House View – July 2022
The global economy has continued to face multiple headwinds in the second quarter, creating a challenging environment for equity and fixed income investors. These economic and geopolitical developments have increased the probability of recession in developed economies, and markets have reset to lower valuations as a result.
The inflationary environment is globally pervasive, and has led to a sharp adjustment in monetary policy. Interest rates are being increased across the developed world in a bid to restore price stability.
The signs suggest that many pandemic-related factors that have driven high inflation, such as elevated demand for goods and supply chain disruption, are much improved.
The risk of a shallow recession in the next 12 months is undeniably higher than normal. But the chance of a severe recession remains small. It is our view that we are witnessing a normalisation of the US economy with core inflation already moderating. This will allow the Federal Reserve space to reiterate their rate hiking timetable,
rather than expedite once more. Investment markets should interpret this favourably.
The global outlook remains clouded by geopolitical developments. The risk of a material escalation of events in Ukraine poses a significant threat to global growth, particularly if energy supply suffers further blockages and prices leap higher. This risk is particularly acute for Europe, where a technical recession seems unavoidable at this stage.
Drivers of inflation are similar across developed economies, however the European Central Bank has fewer policy options to combat it. Competing priorities across member states mean that confidence and stability in the Euro-area will remain fragile.
Our analysis finds that market valuations have reset to reflect all but the worst case scenarios. In the US, equity markets now trade on price-to-earnings multiples in-line or slightly below 10 year average levels, consistent with the outlook we describe.
Portfolio changes this year have had the effect of raising cash, emphasising resilience, and rotating capital away from areas with weakened prospects. We expect to make further tactical adjustments in the coming weeks and months.
The higher inflation environment we are experiencing presents the choice between corrosion of wealth in real terms, or investment in risk-assets. The latter stands a good chance of delivering real returns over the long term, but requires a tolerance for elevated volatility and market weakness.
Our approach remains wedded to core investment principles, seeking out long term growth, value and diversifying sources of return.
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