Central banks have picked their poison

The consequences of high inflation are now clearer to see, as it starts to take its toll on both consumer spending and corporate profits. Left unchecked, it threatens to evolve into a “wage-price spiral” as employers are forced to increase pay and another round of price rises ensues. Cooling demand by raising interest rates, at the risk of triggering a global recession, is regarded as the lesser of two evils. Equity markets have been volatile as they start to price in a now inevitable slowdown. Bond yields have also retreated as the focus of investors’ anxiety shifts from inflation to recession. Against this backdrop, the second quarter delivered the worst combined quarterly performance from global equities and bonds in over 30 years.

Equity valuations not pricing in a worst case

The outlook for markets hinges on whether this engineered slowdown results in a “soft” or “hard” landing. The former would see the economy and inflation cool while unemployment and defaults remain low; the latter would come with greater collateral damage. Global equities are now down just over 20% (in local currency) from their peak at the start of the year. However, the MSCI All Countries World Index still trades at a relatively full 16x forecast earnings over the next twelve months. There could be scope for share prices to fall further if earnings estimates move lower. One relative bright spot is China. Neither its economy nor markets boomed like the US did last year, potentially paving the way for better performance as the country emerges from lockdowns.

Ukraine remains crucial

Central bankers’ efforts to curb inflation would certainly be helped by a de-escalation of the situation in Ukraine, easing supply pressures in commodity markets. Sadly, this looks unlikely any time soon. By contrast, it is still very possible that the conflict escalates – either intentionally or unintentionally. Even if this outcome is avoided, the war in Ukraine could still result in more global division, further disrupting the flow of capital and goods around the world. At the moment, Western leaders do not find themselves in a strong position to deal with this shifting geopolitical landscape. The cost-of-living crisis in many developed countries means that governments are far more focused on domestic challenges.

Portfolio positioning

A global recession is not our base case, but the risk is increasing. We therefore continue to increase the defensiveness of our portfolios. We have already tilted our equity allocation towards higher-quality companies and are now looking to trim our overall equity exposure. This year, we have benefited from our underweight position in fixed income and overweight position in alternatives. However, government bond valuations now look more attractive and we continue to believe that they represent a good hedge against recession. Over the medium term, we are likely to add back to nominal government bond positions gradually, which would further increase the defensiveness of our portfolios.

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