The European Central Bank (ECB) has joined the club of interest rate raising central banks last week and surprised the markets on the hawkish side with a 50 basis points raise and a clear communication. Likewise, the Federal Reserve (Fed) is expected to tighten the interest rate screw by another 75 basis points at the next meeting (27th of July). Of course, the tighter monetary policy of the major central banks has consequences for global economic growth. Not only are estimates for 2022 and 2023 increasingly gloomy, but also the growth outlook differs from region to region. The probability of recession has steadily increased over the past few weeks. We see the following three scenarios for the coming months:
Price pressure peaks during the summer months, first in the US and with a time lag also in Europe. On an absolute basis, inflation starts to moderate, but declines more slowly than in the past. The Fed and the ECB will continue their rate hike cycle along current market expectations, but there will be no tighte-ning of monetary policy. Economic growth continues to weaken and in the major economies we are getting close to or even into a moderate recession in the short-term.
In this scenario, the tightening of monetary policy screws combined with inflationary pressures will lead to declining demand for economic goods. Supply chain bottlenecks are expected to ease materially and Russia will continue to supply gas to Europe, albeit less than desired by key customers. Although inflationary pressures are starting to ease, central banks have too little flexibility to keep economic growth at potential.
Inflation remains stubbornly high and monetary policy is tightened further. Growth expectations are gloomy. The consequence would be a “hard landing” and thus a deep recession. A prerequisite for this scenario would be an increasing escalation of the energy supply crisis with gas as well as electricity, which would have its epicenter in Europe. However, these effects would then spill over to the global economy. A possible energy rationing in Europe in winter would hit the industry and the consumers hard. A possible stagflation scenario coupled with a deep recession in Europe would then be almost unavoidable.
The supply chain problems resolve much faster and consumer demand remains more robust than expected. Similarly, Russia supplies sufficient gas and there is thus a de-escalation in Europe before the winter months. The consequence would be a faster normalization of inflation rates and more room for maneuver for central banks, which could then display more benevolent rhetoric. This would lead to a classic “soft landing”.
In our main scenario, we expect a further decline in economic momentum in the coming weeks and months. Due to inflation expectations both in the US but also in Europe, the market expects a further acceleration of price pressures. Much depends on the tense energy situation in Europe, which has definitely mutated into a pawn between Russia and the West. One bright spot, however, is the consumer in the US, which is surprisingly robust despite record low consumer satisfaction (see page 4). Growth in China is already lower than potential output and the government in Beijing is trying to support the economy with stimulus measures.
For quarters, fixed income has had an unattractive view across assets. With the economic downturn now expected and interest rates rising in recent months, the time has come to upgrade the rating to “neutral”. Thus, we are positioning ourselves a notch more defensively across assets. The equity market has already priced in most of the economic downturn, but not yet a recession. The equity risk premium is at best in the historical average and therefore, in our view, the time has not yet come to build up risk. We maintain our view that selection is a key success factor in the current highly complex environment, also in Q3 2022.
We maintain our regional preference for the US over Europe. While European indices are at a more favorable valuation level than those in the US, the “energy” risk for the Eurozone conti-nues to justify an “unattractive” rating. The US is further advanced in the monetary policy cycle and therefore, despite a higher P/E valuation, US equities (“attractive” rating) are to be preferred to European securities. We also prefer companies with defensive qualities and pricing power on a global basis.
As described above, we are increasing our fixed income rating from “unattractive” to “neutral”. However, the opportunities remain modest, especially for a euro and Swiss franc investor. We see the greatest potential in US government bonds. We also increase the duration to “neutral” and reduce TIPS (inflation-linked bonds) to “unattractive”. We continue to see the greatest potential in the subordinated segment and maintain our “attractive” rating.
Publisher: LGT Bank (Switzerland) Ltd., Glärnischstrasse 36, CH-8027 Zurich
Author: Thomas Wille, Chief Investment Officer, Email: firstname.lastname@example.org
Editor: Alessandro Fezzi, E-Mail: email@example.com
Source: LGT Bank (Switzerland) Ltd.
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