Outlook: Things will get tougher before they get better
The situation in the capital markets will probably remain challenging for a little while longer before the picture starts to improve. Key factors such as inflation, growth, monetary policy and market liquidity are shrouded in significant uncertainty. But the – as yet – robust shape of the economy, healthy profits in the corporate sector and fiscal policy measures are providing support. This suggests that the investment outlook may brighten towards the end of the year.
Andreas Köster, Head of Portfolio Management and Chairman of the Union Investment Committee (UIC)
2022 marks a historical turning point for the capital markets in several respects. The coronavirus pandemic accelerated some existing trends, stopped others in their tracks, and also brought forth certain new trends. In addition, inflation is rising rapidly and interest rates are following suit. Russia’s invasion of Ukraine has furthermore necessitated a reassessment of political risks. In light of these directional changes on three different fronts, the capital markets need to recalibrate. The old, pre-pandemic equilibrium of low inflation, ultra-expansionary monetary policy and small geopolitical risk premiums no longer applies. Now, we are in the process of transition to a new post-pandemic equilibrium. But so far, we can make out only a few vague outlines of what shape it will take – for example, higher inflation and the return of great power rivalry to the international stage. This transition period is characterised by significant uncertainty, which is currently putting a damper on the capital markets and economic growth.
High levels of uncertainty about inflation, growth, monetary policy and market liquidity
From an investor perspective, how the rest of the year pans out in the capital markets will crucially depend on four key variables – inflation, growth, monetary policy and market liquidity. These topics are currently shrouded in considerable uncertainty, and prices are unlikely to climb much until a degree of certainty is restored. The first few months of the year were mainly shaped by concerns about inflation. The inflationary pressure has become established and broadened out, meaning that we will not see inflation return to pre-pandemic levels any time soon. However, over the course of the year, inflation will probably fall again, starting in the US. Many of the tensions in the real economy, from supply chain disruption to excess demand for goods, will ease. As a result, inflation should start to drop slowly but steadily, first in the US and later in Europe as well. This will take pressure off the central banks and reduce the risk of monetary policy pushing the limits too far, which is unfortunately what has happened too many times in the past. For 2022 as a whole, Union Investment’s forecasts predict consumer price increases of 8.0 per cent in the US and 7.6 per cent in the eurozone. A marked decline is not expected until 2023, when inflation will probably roughly halve in both regions.
Peak inflation: slight fall expected over the further course of the year
Inflation set to climb until the summer
Inflation expected to drop slowly but steadily
The slow pace at which inflation is expected to come down will be a continuing cause of uncertainty. The key question is whether the central banks will be able to get inflation under control or whether they will need to tighten the reins further, beyond what they have announced already. Another prerequisite is a marked easing of tensions in the real economy. Otherwise, there may be a risk that monetary policy measures brought in to curb inflation could push the economy into a recession. These concerns will stay with us, at least over the summer. The eurozone is in a difficult position in this respect as it is already teetering on the brink of stagnation, looking at the year as a whole. The picture in the US provides more cause for optimism, which reduces the risk of a global economic downturn.
More specifically, the US Federal Reserve (Fed) will probably take restrictive action more swiftly and emphatically than previously expected and will continue to implement sharp interest-rate hikes. The Fed has communicated its roadmap for tightening measures very clearly and the market has therefore already priced it in to a large extent. Against this backdrop, US bond yields should experience only mild upward pressure going forward. Ten-year US Treasuries will likely yield around 3.2 per cent at the end of the year. The European Central Bank (ECB), on the other hand, finds itself in a very different position, as it has yet to reverse its monetary policy. Things could get turbulent in the European bond markets, especially around the time of the ECB meeting in July. In the eurozone, yields on short-dated paper in particular may continue to climb while yields on ten-year paper will probably see only a modest further rise.
Calm returning after the storm: the bulk of the rise in yields should be behind us
US bond market: change in interest-rate policy priced in
Stress-testing the economy – growth is slowing
The combination of persistently high inflation, lingering supply issues and excessive tightening of monetary policy presents the biggest macroeconomic risk. Concerns about economic growth have therefore rightly replaced inflation as the primary market driver. After all, the risk of the global economy slipping into a recession has increased markedly. However, we expect the central banks to be successful in managing the balancing act between curbing inflation and protecting economic growth. China’s successful containment of new coronavirus outbreaks through swift, robust and effective lockdowns, combined with additional monetary and fiscal policy support, will provide positive momentum. And US consumer spending will also be a source of support for economic growth. Private households in the US built up sizeable cash reserves over the course of the pandemic and are benefiting from rising income levels in the booming labour market environment, so they are financially in very good shape. This is protecting consumer spending from falling off a cliff amid soaring inflation. We predict that the US economy will grow by 2.2 per cent in 2022 despite the challenges posed by rising prices and tighter monetary policy.
The outlook for the eurozone is less optimistic, due to the greater impact of the war in Ukraine. It seems that the war in Ukraine will continue for many months to come. As a result, there is little prospect of a significant easing of tensions around high commodity prices or supply chain problems in Ukraine. In addition, demand from China for exports is currently still weak. Growth in the eurozone has ground to a halt. A moderate recovery is expected to set in over the second half of 2022. Overall, growth forecasts of 2.3 per cent for the eurozone and a modest 1.3 per cent for Germany seem realistic for the year as a whole. If Russia were to cut off its supply of natural gas, a recession would probably be inevitable.
Stress-testing the economy: growth is slowing in real terms
Forecast year-on-year change in real GDP
More clarity on key factors, investment prospects likely to brighten over the course of the year
In the coming months, the capital market environment will thus be shaped by a mix of high inflation, speculation about central bank policy decisions, and concerns about growth. It will be a difficult period for opportunity-oriented investments. In addition, this cocktail of influences could create a situation where a temporary drop in market liquidity and risk management-related portfolio adjustments by large investors might make conditions even more difficult. A cautious approach is advisable in the capital markets for the time being, but we expect conditions to improve over the course of the year. The next few months will bring more clarity.
In this environment, we regard a highly active approach, relative positions and careful security selection as the best way forward. Volatile and fragile conditions require more frequent and more short-term-oriented investment decisions than calmer market phases. In addition, many factors currently favour strategies that exploit differences in the attractiveness of individual sub-segments within one asset class (relative positions or pair trades), for example weighting value stocks more heavily than growth stocks on the equity side. All in all, equities will face challenges in the near term but will remain indispensable over the long term. Trends such as the transition to more sustainable economic practices are intact and continue to provide investment opportunities. In addition, there is scope for active stock-picking in the current unsettled conditions. The profit picture in the private sector remains healthy – but not across the board. Companies with strong pricing power, for example, have a clear advantage at the moment. Moreover, adverse influences are expected to weaken over the course of the year, which should pave the way for further share price gains. Germany’s DAX index could realistically reach a level of 15,100 points by the end of the year.
The market outlook for corporate bonds has deteriorated in the short term, especially in the eurozone. Right now, the ECB is still acting as a strong bond buyer with limited price sensitivity. This support will be withdrawn in the early part of the summer, which will have an adverse impact on corporate bonds and eurozone periphery bonds. More clarity on the aforementioned key issues will be required for the outlook to improve.
Commodities have so far been one of only a few asset classes that have made gains since the start of the year. It remains to be seen whether this trend will continue at the same rate. Oil products will probably remain scarce over the summer, but then the situation should improve thanks to new sources of supply coming onto the market. On this basis, our experts’ calculations put the end-of-year price target for North Sea Brent crude at US$ 92 per barrel. The outlook for industrial metals looks much more promising as the segment stands to benefit from an economic upturn in China.
The capital markets are thus facing a challenging few months and should brace for turmoil. But opportunity-oriented assets may offer more upside potential again as the future trajectories of inflation, monetary policy and growth become clearer. In the short term, it is advisable to be cautious. In the medium term, more opportunities will arise again that investors should not miss out on. And over the long term, the capital markets are facing fundamental directional changes that will bring about a very different environment.
As at 20 June 2022.