Markets Weekly podcast – 27 June 2022

Henk Potts (HP): Hello. It’s Monday, 27^th June and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.

My name is Henk Potts, Market Strategist for Barclays Private Bank. Each week I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then consider the outlook for equity markets. Finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Last week’s news flow was dominated by weakening economic data, rising recession worries, and hawkish central bankers. However, global equities rebounded on Friday on early signs that longer-term inflation expectations are starting to ease back in the United States, and hopes that recession fears may be overdone.

Stocks rose as investors tentatively tried to take advantage of cheaper valuations. A strong rally on Friday helped to snap the weekly losing streak on Wall Street. The S&P 500 rose 6.4% over the course of the week, but is still down 14% this quarter. In Europe, the STOXX 600 rose 2.4%.

In bond markets the 10-year Treasury yield fell 11 basis points over the course of the week, to around 3.12%. Year-to-date, the yield is still up 1.63 percentage points. In commodities, after an aggressive rally this year, fears over weakening activity have pushed prices lower, with oil, copper, and wheat all coming off their recent high.

If you look at the Bloomberg Commodity Index, it has been falling over the course of the past five days. It’s down 4.3%. It’s down 9.4% over the course of the past month. Remember, we have seen a strong rally during the course of this year. Over the past 12 months, it’s still up 31%.

Fed chair Jerome Powell, of course, took centre stage once again as he gave testimony to the Senate Banking Committee. He maintained the view the US economy was very strong and well positioned to handle tighter monetary policy, but acknowledged that a US recession is a possibility, as the US central bank tries to curb the fastest rate of inflation in more than 40 years, by embarking upon its most aggressive tightening path since the 1980s.

On the data front in Europe, the purchasing managers’ index survey showed a significant decline in activity, adding to fears of a recession in the region. The euro area composite PMI fell to 51.9 in June, substantially below consensus, which was at 54.0. The decline was broad based across sectors and regions, with weakness in both services and manufacturing. In fact, manufacturing output is now in contraction territory for the first time since June 2020.

Looking at more detail in terms of manufacturing, new orders were much lower, both domestically and in the external sector. Firms are now running down the backlog of orders, which has been providing some temporary relief, and inventory levels are starting to build up. The sector, remember, is also struggling with supply-chain disruption from China and threats to energy supplies from Russia.

Looking at services, the surge in tourism and recreation that was recorded in April and May has faltered to a near standstill in June, due to price pressures and reduced momentum from the pent-up demand boost following the pandemic.

Meanwhile, tightening financial conditions have weakened activity in the banking and real estate sectors. The report adds to the risk of a technical recession at the turn of the year. Our relatively pessimistic view of eurozone growth is based upon weaker domestic demand, slower industrial output, and reduced levels of investment.

Unlike the US, domestic demand in Europe was still below pre-COVID levels in the first quarter. We think that consumption will remain constrained by more persistent headwinds from high inflation on households’ real income, a less resilient labour market, and a decreased willingness from consumers to draw upon savings accumulated during the course of the pandemic.

Meanwhile, growth investment is expected to be depressed by higher input costs, higher wages, tighter financial conditions, and heightened uncertainty.

For 2023 we have an anaemic economic growth in the eurozone, with just 0.5% pencilled in. Despite that weaker growth profile, the European Central Bank still looks set to end the era of negative interest rates over the course of the next few months, starting at 25 basis points at the July meeting.

In terms of the UK, well, there was a raft of disturbing data that showed the cost of living crisis playing out. Inflation continues to rise, the GfK consumer confidence survey fell to a record low of minus 41 in June, and British retail sales volumes contracted by half of 1% in May.

UK inflation, as we saw, accelerated to a new four-decade high last month, with CPI printing at 9.1% year-on-year, driven by higher fuel, energy, and food. The report showed that price pressures are also developing at the factory gate. Producer output prices surged 15.7% in the year through May. That’s the highest level we’ve seen since 1977 as producers raised their prices to cover higher input costs from raw materials and labour. Annual input price inflation hit 22% last month.

The report also highlighted a notable increase in services inflation, although some easing in clothing, footwear, and used-car prices.

In terms of the outlook for inflation, price pressures, we think, will continue to rise over the course of the coming month. Remember, the Bank of England are forecasting that CPI will top 11% in October, primarily as a result of the expected increase in the Ofgem price cap. However, the increase in energy bills may be substantially mitigated or, indeed, delayed by the government grant, which should provide help to lower household energy costs in the coming months.

In terms of our forecast, we now look for UK CPI to peak at 9.3% in June, then ease down to be printing around 6.8% in December, and continue to moderate through the course of next year, when we think inflation will average 5.3% in 2023. However, with inflation forecasts still to be above 4% till the first quarter of 2024, there’s still plenty of pressure on the Bank of England to tighten policy.

In terms of that policy path, well, the MPC, of course, started hiking rates earlier than other central banks. They’ve hiked at five consecutive meetings, therefore, you could argue they have done much of the heavy lifting, but we do expect another 25 basis points at the August meeting, and that’s assuming that we don’t get a considerable upside surprise from inflation between the data now and then, and a further 25 basis points in September, putting the bank rate at 1.75%, where we think policymakers will pause as growth continues to falter and inflation expectations start to ease back.

So that was the global economy and financial markets last week. In order to discuss the outlook for equity markets, I’m pleased to be joined by Dorothée Deck. She’s the Cross-Asset Class Strategist for Barclays Private Bank.

Dorothée, great to have you with us today. Let’s start off. Can you put this year’s sell-off in stock markets into historical context and tell us how much bad news you think is already priced in?

Dorothée Deck (DD): Thanks a lot, Henk. So as of last week, global equities were in bear market territory, down as much as 21% from their January peak. They’ve recovered a bit in the past couple of trading sessions, but the sell-off we’ve seen in the past six months has been quite brutal in a historical context.

So, if we compare it with the experience of the past 50 years, it represents a two standard deviation move, so quite significant. Now, this sell-off has taken place in the context of a particularly difficult environment for risk assets.

Central banks have turned significantly more hawkish and are tightening monetary policy to a slowing economy. We’ve also had the war in Ukraine and the COVID-related lockdowns in China. So, clearly, the risk of a recession has materially increased, and market participants are very much divided between those who believe that the hard lending is inevitable and those who believe that the Fed will be able to engineer a soft landing.

According to a Bloomberg consensus of economists, the probability of a recession in the next 12 months has now increased to 31% in the US and 30% in the eurozone. Our base case scenario remains that a severe recession will be averted in the coming year. We do expect a significant slowdown in growth, but if we see a recession we believe it’s more likely to be mild and short-lived. And on that basis, it seems that a lot of bad news is now reflected in the price.

Based on our numbers, the recent price performance would be consistent with an ISM Manufacturing slightly below 50 by year-end, and that’s the limit between expansion and contraction. So it suggests that equity markets are already discounting some contraction in activity.

If we were to see a severe recession, which, again, is not our base case in the near term, there would be more downside risks to equity prices. So, to put things in context, over the past 50 years, global equities have declined by 36%, on average, around recessions from peak to trough. The drawdowns ranged from -15% in 1980 to -60% in 2009, so that’s a pretty wide range. We’re already down 19% from the January peaks, so you can argue that the market is already discounting a mild recession but not a severe one.

HP: OK. So, given the aggressive sell-off that we’ve been talking about, are valuations now much more attractive?

DD: Yes, absolutely. So, valuations have declined significantly since the start of the year and they are now slightly below their long-run averages. To be more specific, global equities are now trading on a forward PE multiple of 14 times, down from 20 times at the start of the year, so that’s a 30% contraction.

US equities are more expensive, trading on 16 times forward earnings, compared with European equities on less than 12 times. So, we’ve seen a significant readjustment in PE multiples. What we haven’t seen, though, is earnings downgrades. Those multiples are based on overly-optimistic earnings forecasts which are likely to be downgraded. So you can argue that forward PEs are actually less attractive than they appear. But if we look at cyclically-adjusted PEs, the message is actually quite similar.

Global equities are trading on 22-times cyclically-adjusted PEs, down from 27 times at the start of the year, and will be in line with their 20-year average. And finally, compared with bonds, equity valuations remain more attractive. The equity risk premium currently stands at 4% globally, also in line with its 20-year average, and it remains significantly more attractive in Europe than in the US, at 7% versus 3% respectively.

HP: As you quite rightly mention, on the other side of the price-earnings equation, of course, is corporate profitability. So, let’s go into that in a little bit more detail. What’s your view on consensus earnings forecasts?

DD: Well, we think consensus earnings forecasts are too optimistic and will need to come down. So, as I was saying earlier, global earnings forecasts haven’t been downgraded yet, despite the clear deterioration in the macro environment since the start of the year.

They have actually gone up in the past six months by 4% for 2022 and 3% for 2023. If you look at the main drivers of earnings growth in the past year, it’s clearly been margins, and corporate margins are now close to all-time highs, which means that it will become increasingly difficult for companies to protect margins if inflationary pressures persist, and that’s definitely a risk that has been flagged during the first-quarter reporting season. Companies have generally been more cautious on their margin outlook.

First-quarter earnings have generally been resilient in the US and Europe, but growth has largely been driven by the commodities sectors, and if you exclude energy and materials, earnings growth would have been much weaker. So, consensus is currently going for 11% earnings growth this year globally and 8% next year.

According to our top-down earnings model, 4% earnings growth this year would be more realistic, but in our view it’s more than reflected in the price already. After the recent sell-off, we estimate that the market is now discounting a 7% decline in earnings for 2022.

Now, what’s the downside risk from here? Well, in previous recessions global earnings have declined by 24% on average year-on-year, and those declines ranged from 10% in 1982 to 40% in 2009. So, again, it appears that the market is discounting a mild recession in earnings, but not a severe one.

HP: OK, Dorothee, let’s bring those concepts together. We’ve been discussing the macroeconomic environment, we’ve talked about valuations and earnings expectations, so what level of return can we expect from equity markets over the course of the next 12 months, and which segments of the market should investors be voting on?

DD: So, assuming low to mid single-digit growth in earnings, combined with flat to modestly-higher PE multiples, we think global equities could generate mid to high single-digit total returns in the next 12 months, including dividends. For PE multiples to rerate from here, we would need to see an improvement in the growth and inflation mix and, more specifically, a decline in inflation expectations.

With regards to positioning, we feel that diversification is more important than ever, given the uncertainty in the near term, and that’s why we would favour a mix of defensive and cyclical assets in a barbell strategy, and the objective here is to reduce downside risk in case of a further sell-off, while also taking advantage of undervalued opportunities in dislocated parts of the markets.

Within defensives, we prefer sectors with predictable earnings, stable margins, and strong pricing power, and our favourite sector in the defensive space remains healthcare.

Within cyclicals, we favour sectors which have either overreacted or underreacted to the recent change in the macro environment and now appear to be relatively undervalued. More specifically, we would focus on sectors which have overshot their historical relationship with activity on the downside, or sectors which have failed to reflect the substantial rise in yields and now offer some catch-up potential, and on that basis, industrials and banks look particularly attractive to us at the moment.

At the style level, we see opportunities in small caps for similar reasons. They’re discounting an overly bearish macro outlook, have disconnected from the recent rise in yields, and are trading at steep valuation discounts. At the regional levels, and based on our sector views, we would be looking for opportunities in non-US equities in general and European stocks in particular. And finally, at the stock level, and given the lack of clear direction in the near term, we would focus on secular growth stories, which are less correlated with market moves.

HP: Well, thank you, Dorothée, for your insight today. We appreciate you sharing your thoughts on what has been a nervous time for investors and highlighting how they should be positioned for the rest of this year.

Moving on to the week ahead, the focus this week will be on the Opec+ meeting. Oil prices, as we know, have risen rapidly during the course of this year, with Brent crude trading around 40% higher year-to-date. We also know that, of course, has been a key driver of inflation.

The oil producing cartel remains under pressure to increase production levels to try and alleviate some of that supply and demand stress, particularly as demand from China is expected to bounce back as COVID restrictions are eased and the EU tries to push ahead with its plan to embargo Russian oil by the end of this year.

At the 2^nd June meeting, producers agreed to raise their joint output by 648,000 barrels a day each month in July and August, but data from S&P suggests the group collectively failed to achieve its stated production by 2.6 million barrels per day during the course of May.

Given the struggle to hit existing targets, and fears that demand could actually weaken if global growth significantly deteriorates, Opec+ are not expected to announce dramatic changes in their policies, when it comes to production levels, despite that rising political pressure at this week’s meeting.

So, with that, we’d like to thank you once again for joining us. I hope that you’ve found this update interesting. We will, of course, be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.