Markets look to next recession

The global economy has been moving through the cycle at break-neck speed in recent years. The pace is showing no sign of easing as investors start to worry that the recovery from the pandemic may soon be coming to an end. The catalyst for the move to the next phase of the cycle is a classic one: rising interest rates in response to inflation. History suggests that the concern is justified. As Schroders’ Chief Economist Keith Wade has noted, “the recessions of the 1980s and 1990s followed a similar pick up in inflation to that being experienced today.” While the timing and extent of any recession remain very unclear, volatility has risen as markets start to price in the risk of economic contraction. At their recent trough, global equities were very close to the 20% decline that constitutes a bear market. For the first time in many years, the UK is proving more resilient, supported by the strength of US dollar and commodity earnings.

US dollar at strongest in two decades 

Jerome Powell was in crisis-fighting mode at the Federal Reserve’s latest press conference. In words addressed “directly to the American people” he acknowledged that high inflation was causing significant hardship and reiterated the Fed’s commitment to bring it under control. The dramatic shift in tone has had big repercussions in currency markets, with the US dollar now approaching its strongest level in twenty years. The Bank of England, the European Central Bank and the Bank of Japan have all sounded much less  “hawkish” than the Fed – and their currencies have suffered as a result. Given the pace and extent of US dollar appreciation, we could well see sterling, the euro and other currencies enjoying a modest bounce against the greenback. However, we expect the current dynamics supporting the dollar to remain in play for some time.

Inflation's impact on profits and politics

While recession is a concern for the next year or two, in the very near term companies are having to grapple with the challenge of inflation. This was starkly illustrated by a profit warning from Walmart, the world’s largest retailer. The company saw its shares fall by the most since 1987 after stating that higher costs and weaker-than-expected general merchandise sales would result in lower profits for the year. In the UK, the cost of living crisis has forced the government into a u-turn on a windfall tax on energy companies, which will be used to part-fund support package for households. Economists have suggested that the £15 billion package could put pressure on the Bank of England to increase interest rates at a faster pace than currently envisaged.

Portfolio positioning

The risk of stagflation, a period of high inflation and low or slowing growth, remains high. We have been making changes to our portfolios to reflect this changed environment. We have reduced our exposure to small and mid cap equities, while tilting portfolios towards higher quality companies with stronger balance sheets and greater ability to pass on cost increases. We are also increasing the defensiveness of our fixed income allocation. This has been achieved by cutting our allocation to emerging market bonds and increasing our exposure to high quality credit and short-dated government bonds. However, given the potential for yields to continue rising, we still prefer to diversify portfolios using alternative assets such as gold, broader commodities and absolute return funds.

Outlook

	Economics	The ongoing conflict in Ukraine is raising the risk of “stagflation,” an environment of high inflation and low or negative growth.  High commodity prices and continued supply chain disruption could keep inflation elevated in the near term. Weaker consumer spending could have broader economic implications. Interest rates are likely to continue to rise.
	Valuations	Global equities have meaningfully de-rated this year and now look more attractively valued on a relative basis. Government bond valuations also look relatively more appealing given the sizeable moves we have seen this year. However, the asset class could be vulnerable if bond yields continue to rise.   Alternative assets including absolute return funds and commodities look attractive as diversifiers.
	Sentiment	Escalating geopolitical tensions, rising inflationary pressure and anticipated interest rate rises continue to negatively impact investor sentiment. Consumer confidence is the weakest it has been since 2009. Investor sentiment indicators in or approaching bearish territory.
	Risks	Further escalation of Russia’s actions in Ukraine. Risk of a faster than anticipated rate of monetary policy normalisation. Threats to global economic growth from the impacts of high inflation and a China slowdown. Consumer-led recession.

Asset Classes

Asset classes	Current positioning	Medium term view	Current views
Equities			Russia’s invasion of Ukraine, China’s response to Covid, inflation and rising interest rates have created a less favourable economic backdrop and resulted in higher volatility. Given the greater risk of “stagflation” (high inflation and low or negative growth) we prefer higher-quality companies with the ability to pass on higher input costs to consumers. We maintain conviction in long-term, secular themes including healthcare and energy transition.
Bonds			Longer-dated government bonds offer defensive characteristics given growth concerns. We prefer USD government bonds due to their relatively higher yields and diversification benefits. We prefer inflation-linked bonds to conventional government bonds at this stage. Valuations look relatively more attractive given the sizeable moves we have seen this year, but remain vulnerable to further increases in interest rates.
Alternatives			Attractive diversification characteristics compared with equities and bonds. We favour absolute return strategies with the ability to deliver less correlated returns as well as real assets with long-dated, visible revenue streams and commodities.
Cash			Cash has defensive qualities in potentially volatile markets.

Equities

Asset	Current positioning	Medium term view	Current view
Equities			Russia’s invasion of Ukraine, China’s response to Covid, inflation and rising interest rates have created a less favourable economic backdrop and resulted in higher volatility. Given the greater risk of “stagflation” (high inflation and low or negative growth) we prefer higher quality companies with the ability to pass on higher input costs to consumers. We maintain conviction in long-term, secular themes including healthcare and energy transition.
UK			Valuations remain relatively attractive. Larger companies have benefited from greater exposure to cyclical sectors. The Bank of England remains under pressure to continue normalising monetary policy given elevated inflationary pressures, despite growth concerns.
Europe			Given Europe’s greater economic exposure to Russia (particularly through energy) the inflation and growth outlook for the region looks more challenging. This could impact consumer and investor sentiment. Monetary policy is likely to remain relatively accommodative, while spending from the NextGeneration EU plan will also be supportive.
North America			The US economy has the potential to be more self-sufficient in terms of both energy and agriculture and is therefore more insulated from events in Ukraine. Inflation remains a risk and consumer sentiment is the weakest it has been for over a decade. Valuations remain elevated despite recent moves and certain parts of the market are sensitive to rate rises, although the earnings outlook remains positive.
Japan			A delayed reopening, lower risk of inflation and more policy support (both fiscal and monetary) could lead to improved domestic growth, driven by consumption. Japan’s economic exposure to China could weigh on activity and sentiment in the near term, although valuations are supportive.
Asia/ Emerging markets			In the near term, China’s zero covid policy poses a notable economic headwind, despite some easing of restrictions. However, lending activity is picking up again, with greater political support for fiscal spending to support growth. The earnings outlook remains robust and valuations are now at a significant discount to their 15-year average.

Bonds

Asset	Current positioning	Medium term view	Current views
Bonds			Longer-dated government bonds offer defensive characteristics given growth concerns. We prefer USD government bonds due to their relatively higher yields and diversification benefits. We prefer inflation-linked bonds to conventional government bonds at this stage. Valuations look relatively more attractive given the sizeable moves we have seen this year, but remain vulnerable to further increases in interest rates.
Government bonds			Long-dated government bonds provide some portfolio insurance characteristics, given increasing concerns over global economic growth. Valuations look relatively more attractive given the sizeable moves we have seen this year, but remain vulnerable to further increases in interest rates.
Investment grade			We prefer shorter duration and higher quality credit in the near term given the potential for further spread widening. Opportunities remain within asset-backed securities which offer a relatively attractive yield and often have floating rates, which are attractive in a rising rate environment.
High-yield			Default rates remain low although face headwinds from a rising cost of debt and a more challenging economic backdrop. Recent spread widening offers some valuation support.
Inflation-linked			We prefer US TIPS to conventional treasuries and UK linkers given the low cost of currency hedging. Inflation expectations have the potential to remain elevated in the short term although we are conscious of the potential impact of rising real yields from very low levels.
Emerging markets			Certain emerging markets could see near term balance sheet deterioration as a result of a more uncertain global economic backdrop and continued Covid headwinds. There is selective value across both US dollar and local currency debt.

Alternatives and cash

Asset	Current positioning	Medium term view	Current views
Alternatives			Attractive diversification characteristics compared with equities and bonds. We favour absolute return strategies with the ability to deliver less correlated returns as well as real assets with long-dated, visible revenue streams and commodities
Absolute Return			Selected opportunities in market-neutral strategies given increased stock dispersion and diversification characteristics.
Liquid private real assets			Long-dated revenue streams and income characteristics remain attractive in select parts of the market. Within this space we see good opportunities in digital infrastructure, specialist property and exposure to private companies.
Commodities			Gold is attractive as a diversifier and should provide portfolio insurance in the event of a meaningful equity market correction or economic growth shock. Broader commodities can hedge against further rises in inflation.
Equity-linked income strategies			Offer attractive returns, especially in times of heightened volatility. However, there is a shorter-term correlation with equities.
Cash			Cash has defensive qualities in potentially volatile markets while higher interest rates may offer some potential for returns.

Key

	Positive
	Positive/neutral
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	Negative/neutral
	Negative
	Up from last month
	Down from last month

Terms

Spread: the difference in yield between a non-government and government fixed income security.

Duration: approximate percentage change in the price of a bond for a 1% change in yield.