Four strategies for steering through H2 2022

Fears of a sharp slowdown in global growth have continued to intensify over the past couple of months. And after one of the most significant valuation corrections in more than 20 years across both equities and fixed income, markets are now fretting that a global recession will be required to tame the inflation beast. Volatility has been elevated and likely to persist.

As the outlook for growth and markets remains uncertain, we highlight four key portfolio strategies that investors can implement while we wait for greater certainty on the outlook.

H1 2022 has proved a difficult investment environment

The first half of this year was characterised by a rapid rise in interest rates that has driven one of the most significant valuation corrections in more than 20 years across both equity and fixed income markets, and in virtually every region of the globe.

There is now almost no question that policy, monetary and fiscal, was held ‘too stimulatory for too long’ through 2021, underpinning a faster-than-expected post-pandemic growth surge, driving down unemployment rates, driving up wages growth, and stressing already pandemic-constrained global supply chains. With an extended war in Ukraine (spiking energy and commodity prices)—as well as China’s on-and-off-again lockdowns—this combined to drive inflation to around 9% (a 40-year high) across the US, Europe and UK. Inflation in Australia is close behind, rising over 6% in Q2.

The persistence of that high inflation through Q2 has led to belated, but accelerated, central bank rate hikes. With inflation still high and more interest rate increases ahead, fears of a sharp slowdown in global growth have continued to intensify over the past couple of months. Markets are now transitioning from fretting about inflation to fretting about the rising risk that a recession globally will be required over the coming year to tame the inflation beast.

Views on the outlook revolve around two distinct outcomes

Views around the outlook for growth and markets, while still embodying the typical dispersion, largely oscillate around two distinct outcomes. The first has elements of a ‘softish’ landing then reflation (a potentially ‘good’ scenario), while the second is more stagflation and recession (and more of a ‘bad’ scenario). Clarity around which narrative will dominate markets in H2 2022 may still be several months away, and the only certainty appears that volatility will be elevated.

In the first scenario, the current peaking in inflation pressures should aid central banks in avoiding over-tightening, allowing them to lift interest rates to a level sufficient to drive significant demand destruction but avoid setting in train a global recession during late 2022 and 2023. This view heavily relies on the recent moderation in longer-term inflation expectations to dismiss concern that inflation has become entrenched (and difficult to reverse). A belief that central banks will ‘tilt their tone’ to one less hawkish (but unlikely dovish) when confronted with slowing growth and inflation is also a key facet of this outlook. In this scenario, while the equity valuation adjustment has not fully captured the unfolding earnings correction, clarity that a recession will be avoided will provide a foundation through H2 2022 for equities to base and grind higher into year-end, bond yields to peak and credit spreads to steady. 

The second scenario (and a more problematic one) is one where, despite evidence of easing upstream price pressures, inflationary pressures continue to spiral upwards through economies, or do not ease as quickly as hoped this year, demanding more restrictive cash rates above the current pricing for around 3.5% in both the US and Australia. This scenario likely requires a recession (and a significant uplift in unemployment) to bring inflation lower. In this scenario, equity markets will correct lower as earnings outlooks are cut much more significantly than currently expected, bond yields rally as growth slows, and credit risk increases.

Where do we lean?

Our central case thesis through this year has sympathised far more with scenario one, ‘the good’ scenario, where a significant slowing in global growth gives way to reflation as the global cycle returns to an extended phase in the ‘mid to late cycle’.

But we have to acknowledge, with hindsight, that growth now looks likely to be significantly softer than we expected several months ago, and inflation has proved more persistent. While the risks of recession globally have increased, and our confidence is below normal, we still favour that path and maintain a portfolio positioning consistent with that. The risk of slipping into scenario two remains elevated, albeit we would argue, as the International Monetary Fund (IMF) did in late July, that “we would expect a recession that is fairly shallow”.

Key aspects of our macro central case are below:

• We expect global growth to continue to slow significantly through H2 2022, though sequentially, mid-2022 is likely the weakest point of the cycle before a modest rebound. After 6.1% in 2021, we expect growth of around 3% in 2022 and 2023, above the 2% mark that typically signals a recession. Despite higher rates and energy costs, consumer saving buffers, strong jobs markets and an upswing in global capex are key growth supports.
  
  
• Inflation pressures in the US, UK and Europe (and energy crisis in the latter) render these economies most vulnerable to a period of weak growth (1-2% in 2023), while Asia and Australia look more likely to endure a less pernicious correction, reflecting somewhat less inflation pressures (and in Asia’s case, a belated post-pandemic reopening recovery). We expect growth in Australia to slow from 4.8% in 2021 to 4% in 2022 and 2.5% in 2023.
  
  
• We expect US inflation to more clearly peak by early September, followed thereafter by the UK and then Europe. Australia’s Q4 inflation peak is unlikely to be revealed until early 2023. This will reflect the already significant easing in supply chain pressures, evident correction in commodity prices (from wheat to oil, lumber and copper), as well as the lagged demand destruction from already significantly tightened financial conditions.
  
  
• We expect policy rates to peak at levels around or a little below current market pricing. While we don’t expect central banks to turn ‘dovish’, the extent of their ‘hawkishness’ is expected to be toned down as inflation peaks and growth proves less resilient early in H2 2022. Against market pricing of about 3.5%, we expect the US policy rate to peak near 3.0-3.25% and Australia’s policy rate to peak near 2.5-2.75%, both before end-2022.

Reflecting this viewpoint, we maintain our current tactical positioning. We continue to maintain an overweight cash position, looking for an opportunity to deploy into more constructive equity markets. We remain neutral on government bonds, given broad alignment with medium-term neutral cash rates, while positioning underweight credit given potential stress as economies slow. We maintain an overall neutral equities stance, but a defensive stance geographically, with an overweight position towards Australia.

It’s always challenging to balance positions for both the good and bad scenarios

From a portfolio perspective, in periods of uncertainty, it is always challenging to balance positions for both the good and bad scenarios. Similarly, there can be tension between positioning portfolios for growth and protecting capital. Finally, risk appetite becomes increasingly important at such junctures, with lower risk appetites likely to want to envisage greater protection against short-term volatility, while higher risk appetites may be more inclined to position now, despite volatility, for future growth.

Through H2 2022, we believe there are a number of strategies that can be implemented while we wait for greater certainty on the outlook:

1. Focus on quality—portfolio risk can be minimised, and portfolio liquidity and flexibility enhanced, by leaning towards quality in periods of uncertainty. This is relevant for equities (including focusing on the quality end for tech exposures), as well as fixed income, from highly liquid government bonds to short-maturity floating rate exposures. High quality liquid investments can also convert to capital for future deployment.
   
   
2. Avoid dramatic style exposures—style will be significantly influenced by which scenario (‘softish landing and reflation’ or ‘stagflation and recession’) evolves over time. The latter should support (quality) growth exposures as growth becomes scarce, while even under the former scenario, the sharp sell-off in long-duration equities supports building long-term positions. However, with inflation in the next cycle likely to settle at higher than 2.5%, this will still provide support to value exposures.
   
   
3. Seek opportunities in alternatives—portfolios should continue to maintain/increase alternative exposures at their strategic asset allocation targets, given unlisted investments will continue to provide diversification to traditional assets. Opportunities in private equity investments yet to deploy, real assets with inflation protection, and defensively positioned (ex-real estate) private debt are likely to prove defensive over time.
   
   
4. Invest through themes—implementing capital along longer-term structural thematic lines can minimise volatility through periods of uncertainty. There is a range of investible themes, including digitisation and automation, climate change and decarbonisation, energy security, biodiversity and food security.
   

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