A close look at this week’s trending topic

Uncertainty remains high, despite stock rebound

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Stocks rallied last week due to a moderation of rate expectations and softening commodity prices, among other factors. The rebound in markets is a reminder of the merits of staying invested in line with a long-term plan. But volatility is likely to remain elevated until we see strong evidence that inflation is moderating, recession risks are receding, and geopolitical threats are declining. With uncertainty high, we believe investors should focus on building robust portfolios that can succeed under a wide range of outcomes.

The S&P 500 rallied 6.5% last week, including a 3.1% gain on Friday, as investors scaled back forecasts for rate rises from the Federal Reserve and searched for undervalued stocks after the steep sell-off of recent weeks. All 11 S&P sectors contributed to Friday’s rally, which was the largest daily gain for the index since May 2020. The technology sector was among the leaders, gaining 3.9%, benefiting disproportionately from a re-evaluation of the outlook for Fed rate rises.

Late last week, fed fund futures were implying more than 350 basis points of tightening by the central bank for 2022. By the close on Friday, this had fallen to around 330 basis points. Markets also started to price in rate cuts from the Fed in the middle of next year. A perception that markets may have gone too far in anticipating aggressive Fed rate rises was also reflected in a fall in the 2-year US Treasury yield, from around 3.24% at the start of the week to 3.06% at the end.

The moderation of rate expectations was helped by a softening of commodity prices, which fell 4% last week based on the Bloomberg Commodity Index, along with signs that household inflation expectations may have passed the peak. The five-year inflation outlook in a University of Michigan survey published on Friday stood at 3.1%, down from 3.3% earlier in June. Quarterly rebalancing may also have helped as asset managers added to equities to restore their target proportion of portfolios after the recent decline in markets.

But such signals were set next to continued hawkish comments last week by Fed chair Jerome Powell, and other top Fed officials. In his testimony to Congress, Powell warned that “further surprises” on inflation could be in store and that policymakers would need to be “nimble” in response to incoming data. Bringing down inflation, he added, remained the “overarching focus” of policy. On Friday, San Francisco President Mary Daly, whose voting record makes her a centrist policymaker, said she would support a 75-basis point rate increase at the July meeting, following a similar hike earlier this month.

Other drags to global growth also remained a concern for investors. Germany’s BDI industry association cut its 2022 GDP forecast and warned that a recession would be unavoidable if gas supplies from Russia are cut off completely. Meanwhile, Germany’s economy minister Robert Habeck said that “we must assume that Putin is ready to reduce the gas flow further,” following news earlier this month that supplies to the nation from the Nord Stream 1 pipeline had been cut by 60%.

What do we expect?

The rebound in markets is a reminder of the merits of staying invested, in line with a long-term plan. Nonetheless, volatility is likely to remain elevated until we see convincing evidence that inflation is moderating, recession risks are receding, and geopolitical threats—especially from curbs on Russian energy exports—are declining.

While the decline in University of Michigan inflation expectations data was reassuring, the Fed is unlikely to back away from its recent hawkish rhetoric until officials have greater confidence that the labor market is cooling and will remain alert to the potential for a wage-price spiral. The latest threemonth rolling average of median wage growth was 6.1% to May, more than double the 3% rate in the same month last year.

And although we think a deep recession is unlikely, economic headwinds remain, and we cannot rule out that markets will move to price it in the months ahead. Elevated inflation is straining household finances, with US retail sales falling on a month-on-month basis in May for the first time in five months. Higher borrowing costs for homebuyers are also starting to cool the housing market. The average rate on the 30-year US fixed rate mortgage has risen from around 3% at the start of 2022 to 5.8% at present, based on data from US housing agency Freddie Mac, the highest level since 2008.

In a soft-landing scenario, in which earnings growth expectations for 2023 are close to flat year-on-year, we would expect the S&P 500 to end the year close to current levels at 3,900. If worsening economic data leads earnings forecasts to be revised down to around –15%, in line with average declines during recessions, we would expect the S&P 500 to trade around 3,300.

How do we invest?

The main driver of markets in the second half of 2022 will be investor perceptions of whether we are headed for stagflation, reflation, a softlanding, or a slump(PDF, 576 KB). While the most likely single scenario in our view is for a soft-landing, sentiment is likely to remain fickle, and this is not a market to position for any one scenario with high conviction. As always, our goal is to build a robust portfolio that can help protect and grow wealth under a wide range of scenarios. We think investors looking to build a robust portfolio should take the following progressive steps.

First, manage a Liquidity1 strategy and diversify with alternatives. As the basis of a strong portfolio, to manage the risk of forced selling, earn yield, and prepare for potential future opportunities, investors should build and manage a Liquidity portfolio, sized to meet 3–5 years of cash flow needs. This will likely consist of a mix of cash, cash alternatives, and shortduration bonds. 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.

Second, add to defensives and quality, and make use of volatility. To build up defenses against a potential “slump,” in which weaker economic data drives lower corporate profit expectations and further downside in stocks, we believe investors should add exposure to quality income stocks, the healthcare sector, resilient credits, and the Swiss franc. Capitalprotected strategies may also allow investors to use volatility to work in their favor and mitigate potential downside risks.

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 above 3% also supports the style.

We also like stocks linked to the “era of security.” Recent reductions in gas supplies to Europe from Russia have underlined the need for governments and companies to focus more on safety and security over pure considerations of efficiency and price. As governments and businesses aim to bolster energy, data, and food security, we think this will spur demand for carbon-zero, cybersecurity, and agricultural yield solutions.

Finally, consider using the sell-off to build longer-term positions. A quicker-than-expected alleviation of market concerns about inflation could trigger a rally in growth stocks, as we saw last week. Meanwhile, investing in private equity 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.

At our CIO summit in Zurich last week, regional CIOs discussed portfolio strategy and positioning for the second half of 2022. Watch the video here (9:26).

 

Questions for the week ahead

Is business activity holding up?

With recession fears lingering, investors will be looking to the June reading of the ISM manufacturing survey for signs of resilience. We also get a business climate reading from the Eurozone for June, along with Japan’s Tankan survey.

Will the Fed’s favorite inflation measure provide grounds for comfort?

The Personal Consumption Expenditure index for May is released. This has recently been more reassuring than the Consumer Price Index reading, which hit its highest level since 1981 in May. Investors will be hoping for signs from PCE that inflation pressures are moderating. In April, the headline PCE rose just 0.2% on the month, down from 0.9% in March.

Will Russia add to Europe’s economic strains?

Amid indications that Russia is trimming energy supplies to retaliate against nations supporting Ukraine, investors will be alert for further action or efforts by Europe to form contingency plans.


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