Talking Heads – Mid-year outlook: “Is it different this time?”

This is an edited transcript of the audio recording of this Talking heads podcast

Andrew Craig: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing our outlook for the second half of the year. I’m Andy Craig, Co-head of the Investment Insight Centre, and I’m joined by Daniel Morris, my Co-head and Chief Market Strategist at BNP Paribas Asset Management. Welcome, Daniel, and thanks for joining me today.

Daniel Morris: My pleasure.

AC: Many people will have been surprised by the performance of equities so far this year when they see indicators like the inverted yield curve telling them that a recession is coming. Are they right to be surprised?

DM: You’ve highlighted why there is this confusion. Normally, the inverted yield curve tells us a recession is coming, as well as other signs such as falling oil prices. At the same time, equities have done quite well. In many markets, we see positive earnings growth expectations, whereas in a recession, you would expect to see earnings fall.

That apparent contradiction has puzzled investors for the last six months. The way we can resolve the puzzle is to reinterpret what the inverted yield curve tells us – it’s not necessarily signalling recession. What it is telling us is that interest rates are high because inflation is high. Central banks want to bring inflation down, so they want to slow growth. Eventually, inflation and growth will slow and interest rates will decline, hence the inversion in the yield curve.

But that doesn’t necessarily mean there will be a recession. It’s perfectly plausible that growth will slow to a below-trend level, so under 1.75% in the US. If that happens for sufficiently long, inflation should eventually fall back to central banks’ targets. Once inflation is back to target, growth could reaccelerate and central banks can lower rates.

The reason we assume that there is going to be a recession is that, historically, a recession has followed an inverted yield curve. But I would argue that’s more a function of central bank policy errors – keeping rates too high for too long and inadvertently inducing a recession.

But it’s possible that it’s different this time. That’s not necessarily a crazy assumption. At its last [monetary policy] meeting, the US Federal Reserve realised it was not on target to meet its 2023 inflation target , but instead of raising interest rates, it paused on its hikes and raised the inflation objective. The message was that if the Fed has to choose between a slowdown in growth and inflation falling more slowly, they’re going to err on the side of being patient with inflation. So I think there is less risk that the Fed will make a policy mistake this time because it really wants to avoid a recession. Additionally,, we see that growth in the US is still strong. Consumer demand is robust and the unemployment rate is low. So I think we have a long way to go before a recession might happen.

AC: What is different this time is that we are coming out of the pandemic, a period of huge fiscal stimulus. There’s nothing really comparable in recent history to the events of the last two to three years. If we’re only looking at a slowdown, what does that mean for the outlook for equities and bonds?

DM: An economic slowdown would not be particularly positive for equities over the next three to six months. We would anticipate that we will have more negative economic data. A slowdown is inevitable, in our view, it’s just a question of how far it goes.

We think it will be a challenge for equities. Earnings growth forecasts compared to historical averages aren’t so high, but they may still not be feasible and may need to be revised downwards.

So, what are the alternatives? We recently had US Treasury yields above 4%. It’s been a long time since we’ve seen yields like that, so that’s attractive to investors as an alternative to equities. Independent of a slowdown or a recession, we would anticipate Treasury yields falling over the course of the year. If it’s a recession, they could fall as low as 3%. On a 10-year Treasury bond, a one percentage point decline in interest rates would give a 10% return plus 4% income, so that’s a 14% return over the next year.

How likely is it that you’re going to get 14% returns over the next 12 months from equities? Most of us would be sceptical about that happening. So allocations in our multi-asset portfolios are overweight fixed income versus equities as the expected returns under numerous scenarios look better for bonds.

AC: One disappointment during the first half of the year has been the performance of China’s economy relative to the high expectations we had when China dropped its zero-covid policies. Do you still believe the Chinese equity market could turn around this year?

DM: Many investors had overweights either in emerging market equities or Asia once China lifted the zero-covid policy – it seemed to make sense. We saw how successful the post-Covid reopenings were in the US and Europe once restrictions were lifted and simply assumed the same pattern would happen in China.

But there are quite large differences between China and the US and Europe, the most important one being the lack of support for households from the Chinese government during lockdown.

In the US, the Biden administration provided trillions of dollars of fiscal stimulus. In Europe, most workers were on furlough, so they didn’t lose their job. They were paid, but they were in lockdown, so they didn’t spend much money and savings rates rose. When the reopening came, people had money to spend and we have seen that power, particularly in European earnings, over the last year.

That didn’t happen in China. The government primarily supported businesses rather than households. After three years of lockdown, maybe having lost your job, you’ve probably run down your savings just to survive, so when the reopening came, there just wasn’t the fuel for the consumption fire that there was in the US and Europe.

Chinese growth has been disappointing to foreign investors, but that may have more to do with unrealistically high expectations. What happens next? We can be optimistic for two reasons.

First, China’s growth [rate] isn’t bad. The authorities are increasing stimulus, particularly for the property market, which is crucial. That may improve consumption and perhaps turn around sentiment.

Second, because of the relatively poor performance so far this year, Chinese equities look attractively valued relative to global equities, giving investors an opportunity to pick up some of that discount.

But most important when you’re talking about equities is earnings. Consensus estimates for China for this year and next year suggest earnings should grow at around 14% to 15%. Even if it’s less, it’s still high relative to the US and Europe, where the earnings forecasts are for between 4% and 8% for this year and 13% for the US next year. We’re sceptical about how realistic those forecasts are, particularly as we anticipate a slowdown in the US.

While growth has not been quite as strong as we wanted in China, it is still robust – growth companies have had to go through lockdowns, so it’s not too strange to anticipate a rebound in earnings this year.

The difference between the earnings prospects in China and the US and Europe should ultimately be reflected in market prices. If you have rising earnings and equity prices don’t rise, that means the multiple on those earnings is falling and we think that’s unlikely given how much it has fallen already.

AC: Thank you very much, Daniel.

DM: Thank you, Andy. It was a pleasure.

This presentation includes a discussion on current market events and is not intended as investment advice or an offer of products or services by BNP Paribas Asset Management. Please keep in mind that the information and analysis in this presentation is only current as of the publication date.