Pessimism returns to markets

Equities resumed their slide last week, with the S&P 500 down 2.2% amid resurgent worries over the pace of central bank tightening and concerns that elevated inflation will erode consumer spending further.

The decline left the S&P 500 20.6% lower year-to-date to 30 June, the worst first half of the year since 1970. The MSCI All Country World index also fell 2.2% for the week, leaving it down 20.9% for the first half of 2022. US equities regained some lost ground on Friday, with the S&P 500 closing 1.1% higher, but futures pointed to a weak start to the week.

Hawkish comments by top central bankers attending the ECB Forum on Central Banking contributed to the downbeat tone in equity markets. ECB President Christine Lagarde warned she didn’t “think we are going back to that environment of low inflation,” while Fed Chair Jerome Powell said that restoring price stability was “likely to involve some pain.” Bank of England Governor Andrew Bailey has said COVID-19 had left a “structural legacy,” with the potential for lower employment and a higher risk of excessive pay increases.

The trend toward more aggressive central bank policy in much of the world was underlined by a 50-basis-point (bps) hike on Thursday by Sweden’s Riksbank, its biggest move in more than two decades.

US data added to worries about the impact of elevated inflation on economic growth. Personal disposable income declined 0.1% on the month, and while spending adjusted for inflation was up 2.1% year-on-year in May, the monthly trend was less encouraging—with a fall of 0.4% (versus a gain of 0.3% in April). The ISM manufacturing survey for June fell to 53, the weakest reading since June 2020. While this was still above the 50 level that separates expansion from contraction, it was down sharply from 56.1 in May and below the level expected by economists. The survey also pointed to a contraction in new orders for the first time in two years. This weak reading contributed to a further weakening in the Atlanta Fed’s GDPNow tracker, a running estimate of real GDP growth based on available economic data, which pointed to a 2.1% decline in output in the second quarter.

Expectations for slowing US economic growth were reflected in a roughly 20bps decline in yield on the 10-year US Treasury during the week to 2.9%.

Geopolitical tensions also remain elevated. The UK government unveiled plans to lift defense spending to 2.5% of GDP by the end of the decade in response to Russia’s invasion of Ukraine, above the 2% threshold that the NATO alliance requests of its members. Earlier in the week, NATO announced that Finland and Sweden had moved a step closer to membership.

What do we expect?

Markets in the second half of the year are likely to remain volatile and trade based on hopes and fears about economic growth and inflation. While the 6.5% rally in the S&P 500 the week before last week reflected hopes that a soft landing could be achieved, last week’s volatility reflects comments and data indicating a higher likelihood of a deeper slump in economic activity.

A more durable improvement in market sentiment is unlikely until markets see more compelling evidence that inflation can be brought back under control, allowing central banks to pause or stop hiking rates.

The US's core Personal Consumption Expenditure measure, released on Thursday, did come in fractionally below expectations at 4.7% year-on-year. And the month-on-month core measure held steady at 0.3%. However, the headline rate of inflation, which has now come into greater focus from the Fed, held steady close to multi-year highs, at 6.3%. A consistent decline in both headline and core inflation readings will likely be needed to reassure investors that the threat of entrenched price rises is passing.

How do we invest?

Against a highly uncertain backdrop, we advise investors to build a portfolio that is resilient under various scenarios:

1. First, we think investors should build and manage a liquidity strategy and consider diversifying portfolios with hedge funds. Having liquidity on hand to meet spending needs reduces the risk of being forced to sell assets into a falling market. It also ensures that investors have the resources to buy oversold assets and prepare for a rebound. Investors should also ensure an adequate allocation to hedge funds, which have the potential to deliver performance, even if both bonds and equities are falling. The latest data for the year to May shows the HFR Fund Weighted Index fell just 2.9%, compared to –12.8% for the MSCI All Country World Index (ACWI) and – 11.1% for the Barclays Global Aggregate Bond Index at the same point. Macro funds did even better, returning 9.3% in the year to May, according to HFR.
2. Second, we advise tilting equity portfolios toward defensives and quality, and making use of volatility. Quality income stocks and allocations to the healthcare sector can help investors build up defenses against lower corporate profit expectations, while we also think resilient credits, the Swiss franc, and capital-protected strategies can play a role as downside risk hedges in portfolios.
3. Third, invest in value, including energy stocks and UK equities. We think value would perform particularly well in our “soft landing” scenario, as increased confidence that corporate earnings can stay resilient supports some of value’s cyclical sectors, including financials and energy. Inflation remaining well above 3% also supports the style.
4. Finally, consider using the sell-off to build longer-term positions. ECB President Christine Lagarde last week highlighted many of the themes that we think support investing in “the era of security” In the wake of the pandemic and the ongoing war in Ukraine, she said, manufacturers would be more inclined to choose locations based on whether nations were friends or foes rather than just cost and efficiency. Over the long term, we think this trend will support companies linked to automation and robotics, energy efficiency, cybersecurity, and food security.

This could also be a good time to consider building longer-term allocations to private equity. Investing following public market declines has historically been associated with strong returns: the average annual return on global growth buyout funds launched a year after a peak in global equities has been 18.6%, according to Cambridge Associates’ data since 1995.

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