The internet bubble of 2000, the Global Financial Crisis in 2008 and the COVID-19 driven downturn of 2020 could all be defined as “heart attack” recessions. The speed and scale of each passing one brought new gravity to the word ‘unprecedented’.
This time around it has been earmarked. As inflation reaches decade highs and central banks implement the largest rate hiking cycle since the 1980s, the consensus is a global recession at some point in 2023, so how are investors playing the most anticipated recession of all time?
“You will see a recession in all major economies this year, but the market spent 2022 pricing that in and will spend this year looking ahead to an economic recovery in 2024,” Mike Bell, global markets strategist at JP Morgan Asset Management (JPMAM), said.
“The consensus view is that we are going to see a relatively moderate recession in the US, but recently we feel much more confident that it will not be that deep in Europe either.”
Inflation in the US fell for the sixth month in a row to 6.5% last December, down from 7.1% in November which has helped drive this risk-on sentiment. The S&P 500 and the STOXX Europe 600 have both rallied, and are up 10.8% and 18.1% from September 2022 lows.
Meanwhile, market consensus that the Federal Reserve will cut interest rates at the end of the year has also helped boost fixed income markets.
According to the Bank of America, the energy price easing has resulted in 70% of economies across the world reporting headline inflation decline; but warns investors could still have much to be wary about.
“Markets have latched on to easy wins of inflation. But we caution that until core inflation falls convincingly, central banks may remain erratic and unpredictable in their rate hiking journey, leaving terminal rates elusive,” Barnaby Martin, credit strategist at Merrill Lynch International, said.
This warning has certainly been picked up on by some investors. The nature and uncertainty of the recessionary forces at play have led some to question whether the traditional rulebook applies.
“We are not calling this a recession, we are calling it an ‘artificial’ recession,” Jonathan Prout, CIO at The Private Investment Office, said. “This is being triggered by a huge increase in interest rates and the market might be making a mistake by going to the recession playbook.”
The playbook, according to Prout, is buying more duration in the fixed income market as inflation marches back down to the 2% target.
“There is absolutely a scenario where inflation goes back to a slight premium to target, that is what is priced in,” he said. “What is not priced in is stagflation. There is a real possibility that inflation remains stickier and averages at 3-4%. In this case, will the Fed really crash the global economy by hiking rates to 5-6% if inflation remains sticky?”
Bell agreed the biggest risk to markets is now no recession, resulting in central banks raising interest rates to 6-7%. “That would be a pretty negative outcome for stock markets, but it is not our base case.”
The contrarian trade, according to Prout, is not to buy duration in the fixed income market but to buy inflation. “We see some incredible credit opportunities in ETFs with attractive valuations in underpriced assets, essentially giving you free optionality on this recession being different to other recessions,” he said.
“There are some areas of fixed income that are attractively priced in. For example, sovereign emerging market credit as well as shorter-dated high-quality developed markets.”
Short duration in vogue
As a result of this risk, investors are sceptical about taking on more risk in fixed income, particularly as the inverted yield curve currently means investors do not receive a premium for taking on more duration.
Scott Truter, investment analyst at Marlborough, said he has not been tempted into adding duration to his fixed income portfolio as he anticipates slightly higher inflation towards the end of the year.
“We are looking at ETFs with two years duration with a yield of 7%,” he said. “If you can get that without the duration risk why would you not take it? At the moment, you are not being paid enough to take that risk in the long end.
“If inflation does not keep dropping or heads in the opposite direction and you get more interest rate hikes, that is really bad for credit and high yield.”
Echoing his thoughts, Edward Malcolm, head of UK ETF distribution at JPMAM, said there is currently an opportunity at the short end of the UK gilt market. Highlighting this, the JPMorgan GBP Ultra-Short Income UCITS ETF (JGST) currently has a yield to maturity of 3.7%.
“The opportunity in the UK is much wider than other regions,” he said. “We are hearing from clients the very short duration and low volatility exposure might be a nice place to hide out in this type of environment.”
The value play
While investors remain wary of taking risks in fixed income, many see several opportunities in equities with many looking to value.
“The last time value was this cheap to growth was in 2001,” Prout said. “Europe, and to a certain extent emerging markets, are incredibly attractive. Even after the massive sell-offs last year, we are still at the 95th percentile for value versus growth in terms of valuation spreads.”
James Penny, CIO at TAM Asset Management, said he is underweight equities as he looks to go on the defensive but agreed certain markets are looking “incredibly cheap”.
“We have been buying in areas such as healthcare to help protect us from the upcoming recessionary environment,” he said. “We expect the US to slow down very soon and we are also looking at high-quality corporates and dividend players.”
Despite this, he said there are opportunities for alpha in European value which looks “generationally cheap”.
“We are trying to counterbalance the defensive play with alpha drivers,” he said. “European value and UK mid-caps look incredibly cheap.”
Truter is also more optimistic about equities and is looking for opportunities in emerging markets with a focus on the China reopening play.
“We are overweight equities and we are playing that through emerging markets with a focus on China,” he said. “We think the reopening valuations are attractive. They are reducing interest rates which is likely to help consumption in China.
“We also think it will quieten down from a geopolitical standpoint. There are elections in Taiwan next year, and with a pro-China party in opposition, it does not make sense for the Chinese government to stir up tension.”
China ETFs have been some of the strongest performing over the past few months, with the Lyxor MSCI China UCITS ETF (LCCN) up 39.9% in the three months to 23 January. Although China has rallied on the back of its COVID-19 reopening, the CSI 300 index is still more than 28% down on its highs of February 2021.
“Investors have been caught offside by the more rapid reopening of China and are moving to close their underweights,” Bell said. “Based on the degree of scepticism in Q4 2022, I would be surprised if they did close their underweights. The best opportunity to buy was last quarter, but as we move through 2023 there is still more upside to play for.”
Prout is also betting on China, attracted by its low relative value compared to the US.
“China should be lower value as it carries a large risk premium. However, it is out of cycle with the developed world and could begin accelerating as the other economies decelerate. That type of diversification in equities is a gift,” he said.
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.