Recession, Stagflation, ... Opportunities Exist for Investors Provided They Adapt to New Rules.
Evolve or Be Extinct.
Since the beginning of the year 2022, the situation has changed for the financial markets. The markets are now evolving in a completely different environment. Exacerbated by the geopolitical context, inflationary tensions are causing fears that the current slowdown in growth could turn into a global recession.
However, opportunities exist in the stock and bond markets as well as in the private equity universe.
An obvious slowdown in growth
The situation has changed in the markets as the economic context deteriorates. Rising inflation is pushing the major central banks to revise their monetary policy in depth. In China, the maintenance of a Zero-COVID policy is contributing to prolonged tensions in supply chains.
The sanctions against Russia are amplifying the rise in oil prices, without the decision of the Organization of the Petroleum Exporting Countries (OPEC), at the beginning of June 2022, to increase production quotas being able to restore the previous equilibrium.
However, if this increase in the price per barrel were to continue, it would lead to a more pronounced slowdown in growth in the coming months. While global growth forecasts for 2022 remain highly uncertain (estimated at 3.1% worldwide, and in particular between 2 and 2.5% in the eurozone and the United States, and less than 4% in China), they nonetheless conceal a quasi-stagnation in the coming quarters, after a first-quarter benefiting from a base effect that was very significant compared to Q1 2021.
The trend of the last few weeks confirms the hypothesis of a significant shock, which has already been observed since the outbreak of the war in Ukraine and which is visible in the statistics relating to household confidence in the United Kingdom, the United States, and the eurozone.
This inflationary shock is being borne mainly by households. This already visible decline in purchasing power is leading to a contraction in retail sales. This contrasts with the business sentiment, whose activity indicators (composite PMI) are still expanding (above 50) despite an emerging deceleration. This could be amplified by the worrying drop in US CEO confidence to March 2020 levels.
Structural inflation that will cause a shock to confidence
Combined with the outlook for the economic slowdown, inflation has reached levels not seen in 40 years (8.6% in the US in May, 8.1% in the Eurozone), complicating the situation for central banks and governments, which have become accustomed to operating in such a stagflationary environment.
In 2023, inflation is expected to remain at high levels (+4.6% in the United States, +4.9% in the eurozone), taking hold of the economic landscape and remaining at levels well above central bank targets.
This inflation shock has an important cyclical component, linked to supply/demand imbalances, commodities, and current wage tensions, which can be reversed in the event of a slowdown.
However, the structural deflationary factors observed in recent years (trade globalization, moderate energy, and transport costs, digitalization of the economy, etc.) leave increasing room for inflationary factors, such as the aspiration for more autonomy in several strategic sectors, which could lead to a growing regionalization of the world economy.
There is also a stronger social consensus for a rebalancing of the weight of wages in the sharing of value added in mature countries and at the same time rising wage costs in the emerging world, particularly in China. Finally, the climate transition requires considerable investment and should therefore fuel inflationary pressures in the long term.
The time for monetary policy normalization has come
After the 75 basis point increase announced on Wednesday, June 15, 2022, the Fed should have raised its key rates above 3% by the end of the year, while the European Central Bank (ECB) will move towards an exit from negative rates with a first increase scheduled for early July 2022.
However, real rates are still in the negative territory given the level of inflation. As such, it is difficult to talk about monetary tightening.
The term normalization is more appropriate. The reduction of the Fed's balance sheet is, however, contributing to the rise in long-term rates (the US 10-year has reached 3.5%). The question now is how far central banks will go with their rate hike programs as the risk of recession grows.
Recession fears and the level of indebtedness in the Western economies will probably end up limiting the ability of central banks to continue raising interest rates beyond the beginning of 2023.
Stock markets are in an adjustment phase
The current market adjustment takes into account this rise in rates, which is affecting valuations as expected, while companies have not yet revised their earnings forecasts downwards, after very satisfactory quarterly publications.
Specialists estimate that a 100 basis point increase in the U.S. 10-year yield corresponds historically to a 3.5 point decline in the price/earnings ratio of the S&P 500 index. The ongoing monetary normalization is leading investors to accelerate their deleveraging. This is helping to amplify the decline in asset prices.
However, momentum is in favor of value stocks, yield stocks, and defensives. At the sector level, commodities, banks, energy, as well as healthcare, telecommunications, and utilities, allow us to build portfolios that generate returns. Finally, stocks offering high cash flows and pricing power remain the preferred choice.
On the bond markets, priority is given to yield
With the current economic slowdown, default rates could rise again in the coming months. However, in an environment favorable to yielding stocks, it is preferable to favor corporate bonds.
The average yield on corporate bonds is around 3% in the eurozone and 4.5% in the United States, while it can reach 6% for high yield bonds in the eurozone and 8% in the United States.
Non-listed assets will continue to attract investors
In this difficult environment for the financial markets, the unlisted asset market retains its appeal as it emerges from a record year in 2021. Growth rates and profitability have remained at very high levels. More than $1 trillion was invested last year in private equity and private debt markets, reinforcing investor confidence in these asset classes.
These markets are no longer limited to financing technology and healthcare companies but are expanding into more traditional sectors (manufacturing, consumer, etc.).
Since the beginning of the year, valuation multiples have changed little. The longer-term challenge lies in the ability of companies to maintain their growth and margins in a slowing environment. Companies capable of offering pricing power and imposing barriers to entry should make a difference.
Especially since the decline in the number of companies going public goes hand in hand with an increase in the number of private equity deals, highlighting a phenomenon that is likely to last.
Final Thoughts
The opportunities are there. The economic slowdown should prompt some large groups to refocus on their most profitable activities, their core business. In addition, many business leaders could accelerate the transfer process by bringing in managers or outside partners (primary LBOs).
The context also lends itself to the intervention of investors seeking liquidity in the secondary market. For investments in infrastructure or real estate, financing the energy transition is an attractive and sustainable investment theme.
In short, whatever the context, there are always opportunities for investors to seize, provided they know how to make the right choices by taking into account macroeconomic parameters.
Some reading
Mid-Year Review 2022–10 Lessons for the Financial Markets. The hardest part is probably still to come.
For Contrarian Investors, Here Are the 3 Reasons to Smile With the Bitcoin Price at $19K. "Buy when there's blood in the streets, even if the blood is your own."
Always a Contrarian, Michael Burry Predicts a Bullwhip Effect in the Months to Come. Some of the economic data in America point in his direction.