Principal Monthly Viewpoints (October 2022)
Q: Principal Asset Management (Asia) Investment Management Team
A: Crystal Chan, Head of Investment Specialist Principal Asset Management (Asia)
Q: How will the tightening environment of monetary policies globally affect next year’s economic outlook?
A: All economic indicators are currently pointing towards a downturn in the global economy. Hampered by developed markets, Principal’ s global PMI index fell to 50.3 in September, while the figure in Europe has been below 50 for two consecutive months. Global financial conditions have tightened significantly over the past year, particularly in developed markets where the U.S. experienced the greatest tightening. Financial conditions may remain tight in the future, creating headwinds for some economic activities.
Global central banks simultaneously hike rates to combat inflation may be the main reason for a global economic recession to happen next year. Markets predict that global monetary policy rates could be raised to nearly 4% in 2023, more than 2 percentage points higher than the average level in 2021. Unless supply constraints and labour market pressures are relieved, tighter monetary policy may result in global core inflation (excluding energy) to fall from the current level of 6% to 4% next year, which will still be relatively high compared with the pre-pandemic levels of 2%.
If central banks worldwide continue to tighten policy aggressively next year, and investment markets pull back further, global GDP growth may drop to around 0%, while output per capita may see negative growth, meeting the definition of a technical recession.
Taking the U.S. as an example, Fed Chairman Powell has made it clear that he will prioritise inflation control even at the expense of economic growth, until inflation returns to the target level of 2%. We believe benchmark rates could reach 4.5% by the end of the year, and may climb to 5% or above by 1Q23. As the effects of tighter monetary policy begin to surface, the risk of an economic recession in the U.S. will increase markedly in the first half of 2023. The Fed may reverse course and cut rates in 4Q 2023.
Q: Battered by high inflation and geopolitical factors, is recession inevitable in Europe and the UK?
A: Among major economies, we are relatively pessimistic about the Eurozone. Since the commencement of the conflict between Russia and Ukraine, natural gas prices have surged in Europe, with the year-on-year increase being as high as fivefold at one point. Despite that the gas prices have once corrected by 50% since the end of August, the continent’s natural gas supply remains highly uncertain as we approach winter, coupled with the gas leaks in the Nord Stream Pipeline, a crucial energy pipeline between Russia and Europe. If the local inventory is depleted, natural gas prices may increase again, causing industrial activity to grind to a halt.
Affected by these factors, inflation in the Eurozone rose to 10% in September, which has yet to peak and could remain elevated for some time. Despite growing concerns over a recession, the ECB is left with no choice but to hike rates more aggressively to curb inflation, leading to further normalisation of rates. The ECB has already hiked rates by 75 bps in September, and could impose bigger hikes in the future depending on data performance. We may have to wait until 2024 before we see a substantial improvement in the overall economy of Europe.
The economic outlook of the UK is also highly uncertain as its newly appointed government has announced the most radical tax cut proposal since 1972, in an effort to relieve family and corporate tax burdens and boost long-term economic potential. However, markets experienced turbulence after the announcement, with the GBP falling to a new low and UK bond yields rising across the board. Due to strong opposition, the tax cut plans have been partially scrapped.
Markets panicked due to the lack of expenditure cuts in the programme which attempted to stimulate the economy, while may greatly expand the ratio of a structural budget deficit. This plan may not be sustainable under the relatively weak economic trend. The programme also proposed to mitigate the effects of inflation through energy subsidies. But in fact, it may intensify the pressure on domestic inflation in the mid-term, resulting in much higher expectations of BoE rate hikes.
To stabilise bond markets, the BoE made emergency bond purchases while deferring its plan to sell bonds to October 31, but markets are sceptical of whether such moves could stabilise markets. Apart from snapping up bonds, the BoE seems to be left with the option of hiking rates by as much as 100 bps at its next meeting in order to defend the currency exchange rate. This is much higher than the 50bps hike predicted by markets, and could further weigh on the local economic outlook. Whether market confidence can stabilise will depend on the UK government’s announcement of concrete plans to balance its expenditure and income.
Q: How should equity and bond allocations be made in the fourth quarter amid market uncertainties?
A: Investment markets have been experiencing a new downward trend from mid-August onwards. Global equities decreased by 7% in the third quarter, with developed markets performing relatively better as the U.S. S&P 500 index fell by roughly 5%. Faced with a strong greenback, emerging markets, in general, slumped by over 12%, while HK equities plunged by over 20% in the quarter, more than other major stock markets. In terms of bonds, sovereign bond yields worldwide climbed significantly because of Fed rate hike expectations. U.S. 10-year Treasury yield surpassed 4%, while returns of global sovereign and investment grade bonds were more affected, losing more than 7% in the third quarter.
Looking into the fourth quarter, the three major themes of high inflation, tight monetary policy and recession should continue to dictate investment markets. Global inflation has slowed recently because of the receding effects of oil prices. Nonetheless, inflation should remain elevated for the rest of the year. Global inflation in August inched downwards to 6.7%, only 0.2% lower than the peak in June. In the U.S., core inflation rose again in September, while the rise in prices became demand-oriented rather than resulting from supply shortages. As a result, the Fed and other central banks in the developed markets may have to continue hiking rates.
The aforementioned uncertainties and continuous tightening of financial conditions are detrimental to risk asset performance, implying that investors should take a more conservative stance. The trend of global corporate earnings downgrades is likely to persist and may become the major reason behind further equity pullbacks. This explains our decision to revise our overall view on equities to slightly negative despite reasonable fundamentals and relatively attractive valuations. We are neutral on the U.S., China, Hong Kong, Asia overall and Japan, but slightly negative on Europe.
We are generally neutral on bonds. A weaker economy and growing risk aversion sentiment could cause U.S. sovereign bond yields to fall by the end of the year, which makes us slightly optimistic about global sovereign bonds. We are neutral overall on investment-grade securities because of relatively reasonable valuations and the total return possibly benefiting from rate pullbacks. On the other hand, we have moved to slightly negative on high-yield bonds which are more correlated with economic performance.
(Written on 14th October 2022)
Crystal Chan
Head of Investment Specialist
Principal Asset Management (Asia)