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Banca March takes cautious stance on slowdown and believes recession is likely

04 October 2022 Category: Banca March

  • The macroeconomic landscape is suffering an abrupt slowdown, and the primary objective of monetary policy is to curb inflation at any cost. The slowdown is set to intensify and global growth will slow next year to +1.7% year on year, just half of the average growth rate observed over the last 40 years.
  • Although Europe is managing to replenish its gas reserves, the excess cost and the need to cut energy demand will dampen economic activity in the region, which is unlikely to avoid a recession.
  • The steep losses in fixed income afford opportunities to start putting excess cash holdings to use in short-term credit positions.
  • We must maintain a cautious stance when it comes to equity exposure: a change of trend in equity markets would need to be driven by a drop in underlying inflation which would allow central banks to start toning down aggressive narratives.
  • Equity market downturns have driven down valuations, but it is important to remain cautious, as this would suggest that the earnings downgrades have only just begun.

The primary objective of current monetary policy is to curb inflation at any cost, and the Banca March Market Strategy team expects this to have a negative impact on global economic activity: “Financing conditions have deteriorated dramatically and a recession currently looks unavoidable, at least in the eurozone”. In the US, the bulk of employment growth is now behind us which, coupled with rising financing costs, will drive down domestic demand. The outlook for global growth, as a result, is tailing off abruptly: at the end of next year, Banca March's experts estimate that global GDP will be almost 4 percentage points lower than was forecast before war broke out in Ukraine.

In 2023, global GDP growth will stand at 1.7% year on year, just half of the average growth rate observed over the last 40 years. By regions, US economic growth will be almost flat (+0.7%), and China will see a weak recovery. The bank's experts are expecting a steeper recession in the eurozone, which will begin late this year and see negative GDP growth for full year 2023 at an estimated -0.2%. The Spanish economy will also suffer an intense downturn with growth slowing to just 1%, and will continue to lag behind: pre-pandemic growth rates will remain elusive until late 2023, almost two years later than the rest of the eurozone.

Energy uncertainty is another risk that will shape Europe's future performance. Gas supplies have now been replenished to almost 90%, but the excess cost incurred to cover cuts by Russia is impacting the most energy-dependent economies. The upside, however, is that the scenarios analysed by Banca March show that a 15% reduction in demand – as proposed by the European Commission – should be enough to weather this winter. However, “the margin for error is extremely tight and lower-than-expected temperatures could complicate the situation,” the experts explained.

The challenging role of central banks

Inflation will continue to be the main concern, and although there has been some good news of late, there is still a long way to go before things are back to normal. Falling crude prices – Brent is currently trading at pre-Ukraine war levels – and signs of relenting pressure on global supply chains should see inflation hit its peak towards this end of this year.

However, rising energy costs have already driven up the cost of the broader shopping basket and the experts at Banca March expect core inflation rates – which are what really concern central banks – to remain high, which will lead central banks to continue to taper stimulus measures. The United States Federal Reserve will continue to shrink its balance sheet at a pace of $95bn a month, whilst simultaneously raising official rates to reach over 4.25% by the end of the year.

In the ECB's case, although it will leave its balance sheet untouched, the Banca March Market Strategy team expects to see similar movements in terms of interest rates, closing 2022 at over 2%. What makes the European situation more complicated is that the central bank needs to be cautious and strike a delicate balance between raising rates and safeguarding peripheral countries' ability to finance themselves.

Where to invest in a low-growth scenario with rising rates

There has been nowhere to hide in 2022; both fixed income and equity indices have lost more than 20%. Fixed income markets are suffering particularly virulent losses, but according to the Banca March Market Strategy team, it is still too soon to assume the rate hikes are over, as central bank narratives and persistent inflation will continue to drive down bond prices: “Historically, for long-term rates to stabilise, central banks have needed to announce a hiatus in rate hikes, and that is not expected to happen before the end of this year,” say the experts at Banca March.

A backdrop of rising rates requires a patient, selective approach. The bank continues to recommend being underweight fixed income, but recognises the significant improvement in the valuation levels and risk-return profile of the asset, and therefore recommends moving any excess cash into short-term credit positions. The best approach in fixed income is to be positioned in short-dated bonds within the best-rated segments, particularly European investment grade.

In equities, recent corrections have driven down multiples significantly and sentiment is currently very negative, so a tactical rally is likely. However, there are certain factors which encourage a prudent approach and cautious, underweight position. In past recessions, earnings have dropped on average by 18%, which is not currently priced in, as the market continues to estimate global earnings growth of 5.9% for 2023. The bank's team of experts say that “valuations are compelling, but we are worried about the earnings downgrades we will see over the months ahead, which will put further pressure on the markets.”

They also believe we need to see interest rates stabilise before there is a change of trend in equity markets. In the past, equity markets have bottomed out an average of three months after the Fed started lowering interest rates, which is not expected to happen in the near future. Although all bear markets are different, historically when these downturns coincide with a recession, they tend to be both long and deep. For example, they add, the duration of bear markets stands at 14 months, versus 9 at present.

In the current scenario, they recommend exercising caution in equity exposure, adding that a change of trend in equity markets would need to be driven by a drop in underlying inflation which would allow central banks to start toning down their aggressive narratives.

“Geographically, we continue to prefer regions with lower exposure to the energy crisis and the war in Ukraine, overweighting the US versus Europe. As for sectors, we like defensive sectors such as healthcare,” says the Banca March Market Strategy team. Out of the cyclical sectors, which they are currently underweight, the team prefer financials and technology; they remain conservative, focusing investments on companies with recurring revenues, such as software. There are also long-term investment opportunities in sectors that stand to benefit from increased global security concerns and particularly, infrastructure linked to European energy self-sufficiency and the green transition.

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