Andrea Quapp, Investment Director for Multi Asset Client Solutions (MACS) Continental Europe, explains why the tension between inflation, interest rate peaks and acute recession risks can be a constructive environment for investing, despite numerous risks. In the bond market, higher default rates loom for bad debtors, but opportunities beckon in high yield bonds. Equity markets are still benefiting from better-than-expected quarterly results, although the environment is becoming somewhat gloomier.
In financial markets, a "black swan" is an event that seems highly unlikely and takes everyone by surprise. In retrospect, it may turn out that there were clues that were not seen, understood or taken seriously. In recent years, black swans have flown over financial markets several times, such as the Covid pandemic in 2020 and the Russian invasion of Ukraine in February 2022. Today, fear prevails that the war in Ukraine could spread to neighbouring countries and that there could be a military escalation between China and Taiwan. The negative effects of global warming, such as storms and droughts, are increasing in frequency and thus concerns about climate change have also escalated further in recent quarters. In particular, there is a focus on the impact this will have on emerging markets.
In the worst case, the aforementioned factors could lead to a more pronounced than expected and sustained economic downturn. In this environment, central banks that oscillate between restrictive and expansive monetary policy are not a stability factor. For example, the outgoing head of the Japanese central bank, Hauhiko Kuroda, left the key interest rate in negative territory in March, even though inflation had doubled to 4%. All these uncertainties make for above-average volatility in financial markets.
What impact does this have on our asset allocation?
A rise in inflation is not a black swan event and a pick-up in inflation was also expected at the beginning of 2022. But markets assumed a mild and, above all, a temporary rise in inflation. Everyone, including central banks, were surprised by the high, double-digit inflation rates in many countries. Many central banks reacted with drastic interest rate cuts, which left their mark on markets.
There are now signs of a peak in inflation and interest rates. Whether there will be a recession, and to what extent the economic contraction will occur, is disputed. For the global economy, the International Monetary Fund (IMF) expects slight growth of 2.3% for the current year. Sentiment indicators show a mixed picture. Bond markets are priced for a stronger cooling of the economy while stock markets expect only a temporary dip in growth.
A renewed banking crisis, which originated in the US but also dealt a death blow to Credit Suisse, has recently further dampened confidence in markets. This situation makes us cautious about the related asset classes. However, we favour individual sub-asset classes such as US corporate bonds, value shares from Europe and the US and Swiss residential property.
Ups and downs for bonds
In recent weeks, the bond market has experienced ups and downs on the yield side. Factors such as inflation rates, unemployment rates and lending conditions remain dominant. In recent weeks, yields have reacted directly to the publication of fundamental data, especially from the US. Sentiment has fluctuated between optimism, for example when inflation is falling, and pessimism, when purchasing managers' indices are weakening, and ambivalence when US labour market data continue to be surprisingly strong.
The level of return that can be achieved with corporate bonds depends on the course of the expected recession. Will the economic downturn be mild or significant? On the one hand, this entails risks in the form of increasing default rates for lower-quality debtors, but also opportunities in the high yield bond segment. In the bond sector, we are focusing on bonds issued by Swiss industrial companies and dollar-denominated corporate bonds.
Surprising optimism for equities
The IMF's modest global growth forecast seems to be sufficient to cause share prices to rise. Companies' quarterly earnings figures have so far, on average, exceeded market forecasts, also contributing to confidence. Equities are being bought primarily in anticipation of robust consumer behaviour, as well as investment measures to combat climate change. The Inflation Reduction Act promises the largest investments ever initiated by the US to mitigate climate change. Productivity gains from the use of artificial intelligence (AI) are also giving equity investors confidence. The text generator Chat-GPT, for example, has become the tech hype par excellence in recent months and has broken growth records. But as a reminder, human intelligence will also continue to be an important influencer.
Because the risk-free interest rate in the US has been hovering around 4% for some time, we currently consider systematic exposure to this demanding and often illiquid asset class to be of little value. We invest in the commodities oil and gold on a purely opportunistic basis. These commodity prices are currently driven by less rational currents, such as production cuts on the oil market or "global uncertainty" in precious metals trading. We also see opportunities in the Swiss residential real estate market. Due to high immigration, flats in urban centres are scarce; on the other hand, we are seeing reduced demand for office and retail space due to the trend towards home offices and e-commerce. Selectivity is therefore key. Due to the lack of transparency and the high energy demand, we would not yet consider the non-regulated market of crypto assets.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice or an invitation to invest in any GAM product or strategy. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers.