BlueBay AM: Economic forecast second half of 2022

BlueBay AM: Economic forecast second half of 2022

Outlook
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Mark Dowding, CIO of BlueBay Asset Management looks at the economic forecast for the second half of 2022, and UK, Eurozone, US, and EM markets for the year to date.

In short:

  • BoE rate hikes: BlueBay thinks that the gradualist approach to hiking rates in the UK could see inflation overshoot – both higher and longer, and this may require the BoE to continue to raise rates during 2023, even with an economy struggling in recession
  • H2 2022 forecast: BlueBay believes there will be more stability, relatively speaking, in the coming period, given what has now been built into forward market pricing.
  • Euro returns: Euro credit benchmark total returns, at -12.8%, are now close to 4x as negative in 2022 as was recorded for the entirety of the calendar year 2008.
  • US credit: Valuations in US credit are now at levels which look cheap if we are witnessing a stalling of growth, but may need to correct further in a recession scenario, which triggers a more material rise in corporate defaults. 
  • EM outlook: EM is likely to be a space characterised by success and disaster stories, given different dynamics and policy mixes, with energy and food exporters likely to continue to gain relative to importers.

A game of two halves

By Mark Dowding, CIO of BlueBay Asset Management


As market scoreboards take a H1 battering, the investment mindset needs to be to go back out onto the pitch with the singular focus to win during the second half.

Growth fears continued to depress market sentiment during the course of the past week. As a result, the first half of 2022 has drawn to a close with market returns across fixed income and equities posting substantial losses. 

To put this sell-off in some context, yields on 10-year Treasuries have doubled since January, reaching their highest level in the past decade. Meanwhile, in Europe, investment grade credit spreads have also doubled since the start of the year and now stand at levels wide relative to the end of April 2020, in the midst of the pandemic. 

As a result, euro credit benchmark total returns, at -12.8%, are now close to 4x as negative in 2022 as was recorded for the entirety of the calendar year 2008.

From this standpoint, it seems natural that investors will want to reflect on an exceptionally challenging first half and may be left looking ahead with some degree of scarring and trepidation.

There remains a lot of uncertainty, and price action has grown more erratic as liquidity conditions have deteriorated. However, it strikes us that in the coming period, we should look for more stability, relatively speaking, given what has now been built into forward market pricing. Major central banks are set to hike rates materially in the coming several months, but this has already been signalled to markets.

Consequently, at this point, there may appear to be more risk of central banks under-delivering rather than over-delivering on rate hikes, compared to what is discounted. The past six months have been exceptionally challenging, given that central banks have grown materially more hawkish, but in the absence of additional hawkishness, so pressure on yields should abate.

This said, we continue to think that for markets to stabilise and sentiment to strengthen, investors will need to see evidence that inflation is returning towards central bank targets, such that central banks can moderate their narrative.

Yet, we do think that better news on inflation should be around the corner. Price pressures in the US and eurozone are likely to start to abate in the coming months, as base effects drop out and as demand in the economy cools. German CPI data this week also encouraged us that we could be closer to a turning point. Labour market pressures represent the biggest medium-term threat to price stability, but there are signs that labour demand may be coming off the boil in the US, with weekly jobless claims edging higher and business sentiment surveys on both sides of the Atlantic flagging a slowing in hiring intentions. 

Commodity prices have also been softer on slowing global demand. Although recent growth indicators in China have been a bit more optimistic in line with Covid cases dropping, we think that Chinese output is likely to continue to be overshadowed by the fight to try to deliver Xi’s zero-Covid strategy.

Elsewhere, further escalation of tensions with Russia could lead to a total suspension of gas supply to Europe. This would see renewed short-term pressure on prices and represents a particular risk to businesses in the eurozone. This would probably need to be countered by policy easing given the disruption that would ensue, but this is not our base case. It strikes us that, should this occur, then beyond this point Russia would be devoid of further leverage and would consign itself to a long-term future in an economic wilderness.

Slowing growth and recession fears now seem to be overtaking inflation as the principal point of concern for many investors. In Europe, disruption in the wake of the war in Ukraine probably means that a contraction in output is inevitable, with the question now being how severe a recession proves to be.

Meanwhile, the US economy continues to be intrinsically in a much healthier starting position. As a result, we think that if US rates peak below 4%, then a recession may be avoided, though this continues to be a relatively close call. Generally speaking, we believe that once government yields stabilise, investment grade credit can rally thereafter.

In this context, valuations in US credit are now at levels which look cheap if we are witnessing a stalling of growth, but may need to correct further in a recession scenario that triggers a more material rise in corporate defaults. In the eurozone, we are closer to pricing a recession. In CDS, we believe that, having underperformed cash bonds on a year-to-date basis, iTraxx and CDX indices are now less attractive as a means to hedge risk.

Should credit spreads correct further, then we expect cash bonds to underperform, while CDS could rally as investors close hedges in the first leg of any rally. Meanwhile, downside risks to growth are likely to remain an impediment to performance in higher-yielding credit and equities into 2023. 

 In the eurozone, we continue to have some scepticism with regard to the introduction of the upcoming ECB anti-fragmentation tool. 

Elsewhere, our views on the UK remain distinct to the US and eurozone. We think that the gradualist approach to hiking rates in the UK could see inflation overshoot – both higher and longer, and this may require the BoE to continue to raise rates during 2023, even with an economy struggling in recession. This leads us to maintain a cautious outlook with respect to UK assets and the pound. We also continue to maintain a somewhat cautious approach in emerging markets. 

However, in the wake of price corrections, there are a number of markets that now look very cheap on an idiosyncratic basis. We think that as risk sentiment stabilises, a number of EM assets could trade well, with inflation already having turned lower in several countries that started raising rates much earlier than many developed market counterparts. 

Yet EM is likely to be a space characterised by success and disaster stories, given different dynamics and policy mixes. Simplistically speaking, energy and food exporters may continue to gain relative to importers and we think that as markets turn, so the dispersion of performance between issuers is likely to increase.

Reflecting on football as a metaphor, it strikes us that 2022 could well be a game of two halves. From this point of view, there may be a sense that after the first forty-five minutes, the predominant sentiment is to stem the losses and avoid conceding more goals, with the scoreboard taking a real battering. Yet, in the metaphorical half-time changing room, experienced managers will emphasise to players that it makes sense to consign events of the first period to the bin. The mindset needs to be to go back out onto the pitch with the singular focus to win during the second half.

In many respects, a similar mindset may be applicable to investors today. In saying this, it would be naïve to go quickly into attack at the start of the second half. In the short term, it may make sense to proceed with caution and look to build a platform from which to be more assertive later in the year.

In the wake of dislocations in markets, there will be plenty of opportunities to shoot and score, but it may make sense to maintain discipline and patience at the same time. Though maybe in the summer break, I am missing football just a bit too much.