Managing the slowdown

Trying to anticipate how financial markets will perform in the next few months is always a challenge. Even more so, it seems, in the wake of the COVID-19 pandemic and the various ways in which it has reshaped businesses, work and society. 

While educated guesses can provide pointers to what the macroeconomic picture might look like, be ready for surprises. Extrapolating top-down views into a market outlook adds another layer of uncertainty. 

If someone had said six months ago that the first half of 2023 would see the following, few would have believed them:

• several major US regional bank failures
• a last-minute rescue of a 167-year-old Swiss bank by its historical rival
• a German recession 
• US credit default swaps (CDS) exploding to 175 basis points (bp) from 15bp, on fears over the debt ceiling 

That said, while such bad news might be expected to rock markets, for all the turmoil, going into the second half of the year global equities (MSCI ACWI) are up some 6.8% in 2023. 

Getting the view right is only half of the equation. Anticipating how investors will react to any event is where money is made or lost. To add to the challenge, markets are not always rational and its reaction function varies over time. This is why good (economic) news can occasionally be bad news for markets.

Framing the conversation 

With that in mind, investment analysts could tell you, with the utmost conviction, that the S&P 500 is expected to be at X level at the end of the year. Of course, the forecasts would likely be revised at least a couple of times between now and then.

Alternatively, investors can admit that the future is uncertain. That doesn’t stop us in laying out our base case and the risks associated with it, both on the upside and the downside. From there, a strategy can be established that should help to maximise returns and minimise volatility.  

In other words, trying to find the most efficient asset allocation for a specific level of risk. This won’t prevent losses nor guarantee healthy returns every time, all the time. But, with the help of time, it should help grow capital.

It’s a tough world 

The world is in a tricky place, again. Uncertainty is high on all fronts: macroeconomic, geopolitics, climate and interest rates. Although visibility has rarely been so poor, the following is clear:

• Most people, including ourselves, expect the macroeconomic data to deteriorate over the rest of the year 
• There is no exuberance (at least outside the topic of Artificial Intelligence) and investors’ sentiment is at best neutral, if not outright cautious
• Debt, whether from governments or companies, is yielding something again. 

Aside from that, it’s all about assumptions, probabilities and interpretation.

Our views 

Starting with the economy, our base case is that global growth will slow but won’t contract. Developed countries will likely flirt with recession, posting anaemic growth, even in an optimistic scenario. Lower growth is, in a way, good news as it should help to ease inflationary pressures. In turn, this means that central banks won’t feel the need to lift rates much more. In fact, they may need to cut rates later this year, if the slowdown is worse than anticipated. 

Consumers are, slowly but surely, depleting their COVID-related excess savings built up during the pandemic, but jobs remain plentiful. Even if unemployment rates were to rise, they would probably remain low by historical standards. As a result, consumption may slow, but should not collapse.  

On the corporate side, the pandemic has been a great opportunity to strengthen balance sheets and streamline operations. In other words, management teams had planned for the worst, and so if this occurs, companies appear to be in much better shape than if they had gone into this economic slowdown after years of uninterrupted growth.

It’s not going to be easy 

That being said, the rest of the year is unlikely to be a smooth ride. Equity valuations leave limited room for error, at least when compared to historical levels. Bottom-up analysts continue to expect solid earnings growth despite a worsening macroeconomic picture. Meanwhile, bonds remain highly volatile and cracks are appearing in the real estate market. 

Beware the urge to hide in cash, especially now that investors don’t have to pay (in nominal terms) for this privilege. Many are sitting on the sidelines and waiting for a better entry point to emerge, whether it’s in the form of higher yield, lower stock prices or improved visibility. Unfortunately, better entry points only come with more uncertainty, making the investment decision even more difficult. Improved clarity, on the other hand, often means investing at less favourable levels. 

Embracing uncertainty

Our message remains surprisingly consistent. The question is not whether one should be invested. Being “in the market” is still the key to long-term success. Instead, the discussion should be around how to be invested.  

Diversification remains paramount. In that respect, high-quality fixed income securities have more appeal than was the case 12 months ago. Equity exposure continues to provide a source of long-term upside, and in doing so, a more active, stock-driven allocation may be called for. Here again, quality should be the main characteristic to look for. 

When appropriate, opportunities outside of liquid markets might also be used to help boost returns and lower volatility. The world may be a tricky place, but this is probably when markets have most to offer long-term investors.