Investment Strategy Insights: Europe’s Winter of Discontent

Stance: Our Global Macro score maintains its moderate bearish tilt. While we still don’t forecast a broad global recession, regional scores are in flux. The European CS has deteriorated to 4, with risks to our low-growth forecast rising due to a possible energy shock if Russia cuts off gas exports to Germany. The US score remains at 3; growth is slowing, but tight labor markets will keep consumer incomes growing and prevent companies from accelerating layoffs. The China score has improved to 2.75, with signs of greater policy stimulus likely improving the macro outlook over the coming 12 months. Finally, emerging markets have proven quite resilient despite substantial policy tightening, but protracted inflation and the strong US dollar are keeping the EM score at 3.25.

Backdrop: The risk bias remains skewed to the downside, with central bank policy errors and an escalation of the Ukraine conflict high on the list. However, the most dominant feature of the current business cycle is labor market tightness, which is preventing broad-based layoffs that could set off economic domino effects. Our assumption is that it will take enormous pressure to change corporate behavior. That’s best evidenced in the survey of US small business optimism, in which expectations for business conditions are at all-time lows (since 1986) but willingness to raise compensation (presumably to keep existing employees) remains near all-time highs.

Outlook: The base case is still “Slowdown, no Recession.” Absent a gas shock in Europe, GDP growth should slow, driven by weaker consumer spending resulting from eroding purchasing power. Meanwhile, the coming slowdown in inflation while labor markets remain tight should result in a rebound in real income growth and a re-acceleration of consumer spending at the start of 2023.

Risks: 1) Russia escalating the Ukraine crisis, 2) central bank policy errors (from the ECB in particular), and 3) a sudden change in corporate demand for workers.

As bond markets have exploded in size over the past seven years, liquidity has become difficult, if not impossible, to source absent central bank support due to shrinkage of bank balance sheets, fewer investment banks, and the regulatory restraints of Dodd Frank and Basel III. With illiquidity the new normal, prepare for maximum volatility given the strong US dollar, making US Treasuries undesirable in Japan yen and euro terms (using three-month currency forwards) and high inflation tying the Fed’s hands. With no backstop, volatility reigns.

After a roller-coaster month which saw investor caution rise and then return to where it started, our prior stance of maintaining a marginally more defensive bias has not changed. Even so, valuations across asset classes continue to favor higher-risk high yield (HY) over investment grade (IG), so the defensive posture is largely within asset class positioning. As before, we favor more defensive US credit over Europe and emerging markets (EM).

New-issue supply remains low, with no opportunistic transactions or the market clearing of committed transactions from several months ago. CLO issuance also has stalled on challenging liability spreads, but with AAA rated CLO spreads above +200 levels, there is tremendous value on a risk-adjusted basis relative to corporates.

The drivers of euro/US dollar parity remain intact but could fade once the Fed has tightened financial conditions sufficiently and growth fears become more entrenched. Hence, we stick to our 12-month euro/US dollar forecast of 1.0500. For now, the US dollar remains supported by rising yield differentials, the persistent terms of trade shock, and broad risk aversion. With current data showing few signs of economic weakness, the Fed is likely to ignore growth fears and carry on normalizing monetary policy, which would further underpin the US dollar in the near term. The euro, on the other hand, faces a winter of discontent and a potential debt crisis driven by Italy. These factors serve to hamper any euro rallies. We will have to see if the European Central Bank’s recent 50 basis-point interest rate rise provides more than passing support for the ailing euro.

The ebbing of the terms of trade shock removes one of the factors that drove the Japanese yen to its 24-year low. We maintain our 12-month forecast of 147 based on the dovishness of the Bank of Japan. However, we acknowledge that the Japanese yen is undervalued according to most long-term valuation models, and the euro could turn out to be a new funder for investors willing to remain long the US dollar.

As fears of a global recession rattle markets, credit concerns are rising. Our analysts, however, are convinced that current EM HY spreads are overestimating potential defaults and that emerging markets can withstand a global recession and an extended period of limited market access. Regions vary, of course. Africa faces challenges, but the International Monetary Fund acts as an anchor, and defaults are not in the cards over the next 18 months. Latin America is showing resilience despite continuing inflation, sharp central bank tightening, and political uncertainty. In China, there is hope that the economy hit bottom in the second quarter and that coming fiscal easing will drive recovery in the fourth. Asia core consumer price index (CPI) inflation is less affected by the global food and energy price shock, suggesting central banks can act independently of the Fed. Most EM countries pass the fiscal robustness test, but we flag Brazil as a concern heading into its election campaign season later this year.

Maintaining our macro scenario weightings, we see corporate IG standing out as most attractive on a risk adjusted basis, but the risk of Fed overtightening and a further US Treasury yield overshoot make higher cash levels and investment flexibility more desirable.

As recession risks rise, we maintain our cautious score of 3.5. Stagflationary pressures are likely to persist in the near term, but our base case continues to be that inflationary pressures should moderate, and that the economy is on solid footing and can withstand moderately higher interest rates and unemployment levels over the medium term. The potential for a policy mistake, however, cannot be ignored, as demand-driven tools are likely to fail in fighting supply-driven inflation in the months ahead and overtightening won’t be visible until after the fact.

Meanwhile, China is pivoting to an acceleration of growth and an easing of financial conditions – an acute divergence from the rest of the world. As we have been expecting, a tentative reopening and easing credit are now driving a rebound in China’s leading growth indicators, and its equity markets are taking notice. The deteriorating property sector threatens financial stability, however.

The market is in constant debate about the durability of current inflation and the monetary response. While June’s report sparked fear that the Fed would need to be more aggressive, subsequent data points and Fedspeak suggest the current pace is sufficient. Second-quarter results will reveal companies’ ability to navigate this challenging environment. It appears that pricing power remains robust across most end markets, suggesting companies were likely able to deliver against modest expectations. We expect guidance will remain conservative given ongoing uncertainties.

Continued market weakness has presented us with opportunities to upgrade the portfolio and invest in companies that are typically richly valued. As always, portfolio style balance remains a key component of our risk management.

Our unchanged score is high-conviction long-term. Near-term, however, geopolitics and macro issues are headwinds. The markets’ tentative normalization appears to continue, but conviction is low. However, any reduction in sector- or style-driven dominance works to our investment strengths.

In China, electric vehicle demand remains strong, with this year’s penetration reaching an estimated 27.5%. Property sales in June were up 51% month-over-month despite being down 34% year-over-year. In IT, there are more signs of order cuts in semiconductors and hardware. In India, most consumer companies have increased prices to compensate for inflation, with no immediate indication of demand destruction, while IT companies have not seen spending cutbacks yet by global clients. Latin America has been whipsawed by global top-down and regulatory concerns. Central and Eastern European markets have been under pressure due to an escalation of risks surrounding natural gas flows. Middle East/North African equities have been weak due to recent commodity price softness.

Our portfolio remains unchanged. Overall, we consider long-term opportunities in global EMs to be among the best we have seen in years, but near-term macro and geopolitical concerns make predictions difficult.

Our US Market Cycle Indicator (MCI) worsened after a head-fake improvement last month, with a negative contribution from wider BBB spreads for the first time since July 2020. The curve flattened 28 bps in June,2 and BBB credit spreads widened 31 bps to 204 bps.3 Our Global Corporate Model remains positive on EM and negative on developed markets. In industry selection, our model favors energy, natural gas, electric, and insurance and dislikes financials, brokerage, consumer cyclicals, technology, and REITs. Our Global Rates Model continues to forecast lower yield and a flatter curve.

The rates view expressed in our G10 Model portfolio is overweight global duration. It is close to neutral in North America (underweight US and overweight Canada), slightly overweight in Europe (overweight peripheral and underweight core countries), and, in Asia, slightly overweight Australia and slightly overweight Japan. Along the curve, we are still positioned on flattening and are overweight the two-year/20-year key rate duration versus the rest of key rate points.