The first half of 2022 has drawn to a close with both equities and fixed income posting big losses. The US stocks have had the worst start to the year in over 50 years. With bond markets having had the worst start to the year since records began. Uncertainty is the name of the game, and price action continues to be unpredictable.
The main concern is that slowing growth and recession fears are set to overtake inflation.
The Fed is suggesting that it could swing the hammer and get scalpel-like results. Therefore, our baseline case for the next 12 months is that the Fed is committed to reducing inflation, while bringing growth down to recessionary levels.
If we transition to a recessionary environment, the market impact would be profound. Risk-on and risk-off assets would start to behave differently, as opposed to what has happened this year to date: regardless of risk exposure, all long-term assets are down between 10% to 30%.
Government bonds (and Investment Grade Corporate paper) have responded quickly to the shift from a more aggressive Fed, therefore a stabilisation should be in store. Leveraged, high-yield names could correct further to account for the fact that a rise in corporate defaults is likely.
The equity sell-off has largely been driven by an earnings multiple1 -contraction rather than a deterioration in earnings expectations. The average US company, at current valuations, is still vulnerable to recession-induced lower earnings.
Overall, this transition would be beneficial to our investment stance:
Markets will begin to differentiate between good and bad credit, resilient and not so resilient earning streams.
“Safe havens”/risk-off assets (like US treasuries, low-duration high quality credits, and gold) should start decoupling later this year. If this is the case, we can transfer money from risky assets into areas that will complement (rather than add to) the remaining risk on the table.
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