Top Down

The primary driver of markets so far in 2022 has been the acceleration in monetary policy expectations, which continued in April. Central banks are being forced to act sooner and more aggressively than anticipated coming into the year. The shift is mainly due to higher and more persistent inflation, while economic growth indicators have been strong. 

Market volatility is normal around central bank policy rate lift-off. But, in addition to some uncertainty about post-pandemic economic trends, the current lift-off has been exacerbated by the inflationary supply shocks of the war in Ukraine and China’s Covid-related lockdowns. So, while inflation is forcing higher policy rates, some of its underlying drivers are also causing simultaneous cuts to economic growth forecasts.

Looking ahead a key question is: is inflation peaking, and will it start to subside? Or will inflation persist? Only time will tell. But if it persists, central banks may be forced to go further, beyond neutral, to restrictive monetary policy. This increases the risk of an economic recession.

Consensus forecasts are not projecting recessions in 2022 or 2023. The probability, or risk of recession is still relatively modest. But the forecast revisions trend remains negative and the margin above trend growth is narrowing. The US seems in the strongest position, while European and Chinese growth forecasts seem most at risk to the downside from current levels.

Weak equity markets are reflecting a combination of a deteriorating growth outlook and tighter monetary policy. Energy has outperformed as oil and gas prices have increased. Defensive sectors such as Health Care, Utilities, and Consumer Staples have also been outperforming. The Consumer Discretionary sector has been hard hit by concerns about the impact of inflation on consumer spending. More speculative parts of markets have been hit by the decline in liquidity, which is weighing on the IT and Communication Services sectors.

First quarter earnings were stronger than expected in both the US and Europe. Revenue and earnings have both exceeded analyst forecasts. The proportion of US companies beating forecasts is trending back to historic averages, but it is still high. Despite the European earnings season being very strong compared to forecasts, it has not been driving share price performance. Earnings forecasts have continued to be revised higher through 2022. But the revisions are concentrated in the commodity sectors, with a mix of positive and negative results elsewhere. The supply-driven inflation experienced recently is having a negative impact on margins, reducing equities’ inflation hedging capacity.

With lower prices and higher earnings, global equity valuations have declined and are in-line with historic average multiples. Negative forecast revisions are a risk, but are the normal state, and not always an impediment to equity markets making progress. Still, the over-riding issue is that the economic cycle is more advanced than anticipated, which favours a more defensive stance.

While double digit equity market falls are unpleasant, similar declines in fixed income markets are thankfully rare. Since the last Top Down, US 10-year bond yields increased from about 2.5% to 3.1% and German 10-year bunds from about 0.6% to 1.1%. Corporate bond returns have had little protection from higher starting yields as credit spreads have widened.

Market expectations for future policy rates have stabilised somewhat over the last few weeks, reflecting policy announcements and economic data. The US Federal Reserve (Fed) increased its policy rates by 50bps at the start of May. It outlined expectations for another 50bps hike at each of the next two meetings, and so far, has ruled out 75bps rate hikes. That will depend on how the situation unfolds.

There have been some key economic releases since the Fed announcement. The US employment situation report was strong but showed moderating growth and slightly lower-than-anticipated wage inflation. Inflation data has been mixed but includes some anomalies. Bond yields have subsided (bond prices increased) since the Fed announcement and economic releases, which might suggest that policy expectations have caught up. However, two data points don’t make a trend. It will take some sustained easing of inflation metrics to ease the risk of restrictive monetary policy.

Nonetheless, the rise in bond yields that has occurred in 2022 increases the income attractions, and relative value compared to other asset classes. The higher initial yield should also provide greater diversification benefits for fixed income.