2022 H2: What investors should expect

Is Canada’s real estate bubble finally going to burst? The country’s red-hot housing market has sent prices to a record over the past 12 years, fuelled by low interest rates and heavy borrowing during the pandemic. For most of the last three decades, homebuyers have typically been able to refinance their fixed, five-year term mortgages at increasingly lower rates, as the chart below shows.  

But with the Bank of Canada rushing to normalise monetary policy amid surging inflation – it is widely expected to raise rates by another 50bps on 1 June – some high-debt households could be in for a shock when the time comes to renew their mortgages…”

Just one year ago, there was little consensus on the outlook for US stagflation. But much has changed since then.

The Federal Reserve has so far raised interest rates by 75bp to rein in inflation, but with real rates still in negative territory, the efforts made so far are unlikely to alleviate the situation.

With headline inflation hitting 8.3% in April, and core CPI, which excludes food and energy, rising to a greater-than-expected 6.2%, we can probably expect higher inflation for longer – making the prospect of stagflation in the coming quarters ever more likely.

A recession may temporarily slow inflation in the second half of the year. But if weakening economic growth prevents the Fed from implementing further planned rate hikes, it will have to choose between fighting inflation or helping the economy.  

As all risk assets tend to correlate during heavy sell-off periods, the US dollar will offer the best protection during the short transition period before investors seek longer-term shelter in assets that have historically performed well in stagflationary times, such as agricultural commodities and precious metals.

Which yield curve should investors watch for inversion as a potential sign of a global recession? The 2y to 10y? The 3m to 10 y? How about all of them?

Currently, only 7 percent of all yield curves are inverted versus more than 50 percent before previous recessions (shaded columns in Chart 1).

Broad diversification across asset classes and sectors in this period of heightened volatility makes a lot of sense, not because there aren’t any attractive ideas, but because diversification itself is an especially good idea right now. The correlation across markets has fallen to the lowest levels in 20 years. (Chart 2) Countries, sectors and industries are demonstrating some of the lowest correlations in a generation. This can help to manage overall portfolio volatility.

Is the yield curve signaling a US recession this time?  

An inverted yield curve – which happens when short-term interest rates exceed long-term rates – has been a good predictor of recessions historically, as it shows that bond investors expect economic growth to slow.

The US yield curve has flattened considerably this year, with the two-year Treasury yield rising by almost two percentage points on expectations that the Federal Reserve will raise rates to tame inflation. By the start of April, it had topped the 10-year yield – the first time that has happened since 2019.  

But I would not put too much weight on the predictive power of the yield curve this time. The economy and labour market are both still strong, while the Fed’s massive bond purchases have distorted market pricing for longer-dated Treasuries. Monetary policy tightening will dampen growth in the US, but recession fears seem overblown.

How long will we have to live with inflation?

Although the pivot to a more hawkish tone at some of the major central banks is welcome, their more aggressive stance must be seen from a starting position of extreme dovishness, with some time before a neutral policy rate is achieved even in the US. Other major central banks are even further behind. 

When we look back in history at periods of high inflation, there are worrying similarities to today’s backdrop. Monetary and fiscal policy remain at highly stimulative levels even with inflation at multi-decade highs. Years of worrying about inflation undershoots have become embedded, making it difficult to contemplate that some historical economic relationships may be reasserting themselves. We don't believe that the world is about to see a rerun of the 1970s, but we do believe there are risks that inflation may prove persistent for longer than expected.  

This belief is reinforced when we examine central banks’ own attempts to measure the ‘stickiness’ of inflation. For example, core sticky inflation, as measured by the Federal Reserve Bank of Atlanta, is at levels not seen since the 1990s, suggesting that inflation may not easily return to pre-pandemic levels.”

Here’s the real problem with inflation – and why it will be so hard to solve it without a recession.

First, don’t pin all the blame on high energy and food prices or supply chain disruptions. Those problems usually get resolved more quickly than you think – and this time should be no different.

The real culprit behind inflation is the incredibly rapid tightening of labour markets and the surge in wage inflation. US is first in line, with job vacancies at twice the normal level. The correlation between the vacancy rate and changes in wage inflation, measured by Atlanta Fed’s median wage tracker vs its ten-year average, is extremely tight. Vacancies are nine months ahead of changes in wage inflation, which has accelerated to 6%.

It would be near impossible to keep CPI inflation at the targeted 2% over time if wage inflation does not drop sharply. And wage inflation will not drop unless the vacancy rate, currently at 7%, returns to normal. And the vacancy rate will be difficult to normalise without dampening demand for goods, services, and labour. And would it even be possible to cut the vacancy rate without increasing unemployment, which in turn could trigger recession?

The Fed thinks a softish landing is possible without a recession – but the shaded areas in the chart below tell a different story!

There is broad agreement that the US inflation surge of the past year reflects both supply and demand factors. On the supply side, even putting aside the ongoing geopolitical events, the Covid-19 pandemic undermined productive capacity by curtailing labor supply and complicating supply chains.

On the demand side, fiscal transfers led to unprecedented surge in personal income and massive excess savings.

But the demand story is not just a matter of aggregate spending. It is also a function of the composition of said spending, and the highly abnormal skew in favor of goods consumption (Figure 1). In other words, even if supply capacity was unimpacted, supply chains would still have struggled; the system simply hasn’t been built to support this level of goods demand.

As firms sought to satisfy this surge in goods consumption, they have built a lot of inventories, mostly outside of motor vehicles (Figure 2).

This dynamic has important implications for future growth (negative) and inflation (disinflationary) because goods demand will likely need to calibrate lower to better align with income growth and historical consumption patterns.

Gulf equity markets are up around 10% this year, near the top of the global league table, in part due to surging commodity prices (oil, gas, petrochemicals, aluminium, fertiliser) but also the sensitivity of many regional banks to rising interest rates. International investors have also begun reducing long-held underweights and swapping some Russia exposure to the Gulf.  

In a world stunned by soaring inflation, high commodity prices and sharply rising interest rates, the sun is shining on the Gulf, especially as we expect $100+ Brent is set to remain. Moreover, as global commodity supply limitations cannot be resolved in the near term, the Gulf will likely benefit for years to come. Earnings growth and government spending are expected to be strong over the year. The challenge for investors is determining an appropriate earnings multiple at a time when global recession concerns are rising.

Three things are roiling markets at the moment: 1) the Russia/Ukraine war 2) the impact of zero-Covid and the economic slowdown in China; and 3) the implications of high inflation for US and global monetary policy.

The first two are disrupting the global supply of energy, food, components and final goods, while the main question for the third factor is to what extent the Fed has been mistaken in keeping policy too loose for too long.  

The upshot is high inflation in several countries, in large part due to the first two negative supply shocks, as well as domestic labour market issues.  

However, nominal demand is an important contributor, too, and, while the food and energy contributions to inflation may moderate over the next year, core inflation may well remain uncomfortably high -- in which case a tightening that involves taking rates into restrictive territory will be necessary. Expect market volatility for a while.

To outsiders, Switzerland may appear to be the land of the blissful, as economic momentum has barely slowed despite the war in Ukraine, and inflation remains lower than elsewhere. We advise caution with this interpretation: Anyone who, for the sake of convenience, only looks at purchasing managers' indices (PMI) to compare momentum in manufacturing across countries could overestimate dynamics in the case of Switzerland. As a special case, the Swiss PMI lacks a component on new orders.

In Germany, it is precisely this component that has fallen in recent months, and Swiss manufacturers will not escape this trend. Assessing inflationary pressures also requires a second look: The share of administered prices in Switzerland’s consumer price index is twice as high as in Germany. One must therefore assume that the increase in consumer prices will only be felt in Switzerland with a delay.

‍Seeing value in fixed income

With inflation above target and the labour market very tight, the Fed has laid out a plan to get to a “neutral” federal funds rate as soon as “practicably possible” and then to move beyond that if necessary. We anticipate the Fed will rapidly move interest rates higher in the next couple of Federal Open Market Committee meetings, likely 50 or 75bp at a time, to get short interest rates close to 3%.  At that point, the Fed will potentially be able to take a more measured approach to further rate adjustments and will likely be responsive to inflation developments over the balance of the year.

We likely saw the peak in the year-over-year rate of core inflation in Q2.  Sharp rises in energy prices and supply chain-related prices have pushed inflation up aggressively in the last 12 months, and we believe the worst is behind us.  If this is true, we should see rates of inflation drift lower over the balance of this year and next.  Even though it is not likely to return to the Fed’s 2% target for core personal consumption expenditures in the near future, the fact that overall levels of inflation are coming down may remove some of the extreme pressure from the Fed later this year.  This should provide it with some breathing room to take stock of the impact of its tightening so far, and the likelihood of further inflation pressure.

Markets are pricing in the Fed

Markets have moved well ahead of the Fed to price in likely rate hikes and are now pricing in aggressive rate hikes for the balance of this year.  This has also had the impact of tightening financial conditions across the economy.  

Mortgage rates are sharply higher, interest rates and credit pricing have moved higher and money supply growth is slowing.  After getting to neutral in short-term rates, the Fed will likely want to see how all this tightening is impacting the overall economy.  We expect economic growth momentum to slow over the balance of the year.  The combination of slower growth, tighter financial conditions, and inflation that is at least headed in the right direction may give the Fed pause in its tightening plan.

For investors, this means there may be some value in fixed income, particularly in some of the high-quality credit sectors such as investment-grade corporate bonds and municipals.  The combination of higher US Treasury rates and wider credit spreads and ratios means that all-in yields have become more compelling in a historical sense and have started to offer decent yields on relatively high-quality assets.  Also, in a tail risk scenario in which growth slows more than expected and recession probabilities increase, these high-quality asset classes should be a good place to hide.

Bottom line

We believe the big bear move in US Treasuries is behind us — the short end of the US yield curve is priced for likely Fed action and should provide some stability going forward.  The longer end of the US yield curve could see continued moves higher as the Fed engages in quantitative tightening, but we would not anticipate 10-year Treasuries to rise much above 3% in the near term.  High quality credit assets such as investment grade and municipal bonds may provide an investment opportunity.

There is a still a pathway for a US soft landing, but we’re increasingly nervous. Quantitative models such as the yield curve are not yet signaling a recession and the 2-year/10-year Treasury curve has actually re-steepened in Q2. Unemployment is still low, payroll employment gains have been robust, job openings are elevated, and initial jobless claims remain low.

So what drives the discomfort? Quantitative models often implicitly assume smooth behavior as markets clear. Today, we’ve already had a surprise negative quarter in Q1 while supply and demand still look imbalanced, which is generating “sticky” inflation. Either supply has to rise, or demand fall to restore a balance and remove inflationary pressures. Central banks have run out of patience, as longer-run inflation metrics bubble, e.g., the NY Fed 3-year survey.

Bottom line: the Fed has to act. Their hope is to destroy job openings before they destroy jobs. Such an outcome is possible given the data in 2022, but not a simple task.

“Equities may be in a challenging environment for some time yet. What may turn out to be sticky inflation could lead to more Fed tightening and higher real rates, which in turn would provide investors with a viable lower-risk alternative.

Simultaneously, reduced household purchasing power, increased economic uncertainty and tighter financial conditions are taking its toll on the global economy. Goods to services transition, demand destruction and margin pressure may contribute to further downgrades of global earnings estimates.”

The cost of labour is not going to be a major driver of inflation in the near future.

Much has been made about the inflationary impact of wages. Just a few years ago, $15 per hour was unheard of. Now it’s the benchmark. But if you dig deep into the US payroll report, or more officially, the "Employment Situation Report," you will see things a bit differently.

In the below, I break down the data from 3 June into its numerator and denominator. The wage or "Average Hourly Earnings" growth number for May in the top graph remained high at above 5%, but it is being supported by a slowdown in “Hours Worked” in the lower graph. The slowdown in Hours Worked appears to be led by the very important Retail, Leisure & Hospitality, and Transportation & Warehousing sectors. If the strong 5% wage growth is actually being supported by a slowdown in Hours Worked, it is probably less inflationary than it implies.

(FYI, the growth spike in April 2020 "Earnings" reflects the effect of the national shutdown on lower wage jobs, such as those in the hospitality industry. The slump in April 2021 shows the effect being reversed.)

Covid accelerated the housing market tremendously. However, recent interest rate hikes, a pick-up in listings as prospective sellers looked to time a ‘peak,’ and some return to normal following major lockdowns, has brought the housing market into greater balance between demand and supply.

Price growth generally lags market conditions so it’s likely that the rampant acceleration of home prices through the pandemic has come to an end. Much more moderate price growth is likely in the months ahead.

The usual bidding war between economists to see who can come up with the most aggressive Fed rate-rise profile is underway.  And to be fair, the Fed has been fanning the flames.  They delivered a 75bpt rise in June, the largest in 28 years.  They have all but promised a repeat performance when the Federal Open Market Committee (FOMC) meets in July.

Financial markets also have some aggressive pricing.  One approach to quantify where the market places the terminal rate is to look at bond yields.  A 10-year bond can be thought of a series of daily interest rates (the Fed Funds rate) plus a term premium for the risk of locking up your funds for ten years.  Rearranging the equation reveals the market pricing for the Fed Funds end point (10-year bond yield less the term premium).  The implied terminal rate is 3.5%, the highest since 2007.

But there is a need to step back.  What the market thinks is one thing.  What the Fed can feasibly deliver is another.  The data shows that US financial conditions are tightening at near the fastest pace since 1999 (which preceded the 2001 recession).  

Timely indicators of US economic activity, like the ISM index, are already responding to the tightening in US financial conditions.  The Fed will need to be cautious on how far and fast it moves on the rates front from here.

Increasing policy and inflation rates are leading to lower government bond prices; a deteriorating business cycle is weighing on equities and corporate bonds; and higher real rates are reducing the attractiveness of gold and real estate. Fortunately, there still is the Swiss franc. We saw a very important shift from the Swiss National Bank in mid-June: After years of considering the franc as highly valued, they no longer do so. The real effective exchange rate is currently even below its 10-year average. It looks high only in nominal terms. As a result, the SNB is unlikely to intervene against the franc any longer – allowing instead for a gradual appreciation to keep import prices in check. Hence, the Swiss currency seems the safe place to hide.

Many observers believe that the inflation surge of 2021–2022 is tied, in part, to excess aggregate demand growth created by highly accommodative macroeconomic policy starting in 2021. One way to see this is to look at nominal GDP (NGDP), a measure of aggregate demand relative to its pre-crisis trend path.

A more sophisticated way to view it is to look at NGDP relative to forecasts for each period. The Mercatus Center’s NGDP gap measures the percentage difference between the neutral level of NGDP (the public’s expected growth path of nominal income) and the actual level to determine whether monetary policy is too loose or too tight. Our chart shows NGDP exceeded expectations in Q4 of 2021 and the gap is still widening – signaling an ongoing expansion in monetary policy. We expect the NGDP gap to continue to widen through Q3 of 2022 and then begin to slowly close over the next two years.

iThe Gulf Cooperation Council (GCC) economies are in some of the strongest positions to deal with the heightened global economic risks following the outbreak of the Ukraine war. They will see a sharp increase in hydrocarbon revenue, and we see all GCC countries realising a fiscal and current account surplus in 2022. Saudi Arabia and UAE will also see strong real GDP growth driven by the oil sector as production increases. The tight fundamentals in the global energy market should keep oil and gas prices elevated in the medium term. The high oil income outlook is positive for sentiment and should support progress with investment programmes, though much of the capex will come from government-related entities. The higher prices and sharp increase in interest rates will provide headwinds, though overall inflation in the region will be below the global trend. The focus on structural reforms is also positive for the near- and medium-term outlook for the region, though progress by country has been uneven.

We know real estate has long-term inflation-hedging advantages, either through rental growth or indexation. The prerequisite for this inflation compensation is scarcity. One typically sees scarcity of tenant space in periods of medium to high economic growth, when demand exceeds supply. But the reverse is often true during recessions. For this reason, a stagflation scenario is usually one of the worst for real estate.

This chart divides the full UK real estate real return history (1971-2021, source MSCI/IPD) into nine economic environments, using low, medium and high GDP growth and inflation. Real estate typically provides a very good inflation hedge, i.e., strong levels of real returns, in periods of medium to high economic growth. Only during low growth periods might returns fail to keep up with inflation, as is clearly shown in the high inflation/low growth scenario with strong negative outliers.

For the next couple of years, we are likely to see lower economic growth, but still within the “normal growth” range. The ability to increase rents in line with inflation will therefore depend on scarcity. Many real estate markets are relatively healthy, with low levels of vacancy, while many European office CBD markets and the healthcare, residential and logistics sectors are currently short on supply – so inflation compensation is certainly possible in these instances.

In addition, the huge increase in construction costs will reduce new development activity, potentially lowering vacancy rates and thereby exerting more pressure on rents. On the other hand, secondary office and retail locations will have a tougher time, as vacancy rates are already relatively high, and we expect consumers to spend less as inflation erodes their spending power.

Indonesia’s consumer confidence index posted a stronger recovery than expected. Given the lower inflation situation in Indonesia than other Asian countries, I expect the Indonesian domestic demand to expand at a firmer pace than others in the second half of 2022.

As the first chart shows, the score for both consumer confidence and buying conditions for durable goods improved significantly in May.  

While inflation can breach the central bank’s 4% upper target this year, an overshoot is unlikely, allowing Bank Indonesia to raise rates gradually.  

Overall, the data suggests that the recovery of the domestic economist will be stronger than previously expected, which means that the Indonesian economy return to 5% growth this year.

Will Japanese bond investor outflows turn into inflows?

Japanese institutional investors are among the most influential bond investors in the world. They invest globally, often using various hedge strategies for FX and rate risk.

For US dollar bonds (Treasuries, US MBS, and some investment-grade corporates), the latest monthly data for April showed $120bn of sales and redemptions vs $103bln of purchases – both the lowest in over 3 years.

The net number of negative $17bn for April means outflows continued for the third consecutive month, probably led by loss-cutting trades at banks and life insurers. However, more recent weekly data seems to imply that the selling is slowly abating. Fed Chair Powell's recent recession statement, along with the most elevated US long-term rates in years, should help sentiment improve going forward.

Markets have been very volatile over the past quarter, with equity prices falling and bond yields rising, both sharply, thanks to swift repricing in central bank interest-rate outlooks. Wrong-footed policy makers have rushed to tighten monetary policy as inflation surged well above target and unemployment plummeted while labour demand remained strong. 

The NAB Business Survey reveals the perfect storm of inflation shocks that have sent energy and food prices soaring, including Covid-19, the Russia/Ukraine war, and the overlapping nature of these inflation shocks – COVID first and now the Russia/Ukraine energy and recent flooding in Australia. 

Central banks are signalling a very strong commitment to return inflation to target and prevent a sustained change in inflation psychology. This suggests relatively forceful interest rate rises will continue through the end of 2022.

The combined impact of significantly higher interest rates coupled with much higher energy prices, produces a less favourable economic outlook, particularly for interest rate-sensitive sectors (housing, cars) and related durable goods demand and discretionary spending, though it’s likely travel and accommodation will hold up relatively well due to pent-up demand. An offset to these forces should be provided by a pick-up in wages due to tight labour markets, but the intentions of central banks seem likely to “outpace” this positive for household cash flows in the near term. In many cases, growth forecasts for 2023 are quite weak (in the US, Europe and Australia).

Much will depend on the timing and degree to which inflation moderates. There are some reasons to be optimistic for an eventual significant moderation in inflation, as much of the increases are related to specific but ultimately temporary pandemic effects and the Russia/Ukraine energy and food price shock, which are unlikely to be repeated. Demand should also ease as monetary policy tightens significantly.

But this is more likely a 2023 story, as the sharp rise in energy and food prices is likely to continue to flow through cost and pricing decisions for the remainder of 2022. 

The ISM Manufacturing Survey Prices and Supplier Delivery components have provided very good indication of supply chain disruptions and inflationary pressures. Both remain very elevated and should be monitored closely as they should provide early signs of any easing in inflationary pressures.

Under the current monetary tightening environment, we expect equities to trade in a volatile fashion over the next six to 12 months, with modest gains on average. Equity markets will struggle to sustain gains until recession concerns ebb on the back of a less hawkish Fed when US/global inflationary pressures peak.

For now, oversold technical conditions (example given in the S&P 500 below) and light investor positioning imply that equities do have some potential upside.

From a price-earnings angle, valuations have corrected significantly from earlier highs, with the FactSet World Index P/E multiple declining to 14.5 from 21.8 in Dec 2021 and a peak of 35.2 in Feb 2021. This shows that most of the valuation excesses of recent years have been unwound. As such, there is the potential for stocks to rebound, led by non-US equities, should global economic growth conditions remain resilient, and assuming interest rate expectations and bond yields calm in H2 2022.

With valuations reset lower, the outlook for equities will largely hinge on the performance of earnings. Corporate profits in most markets remain resilient. The 12-month forward earnings for developed and emerging equity benchmarks remain in an uptrend. More importantly, the US continues to be a standout performer, with underlying forward earnings at a new high. While there were some notable disappointments during the recently completed Q1 earnings reporting season, overall results were solid, with most US companies beating bottom-line expectations. 

Given the uncertain global economic growth outlook, ongoing supply chain issues, and cautious corporate commentary and guidance, downgrades to global earnings estimates are possible in the months ahead. 

This also means that year-on-year earnings growth will slow, consistent with a moderation in global economic growth momentum. As growth decelerates and some profit downgrades play out, investors could become more nervous about the earnings outlook, especially given the elevated nature of profit margins. This will put more selling pressure on equities. These dynamics underpin our view that equity performance will remain choppy before stocks find a durable bottom. 

We do not expect the global economy to lapse into a recession and expect 2023 earnings to be above this year’s level, implying that earnings will sustain their underlying uptrend, albeit at a more modest pace than in the past 18 months. This, in turn, will eventually support higher equity prices.