Monthly House View - June 2022 - Download here

"Loss aversion helps produce inertia, meaning a strong desire to stick with your current holdings”

Richard Thaler, Nudge

Many investors would probably like to turn back the clock a few months and retroactively adjust their portfolios to avoid the two major corrections in recent months: one on government bonds and the other on Growth stocks. In hindsight, the lesson learned from this correction is that it is hard to remain clear-eyed on high market prices and resist the idea that the future will be a continuation of the present. This is particularly true in a year when the macro-financial scenario has been seriously undermined by the conflict in Ukraine. Nevertheless, it would equally be a great a risk to think that inflation will continue to increase and that central banks will simply go back to a 1970s-style Fed approach.

The high level of uncertainty and the unease caused by capital losses can lead as much to investor paralysis as to an emotional decision to capitulate. This is what often happens after markets take 20% pitfalls; a famous bear market threshold which aptly reflects the swing from optimism to pessimism. This risk of capitulation in 2022 can be seen as the counterpart to the “fear of missing out” (FOMO) uptrend that dominated the markets in 2021.

To avoid the twin emotional trap of capitulation and impulsiveness, it might be better to try to make sense of the current environment. In the last few weeks, we have seen two alternating and competing narratives that are in fact two sides of the same coin: first, inflation with monetary policy normalisation and, second, fears of a recession.

Up until early to mid-May, the markets were primarily governed by inflation data (which once again exceeded expectations), and by the more determined tone of central banks (which fuelled the rise in long term rates). Paradoxically, future inflation expectations have corrected, reflecting the anticipated impact of the economic slowdown and monetary tightening. This correction has also led to a rise in real interest rates, which affected both Growth stocks and gold.

But in parallel long term rates have eased due to the increase in the likelihood of recession over the past few days.

This clash between the inflationary narrative and the recessionary narrative has also been stimulated by the sharp divergence between signs of a downturn in the business cycle, on the one hand, and surprisingly resilient corporate earnings, on the other. We can see a parallel with the divergence between economic indicators (such as PMIs), which are stabilising at high levels, and depressed consumer confidence indicators, which are affected by the decline in household purchasing power. All this confirms that the current shock is consumer rather than business-driven, but the latter will soon start to feel the effects on their sales volumes.

The rise of the recessionary narrative inevitably leads to changes in market positioning, with a better performance by Defensive sectors at the expense of Growth and Value. It could be tempting to see this as an entry point for Growth stocks after six months of correction. The signal will likely come from central banks. If the Fed were to soften its tone in the coming months in response to the risk of an excessive economic slowdown, investors would likely return to these stocks. The timing could also coincide with the possible and long-heralded weakening of the US dollar, something that is hard to imagine as long as the Fed sticks to its harsh tone. However, the dollar could return to gravity if the Fed signals an inflection point in its tightening cycle and the European Central Bank (ECB) exits negative rates.

The expected exit from negative rates is at least one positive that investors can hold onto in this anxiety-inducing environment, and which signals the return of bond carry. At the same time, the equity market correction could restore more attractive rates-of-return that investors need in order to combat the capital erosion caused by inflation.

 

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_{Monthly House View, 23/05/2022 release - Excerpt of the Editorial}