There’s no escaping the fact that much of the news about the economy this year has made for unpleasant reading.
With no sign that the war in Ukraine will end in the foreseeable future, supply-side constraints are now expected to remain until well into 2023 and inflation is anticipated to remain significantly higher than key central banks’ targets for the next two years at least.
Against this backdrop there are fears that household spending will be increasingly constrained, growth will weaken and corporate profit margins are set to decline. Elsewhere, there has been a hawkish shift in central bank guidance, with the Bank of England base rate expected to rise above 4% in 2023.
Deteriorating outlook
A deteriorating economic outlook, the highest inflation since the early 1980s and the prospect of a significant rise in interest rates have been a toxic combination for financial markets. During this year, equities have posted their worst six-month performance for 50 years, and global bonds their worst performance on record.
For the multi-asset investor, diversification has been difficult to locate, with only commodities generating positive, if mixed, returns.
Investor sentiment remains poor, with markets no longer giving central banks the benefit of the doubt in their attempt to engineer a soft landing for inflation in 2023 while maintaining reasonable economic growth.
However, the steep falls in equity valuations to a significant degree reflect this.
The price-earnings ratio on the global stock market based upon expected earnings for the next 12 months has fallen from 18 to 13.5, somewhat below the average for the last 10 years. Elsewhere, the yield on corporate bonds has more than doubled, to reach its highest level for a decade.
This dramatic repricing of equities and bonds provides a much more attractive entry point for an investor looking to make a long-term allocation to a traditional 60/40 portfolio split between equities and bonds.
Our analysis suggests that such a portfolio could deliver circa 2.5% to 3% above inflation over the long term, roughly 1.5% more than was the case at the start of the year.
With geopolitical risk likely to remain elevated for the foreseeable future, investors are rightly cautious about the near-term prospects for markets.
However, the risk of a global recession is increasingly priced in and there is no evidence yet of the type of wage price spiral that would cause inflation expectations to become unanchored; if anything, the significant decline in real wage growth will ultimately prove disinflationary.
Peak inflation
This brings us to the role central banks and interest rate markets will play.
Once investors feel able to identify the peak in the inflation cycle and feel comfortable that the anticipated level of interest rates is appropriate, stability will return to bond markets.
With yields no longer rising, the pressure on higher-rated growth stocks, such as big tech in the US, will begin to abate as valuations will no longer be driven lower by further increases in the discount rate applied to future corporate earnings.
To sum up: the bond market sell-off is in its last throes, with implied policy tightening sufficient to restrict the second-round effects of the supply side driven increases on inflation.
If this view is correct, we would expect equity markets to recover ground as we head into the autumn and bonds to add to the performance of a multi-asset fund whilst providing the valuable diversification that has been sadly absent for much of this year.
Jon Cunliffe is managing director of investments at B&CE, provider of The People’s Pension
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