That’s a lot of catch-up potential and is why September’s 0.8% monthly rise in CPI is likely to last for many months to come. The good news is that the Case Shiller Index fell 0.33% in July and is expected to fall further. This will help lower the CPI, but not before the end of 2023.
All of this is small consolation for the Federal Reserve. Core inflation of 6.6% and rising is too high, as are measures of sustained inflation. The Fed has no choice but to continue raising interest rates aggressively given its lack of confidence in leading indicators that suggest inflation will pick up again later next year. In fact, clear and compelling evidence of falling inflation and a rebalancing labor market is likely at least three or four months away. This means that a 75 basis point rate hike in November, a coin toss between 50 basis points and 75 basis points in December and 25 basis points in February is a pretty good assumption, while anticipating a Fed turn much sooner is hope than reality.
A month ago, it appeared that investors were waiting for something to break as inflation barely eased, and major central banks’ rhetoric and actions focused on bringing inflation down at almost any cost. Those concerns have only increased over the past month. For markets to break out of their trading ranges over the past six months, something else would have to break out first: inflation, jobs, or financial markets. There are small cracks in the first two, but not enough to be clear and compelling. Financial markets have shown more vulnerability highlighted by the UK gilt market.
This leaves us with an unattractive risk/reward trade-off for the markets over the next three to six months, in our view. As the Fed remains focused on tightening financial conditions to slow growth and reduce inflation, financial markets will remain volatile and subject to wide swings. In addition, the economic and market conditions typically associated with market bottoms have not yet been reached: the Fed is still tightening; the expected slowdown in economic activity is not yet fully reflected in earnings forecasts or credit spreads (CIO now forecasts -4% EPS growth for the S&P 500 in 2023); and valuations are not pricing in enough risk premiums to fully offset the bear-case results.
As a result, we downgraded our preferences on US equities, US high yield corporate bonds and US senior credit to least preferred and reduced commodities to neutral from most preferred. To be clear, this is a message to mitigate short-term downside risks while maintaining upside risk in the medium and long-term. Selling stocks and riskier corporate bonds doesn’t necessarily send a message. Investors who are underinvested in equities should take advantage of the current period of volatility and lower prices to build long-term exposure. To use a protective analogy, if your portfolio is your home, prepare for challenging fall and winter weather by beefing up your home to protect it from harsh elements, but don’t clear it for safer and sunnier climes.
In fact, later in Q1 23 green shoots could emerge for the market outlook, leading to a more constructive environment for risky assets for the remainder of 2023. The Fed halting its rate hikes will be the clearest sign that the risk reward is beginning to shift. Inflation may be falling at a slower pace than investors had hoped, but real-time indicators of future inflation are almost all pointing down, including home prices and new rents, wage growth, import prices and price paid indices. US and global growth is likely to bottom out by mid-year, setting the stage for a macro environment in which growth recovers, inflation falls and central banks become less hawkish – a combination that has typically supported financial markets .
Before a sustained new bull market begins due to improving fundamentals, technical bear market rallies are certainly possible in the coming months. Investor positioning is very light, similar to June, and any positive economic data or Fed comments could prompt sharp but short rallies. However, a repeat of the S&P 500’s 17% move over the summer is unlikely as it was also fueled by brief hopes of a soft landing from Goldilocks, which looks far less likely today. Poor market liquidity also means that asset prices are just as likely to trend down as they are up.
The bottom line: Portfolio positioning needs to take into account an unfavorable risk/reward outlook for three to six months, a more constructive environment for risky assets likely to emerge in 2023, and valuations in portions of fixed income and equities that have become quite attractive for a long time to come. long-term investors. Balancing these factors argues for additional downside protection in equity allocations to reinforce defensive sector positioning. Improving the quality of fixed income securities to generate yield and incrementally increase duration; and maintaining exposure to oil within commodities due to constrained supply and as a geopolitical hedge.
Principal responsible: Jason Draho, Head of Asset Allocation, CIO Americas
Original Blog – Gimme Shelter, October 17, 2022.
This content is a product of the UBS Chief Investment Office.
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