Europe is the place to be
By Fraser Lundie, Head of Fixed Income – Public Markets
The outlook for the global economy hinges on the macroeconomic picture and its implications. Further growth shock and volatility are expected, and with nations reducing reliance on Russia, commodities remain a key focal point. However, opportunities can be found for credit investors in European financials.
Since the start of the year, the global economic outlook has deteriorated significantly.
China is a key area of focus, welded to a zero-Covid policy of mass testing and rapid lockdowns, more recurrent and pervasive restrictions to activity and consumption has battered businesses. We therefore believe there is more growth shock to be expected from this region than what’s currently priced in.
When we look at the Russia-Ukraine conflict, it feels like its heading to an ugly stalemate and as nations across the globe move to reduce their reliance on Russia, our outlook for commodities is very much on the bearish side. Inflationary pressures and the strength in the US dollar we’ve seen recently suggest that the Fed’s aggressive monetary tightening policy to curb inflation is already starting to be felt.
Against this backdrop, if we are at or near the top of the cycle in commodities, then we think inflation expectations are also possibly close to peaking. Seeing the end of this extremely high volatility range for interest rates would be the ultimate catalyst for credit to start meaningfully performing again.
In our view, Europe is the place to be right now, given the correction has been more marked, the region having been hit by both geopolitical worries and rates volatility combined. Also, we view the US as quite expensive in terms of valuations right now, largely driven by continued outperformance of the energy sector.
In the European space we like the banks based on how much systemic importance they have and therefore are more likely to have support from government and regulators through periods of stress. Conceptually, financials (banks, in particular) are helped by the prospect of higher rates on account of them being asset sensitive. We particularly like national champion banks, in Northern Europe, which are more recession proof than your average single ‘B’ high yield corporate.
The outlook for the global economy, which was previously fairly positive, now hinges on the evolving macroeconomic picture and its implications. Despite improved valuation levels, the percentage of negative-yielding assets falling significantly, an improved convexity profile, we remain cautious where the prospect of a more aggressive hiking cycle could negatively impact investor sentiment. Furthermore, the slowing global growth will likely benefit higher quality credit in the medium term, with more risky areas of the high-yield market heavily exposed to weakening fundamentals and rising financing costs. It is difficult to gauge what will happen next, despite talks around negotiations we expect volatility to remain high and disruptions to continue in sectors heavily reliant on trade with Russia. We continue to strongly believe that seamless integration of sustainability risk is a key driver of outperformance over the long term.
Ongoing megatrends create buying opportunity in Emerging Markets
By Kunjal Gala, Global Emerging Markets Portfolio Manager
In the near-term, Emerging Markets should prove resilient to the food security crisis and a global slowdown in comparison to the developed world. Further ahead, EM companies exposed to ongoing megatrends such as digitisation, electrification, automation, biotechnology and infrastructure are set to benefit.
Unless resolved, the ongoing Russia/Ukraine conflict will complicate the global food security situation. Food exporters will prioritise domestic consumption over exports leaving importing nations to find alternatives at high prices. Combined with the rising cost of energy and higher borrowing costs, the situation is becoming increasingly worrisome.
Contrary to the developed world, which imports majority of its resource requirements, most emerging markets are well placed to navigate this tricky situation. For instance, India which typically imports the majority of its crude, is a major food producer, self-sufficient in its staple food grains. Indonesia is a major producer of coal, copper, nickel and palm oil. South Africa is a major producer of PGMs and Brazil is a major exporter of soft commodities. Chile and Peru control 40% of world’s copper reserves and the Middle East is a major producer of oil and gas. China (and to a certain extent India) will use its financial clout to buy commodities at a deep discount from Russia to soften the impact of rising prices.
Nevertheless, higher energy, commodity and food prices will inflict significant pain on the global economy especially the middle/lower income households. A protracted war heightens the risks of a global slowdown as households’ disposable income is squeezed impacting discretionary consumption. In this scenario, the majority of the developed world will find it increasingly difficult to stimulate their economies, having spent significant sums of money during the Covid crisis resulting in elevated leverage and stretched balance sheets.
Within EM, major economies such as China, and India did not spend significantly during Covid rather pursuing targeted support measures. China has means to provide additional fiscal support to help boost the domestic economy. India on the other hand continues to reform its economy and pursuing production linked incentive programme to boost manufacturing and investments. The Brazilian Central Bank is significantly ahead of the curve in tightening monetary policy to control inflation, taking the Selic rate from 2% in March 2021 to 12.75% now. The world’s steepening monetary tightening process and traditionally vulnerable economies such as South Africa, and Indonesia are benefitting from positive terms of trade due to commodity shortages. Taiwan and Korea are net creditor economies to the world and do not suffer during a rising interest rate environment. China, India, Indonesia, Taiwan, Korea, Brazil and South Africa combined account for over three quarters of the emerging market universe.
Beyond the near-term volatility, we see continuation of several mega trends – digitisation, electrification, automation, biotechnology and infrastructure benefitting companies exposed to these themes over the medium/long term. We believe these trends help mitigate the impact from any macro slowdown, volatile input costs, rising cost of capital and costs associated with fixing climate related issues in the future. We believe technology is going to play an ever-important role in the changing global landscape where efficiency, and productivity will play key roles in boosting growth and profitability.
Technology has moved beyond its traditional back-office support role and is driving business in most industries, market share gains and enhancing consumer experience providing strategic competitive advantage. While investors’ concern about rising interest rates has de-rated the technology sector, we see this as an opportunity to buy interesting technology businesses with much greater margin of safety in the price.
Inflation, elections and regulation capture investor attention
By Louise Dudley, Global Equities Portfolio Manager
The preference for Value continues, but with inflation still a concern, focusing on a company’s business model will be vital. Investors will be keeping a close eye on US Mid-term elections and EU regulation and will feel sustainability affecting all corners of the market.
Over the last decade, markets have been driven by the (now) mega cap tech names, but we are now witnessing a change in the market dynamic. The hyper-growth rates these companies experienced is under threat and many are starting to think more about cost cutting as they struggle to justify their valuations as the hype disappears. Investors have undoubtedly become more valuation conscious and, with inflation remaining elevated, interest rates expected to rise and the continued wide gap between Growth and Value, the preference for Value seems unlikely to run out of steam.
Inflation, Covid, war in Ukraine and supply chain issues are likely to continue grabbing the headlines, which will likely lead to a continuation of the macro-driven market that we’ve seen for most of the year so far. Inflation remains the number one concern and, although headline numbers show some signs of stabilizing, there are still likely to be pockets of excess. Looking back, the last time we witnessed inflation at such high levels was in the 1980s when investing in small cap value was the best way to generate excess returns. Today is a little more complicated and with the increased threat of recession and growth more scarce, we believe that it will be more important to focus on prospective earnings. So, while macro factors are likely to continue to drive markets, it will not simply be a case of gaining exposure to Value: focusing on a company’s business model and the competitive backdrop will also be vital.
Looking ahead, towards the end of the year, the US Mid-term elections take place. President Biden’s approval ratings are not particularly healthy currently and if they remain close to current levels, the Republicans should benefit. Moreover, on the Republican side, it seems that candidates that back Donald Trump are not doing well in the primaries. A more moderate Republican party and a President whose tax and spend agenda is hampered are likely to benefit equity markets into the year-end. While it’s still too early to make any predictions, it will be worthwhile paying attention the closer we get to the elections.
It’s also worth paying attention to upcoming regulation in Europe. At the forefront is the EU’s Digital Markets Act, which promotes competition by allowing new entrants to challenge and prevent large companies from abusing their market position and power through a series of obligations and the threat of significant fines if these obligations are not met.
ESG and Sustainability are also likely to gain more attention too as the EU continues to focus on energy security following Russia’s invasion of Ukraine. Funds will need to be committed to LNG terminals and more renewable energy projects to enable the transition away from Russian oil & gas. All of this takes time and could create some tension against a backdrop of more rigorous decarbonization targets for companies. Over the longer-term, however, we remain of the view that sustainability will affect all corners of the market, which will provide plenty of opportunities across the universe, enabling us to retain a diversified portfolio of companies that have strong ESG credentials and long-term fundamentals.
Inflation to remain sticky and close to peak for the balance of the year
By Silvia Dall’Angelo, Senior Economist
Where will the current world of cost push inflation lead us? And how will households' attitude to savings affect the timing and depth of the likely slowdown ahead?
A dramatic shift in the global economic outlook took place after the Russian invasion of Ukraine earlier this year. The ensuing surge in commodity prices imparted a sharp shock to the global economy still recovering from the Covid-related recession. Higher cost-push inflation across the board has exerted a squeeze on real incomes, which will result in weaker aggregate demand going forward. The global economy is likely to slow down sharply over the second half of the year, with chances of a recession in advanced economies rising to above even for next year. The last couple of readings of the global composite PMI are consistent with global output growth of about 3% on an annualised basis, which would be below rates of ~3.5% prevailing before the Covid crisis and well below forecasts for global growth early this year (4-4.5%). Confidence effects and the potential for broadening geopolitical risks are sources of downside risk.
Although inflation is probably close to its peak, it is likely to remain sticky at elevated levels for the balance of the year, contributing to an uncomfortable growth-inflation trade-off for central banks. On balance, central banks will tighten their policies over the next few quarters, as their credibility – the most powerful tool they harness – is now on the line. While the direction of travel for monetary policy will be the same across the board, the speed and the destination will vary across regions. The Fed is set to lead the global tightening cycle, while European central banks will proceed more carefully.
Looking further ahead, the kind of cost push-inflation we are experiencing, together with fiscal and monetary tightening, will inevitably contribute to a demand slowdown. The timing and depth of the slowdown will depend on the consumer’s behaviour. Having accumulated excess savings in the region of 10% GDP in most advanced economies during the pandemic, households could eat into their savings buffer, which would lead to a gradual slowdown and, most likely, a more forceful monetary tightening. Alternatively, they could cling to their excess savings for precaution, against the backdrop of the sharpest cost-of-living crisis in decades and elevated uncertainty. The latter scenario would pose a particular acute growth-inflation trade-off and, accordingly, a policy dilemma for central banks.
Meanwhile, the Chinese economy has probably bottomed. After a likely contraction in the second quarter due to several lockdowns, the gradual re-opening of Shanghai and targeted fiscal and, to a lesser extent monetary stimulus, will re-launch growth in the second half of this year. However, as long as the zero-Covid policy remains growth will remain constrained. Amid short-term and long-term challenges, China is unlikely to be the engine of global growth it used to be in the previous two-three decades.
The investment industry will face further scrutiny
By Eoin Murray, Head of Investment
‘ESG’ continues to be in the spotlight and will remain so for the rest of the year. COP27 will be a driving force for further and welcomed scrutiny.
The investment industry will be subject to further scrutiny over the next six months or so given the odd moment that “ESG” is having right now. We have seen a massive "greenwash backlash" that has not been helped by the investment industry itself being vague about impact versus risk.
It’s also increasingly clear that too many want to paint ESG matters into a simple good versus bad split, when we all know that it is complex and often involves trade-offs. Perhaps too we can at last move away from focusing on aggregate ESG scores, for example, rather than doing the hard work to establish meaningful granular data around key material issues.
It’s also time to recognise that we need to properly bridge the gap between climate science and investing – there are significant gaps in general understanding that must be filled. Ultimately, this short-term pain will shape our industry for the better, and we anticipate more players to be walking the talk.
COP27 will also be a driving force for this change. We should see the commitments made in Edinburgh last year being turned into action with significant progress made a year on.
Expectations for COP27 in Egypt are mainly focussed on how the developed world will meet their commitments to the developing world in terms of Finance. The scene was set when climate negotiators met at the scheduled inter-sessional climate talks, known as SB56 (the 56th meeting of the Subsidiary Bodies), held in Bonn, Germany 6-16 June. SB56 set in motion the implementation phase of many elements agreed at COP26, and began technical work on issues that could be decided at COP27 in Egypt in November. The main takeaway from this interim session was that the global climate process has not stalled or lost ambition despite all the geopolitical events at play.
The key goals of COP27 in Egypt are still unclear because of global political focus elsewhere, finance and the rising cost of living around the world, and the desire to secure energy needs over varying timeframes. The Synthesis science report from the UN's climate science body will likely be delayed until 2023 and hence not be able to provide a boost to urgency. Australia's recent stronger climate pledge is positive, and adds to the pressure for Egypt to lead from the front by strengthening its own climate pledge well ahead of hosting COP27. It is unlikely that there will be any particular moves focused on investment.