compared with gold. In this context, commodities in general – and gold in particular – may currently provide better diversification.

Source: Bloomberg. Data as at June 2022. Chart uses monthly average of daily rolling correlation based on rolling 260-day window using daily returns of US equities (S&P 500 futures), US Treasuries (US 10yr Treasury futures), Gold (Gold futures).

Next: Macro view