At how many knots are the winds of recession traveling? What is the outlook for GDP? Will the second half of the year be Bear or Bull? Increasingly pressing questions downstream from the slowdowns in European and world stock markets in recent days, trailed downward by the U.S. private sector employment figure and the services Ism, which fell less than expected. Thus, clouds are returning to financial markets, and those who were betting on an easing of restrictive monetary policies are likely to be disappointed: the robust U.S. labor market, the minutes of the latest Fed meeting, and the performance of the U.S. services sector confirm the strength of the U.S. economy at this stage and leave ample room for maneuver for the Fed's "hawks."
For all these reasons after the recent slowdown in inflation and the boom in European and world stock markets in the first half of the year, savers and investors, now that the roller coaster is starting up again, are wondering what will happen in the second half of 2023. To begin to answer this question, it is good to start with the new ECB survey data that showed that average inflation expectations for next year will fall to 3.9 percent, the lowest since the start of Russia's war in Ukraine.
Good news but certainly not an end point. The CPI (consumer price index) is still well above the former Eurotower's 2 percent target and core consumer prices remain high. High interest rates are also hurting the housing market: official data showed that house prices in the Eurozone fell for the second consecutive quarter, the first two consecutive contractions in nearly a decade.
A tentative positive sign, however, is coming from manufacturing. New data from the Pmi survey for the services sector in June showed a cooling of price pressures in the eurozone. Input costs remained high but fell to a 25-month low, with firms moderating price increases in response. The sector is still fragile, with growth slowing, although job creation has remained solid. The slowdown in momentum was most evident in France, a country hit by protests and strikes over pension reform, along with tougher financing conditions and weaker demand.
The highlight of the Pmi data series as highlighted by the Financial Times in an ad hoc in-depth feature is China where slower than expected services activity has reinforced concerns about the strength of the country's recovery, dragging down stocks in Asia and Europe. While in the United Kingdom, the picture is two-speed. Momentum in the last quarter was weak as new order growth slowed, although job creation was robust. Purchasing cost inflation fell to its lowest level since May 2021, while business and consumer spending remained resilient.
So what to expect in the coming months? According to Generoso Perrotta, Banca Generali's Head of Financial Advisory, the current economic slowdown could intensify but, according to the latest forecasts of major international bodies and central banks of major countries, without jeopardizing the positive growth trend.
A more restrictive than expected approach by central banks could further slow the pace of business cycle recovery in their respective countries. Economies, where the rate hike cycle has already peaked, could experience a more stabilizing phase.
"The restrictive action taken by the central banks of countries that have experienced high levels of inflation so far should contribute to the gradual retrenchment of price pressures, favoring the continuation of the ongoing disinflation process," Perrotta comments.
"However, inflation in some economies, while slowing, may remain at levels still far from target, proving more sticky and persistent than expected. The inflationary environment in China is expected to continue to remain moderate, bucking the trend in major Western economies," he continues.
In short, the drawn context is not immune to risks. Inflation that is difficult to tame could prompt major central banks to continue their restrictive actions. Tightening credit conditions as a result of prolonged restrictive monetary policies could affect growth and exacerbate the ongoing slowdown.
In this scenario, how do the different asset classes move? Most analysts see a somewhat weaker equity market in the coming quarters influenced by indicators related to new orders, credit availability and liquidity supply. In addition, this is a seasonally weak period for markets. For this reason, Fidelity is positioning itself underweight equity with a time horizon between now and the next 3-6 months and targeting defensive sector positioning in sectors considered anti-cyclical such as healthcare and consumer staples. For its part, Ubs anticipates possible significant downturns in the equity market related to concerns about reaching a debt ceiling agreement: "if the U.S. government does not meet its debt obligations, it could be an interesting phase to increase equity exposure," they explain in a report.
Analysts note that companies have maintained pricing power amid slowing economic growth, and nominal activity is still high and has room for further deceleration without triggering recession fears. The resilience of U.S. companies' nominal activity and margins suggests that earnings declines are limited on the net of a possible recession, which experts do not believe is imminent. Ahead of the debt ceiling negotiations, relative value positioning in equities and foreign currencies has become somewhat more defensive for Ubs, in line with the belief that there will be some discomfort in markets along the path to an eventual agreement.
What about the bond market? Most analysts remain neutral on fixed income. A rate cut by the Fed and a reduction in two- and 10-year rates are expected in the coming months. Therefore, experts confirm the current positioning on bonds and continue to favor government bonds with an overweight view. This is at the expense of the credit segment, where the experts believe that spreads-especially high yield spreads-do not adequately reflect or compensate for looming economic risks. As a result, Vontobel's view is negative on the high yield segment and neutral on investment grade. Finally, it remains overweight on hard currency emerging market debt.
In addition, many believe that the new market regime may have lower expected returns and a higher than last cycle. The view is well-founded, although according to Goldman Sachs it is probably skewed toward the equity market. In fact, this same new market cycle also offers renewed opportunities in core fixed income. According to analysts, investors can capitalize on the highest levels of return in more than a decade thanks to tighter global monetary policy and higher interest rates, potentially doubling annualized returns and reducing overall volatility. The post-pandemic market cycle has brought the first investment challenges, but core fixed income may henceforth be considered a reasonable alternative to equities.
Coming to currencies, most analysts agree that the dollar could weaken slightly. Of the same opinion are both Alliance Bernstein and Ubs that evidence of the global cyclical low could lead to renewed weakness in the U.S. dollar although, in the short term, deteriorating risk appetite, persistent inflation and recession risk could trigger episodic strength in the U.S. dollar. In Japan, the BoJ confirmed a long period of strategy review, although some adjustments to the Ycc remain possible. Coupled with improving domestic growth and a spike in other martial market rates, we see upside potential for the yen.
Finally, according to Goldman Sachs, commodity markets continue to be torn between macro headwinds and micro headwinds. Short-term performance is expected to be tested by unresolved recession fears, high real rates and multi-year periods of Usd strength. In the longer term, analysts believe physical constraints on the commodity complex will weigh more heavily. Meanwhile, dislocations among property types may present attractive entry points for assets that benefit from secular trends supported by solid fundamentals.
Generoso Perrotta, Head of Financial Advisory at Banca Generali
The restrictive action taken by the central banks of countries that have experienced high levels of inflation so far should contribute to the gradual retrenchment of price pressures, favoring the continuation of the ongoing disinflation process.
