For equities, the outlook for the second half depends on whether expectations of recession in the US are realised, official support can buoy growth in China, and Europe can handle the fallout from the possible cut off of Russian gas.
While many expect a contraction in the US, bond markets, equity analysts and economists still view the future as fairly bright. Rate rise expectations and yields may rise further, and hence US equity valuations may still be at risk, but we believe valuations have now largely normalised. The main driver of equity returns from here will be earnings.
Historically, in equities, the growth style beats value as commodity prices and interest rates fall. Stagflation is likely to hit fixed income harder than equity portfolios. But is stagflation likely? As recession hits, US inflation may have fallen already. It is forecast to have dropped to 4% a year from now and to fall further after that.
In the eurozone, recession risks from higher central bank rates appear to be lower than in the US but the Ukraine conflict may cause one anyway. Valuations of eurozone equities are more attractive relative to those in the US, but an end to Russian gas exports would almost certainly cause a deep recession in the eurozone.
On Chinese equities, there is upside further out. Valuations are attractive and we have confidence in the medium-term earnings outlook, particularly for the technology sector.
We believe the Federal Reserve should take policy rates into restrictive territory, to 3.75-4.00% by the end of 2022. This is higher than bond market pricing. Further rate rises look probable in 2023.
The idea that the Fed would stay its hand at the first whiff of slower growth or equity weakness seems misguided to us. Lowering inflation may take longer than markets are currently pricing.
We expect the ECB to revise its inflation projections higher. The 125bp of rate rises signalled so far look more like the lower bound of ECB action. The risks are skewed to the ECB over-delivering rate rises before sluggish consumption and poorer terms of trade slow price and wage inflation.
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