Market recovery on the horizon, just not yet

Investors have had to struggle with simultaneous inflation and weakening growth for the first time in a while, but the light at the end of the tunnel isn’t far off, according to Chris Iggo, Chief Investment Officer for Core Investments at AXA Investment Managers (AXA IM).

Iggo highlighted how this combination of high inflation and weak growth has lengthened the prospect of a U.S. Federal Reserve put, but better valuation levels and some improvement in the news flow will create a better environment for credit and equities in the long-term.

“Interestingly, interest rate futures markets are starting to price in cuts in rates in the second half of 2023 with the peak in the Fed Funds rate and bond yields coming in at much lower levels than we saw in the last tightening cycle,” he said.

“But that does not negate the strong expectation of up-front interest rate increases.”

Despite these headwinds, Iggo said momentum from the COVID-19 pandemic has seen a shift in spending towards services, with investors retaining purchasing power from accumulated savings and strong household balance sheets.

“Inflation and war on the news is not good for consumer confidence but the jobs market is roaring and people entering employment – as the participation rate improves – are doing so for wages that just were not there pre-the pandemic,” he said.

The ripple effects of the Russia-Ukraine war have also translated into a global energy shock. Geopolitical tension and supply chain disruption caused surges in the ‘misery index’ – the sum of the inflation and unemployment rates. The index sat at 10 per cent in the U.S. as of last year and is expected to remain above average.

“Since the invasion, [inflation-linked bonds] have performed best and as inflation is to remain high for a good few months to come, the carry that investors will get from holding inflation linked bonds remains an important attraction,” Iggo said.

Iggo also said despite the four-point decline in forward earnings multiples since the peak in mid-2020, equities have returned to fair-value or below with the U.S. still the most highly valued. He also emphasised credit spreads as an early entry point for investors to enjoy positive returns.

“When I look at the current “break-even spread” – the number of basis points spreads would have to widen from here to underperform the appropriate government bond benchmark – they are at levels today which, historically, have generated meaningfully positive excess returns in the year ahead,” he said.

“This means credit outperforms government bonds.”