Bear Market Rally?
August 09, 2022
Bear Market Rally?
August 09, 2022
July saw a rally in major developed markets, which had their best month this year, despite the U.S. going into a technical recession. The S&P 500 (TR) (USD) was up 9.2%, the MSCI Europe (TR) (EUR) followed at 7.6% and the MSCI Japan (TR) (JPY) was up by 4.0%1. Emerging markets did not receive the same boost, with the MSCI Emerging Markets Index (USD) marginally down -0.2%1. The last week of July saw a broad-based decline in yields globally. The U.S. 10-Year Treasury yield moved down from 3%2 at the end of June to 2.64%3 by month end. The VIX index also moved down to 213.
Despite the U.S. Consumer Price Index (CPI) surprising to the upside at 9.1%4, a lot of pessimism over inflation prospects appears already to be priced in. There is evidence that demand may come down, and has already done so for gasoline5, as consumers feel the impact of high inflation and a slowing economy. A technical recession, with U.S. Gross Domestic Product (GDP) coming in negative for the second consecutive quarter at -0.9% (Q2 2022)6, did not deter markets, which rallied. With the Federal Reserve hiking 75bps7, as expected, in the same week, markets may be sensing peak hawkishness. Remaining in the U.S., Q2 earnings have beaten expectations and guidance for the next quarter appears not as bad as markets feared. However, though we have seen a substantial derating in valuations, we do not think equities have priced downward revisions in earnings. Depending on the depth of the slowdown to come, our estimates suggest earnings for the S&P 500 should be 12% – 19% lower than current levels8. This supports our belief that recent strength in developed markets is a bear market rally, so we could still see further downside.
We remained defensive throughout the month, seeing earnings revision downgrades as the next major potential headwind for equities. Our overall fixed income exposure also remained unchanged, in an environment of high inflation, rising rates, continued geopolitical concerns and intensifying threats to global growth. However, within equities, commodities and fixed income, we made a number of tactical changes:
We reduced our overweight to energy. While supply constraints persist with U.S. producers, demand destruction is evident in the U.S.. As global growth continues to slow, cyclical headwinds will likely intensify, which should be negative for oil prices and the energy sector.
UK, Value and Growth Equities
We moved from overweight to neutral UK Equities, an overweight we had held since February 2022 and, likewise, moved from overweight to neutral Value Equities. For both, economic cycle dynamics warrant a reduction in cyclical exposure. Instead, we allocated to broad-based equities, to maintain stable equity exposure. For portfolios which have active funds, we continued to reduce allocations to growth-oriented active funds.
China A Equities
We added to our overweight China A, first implemented in June 2022, which we continue to believe should benefit from improving growth prospects and supportive policy backdrop, whilst the rest of the world experiences monetary tightening and slowing growth.
We moved overweight to neutral broad commodities due to slowing growth and signs of less supply-demand imbalance. We took profits on this position, held since the beginning of February 2022. This was initially an explicit hedge against escalating Russia-Ukraine tensions, which we held given the tight market.
First initiated in early May, we moved overweight to neutral agricultural commodities. Inventories are greater than expected, leading to less support for prices in the second half of the year.
We reduced our overweight to gold. Near-term upside potential is limited based on its long-held relationship with real yields and our view that real yields should stay in positive territory.
European Investment Grade Credit
We moved from neutral to overweight European Investment Grade Credit. Spreads appear already priced for material growth slowdown. This, coupled with slightly cheap Bund yields, should lead to a more favourable risk/reward set up, as the global economy is in the late stage of the cycle.
U.S. High Yield
We moved from neutral to underweight U.S. High Yield, given our cautious outlook on U.S. growth and consumption. We believe U.S. High Yield may suffer more from a potential economic shock over the coming months compared to higher quality credit.
We moved from underweight to neutral, as the euro is pricing in bearish economic growth in the eurozone and we may have reached peak fear on Russian gas supply. Likely elevated energy prices should maintain pressure on the European Central Bank (ECB) to be hawkish in forthcoming months. This should support interest rate differentials, which are already inferring higher EUR/USD. With downside risks likely largely priced in the eurozone, the euro could start to revert to fundamentals in 2H 2022.
Japanese Yen (JPY)
We moved first from underweight to neutral, then to overweight, as the downside to JPY against the USD appears to become more and more limited. Interest rate differentials, oil prices and other fundamental drives indicate the JPY is undervalued.
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Consumer Price Index: The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.
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