As we enter the final quarter of 2022, a hard landing looks increasingly likely due to tightening financial conditions, the soaring dollar, an energy crisis in Europe, and a weaker Chinese economy. But what should investors be watching and are there any green shoots emerging?
Salman Ahmed, Global Head of Macro at Strategic Asset Allocation at Fidelity International, comments “Winter is coming, and with it arrives an energy crisis that will affect much of Europe’s energy security. Interest rates in developed markets continue to rise, ushering Europe and increasingly the US towards recession, the US dollar continues to strengthen, draining capital from other regions, while the UK has nosedived into a gilt market accident on the back of unfunded tax cuts necessitating BOE action. However, a potential bright spot is China, where the economic impact of zero-Covid policy and a struggling property sector may be mitigated by central bank and government support.”
Against this backdrop, Salman Ahmed picks out three key themes to watch for the remainder of the year.
- Soft, hard, or crash landing
“Hopes that the Fed would soon pivot away from its tightening path have been quashed. In two consecutive meetings, the Fed hiked rates by 75bps and it has struck a consistently hawkish tone since Jackson Hole at the end of August. The central bank appears fully committed to getting inflation under control, even at the cost of significant demand destruction. Nevertheless, economic data in the US is proving relatively resilient. The labour market is still healthy and inflation remains high. Our future activity trackers improved in August, and the US dollar continues to strengthen. We have pushed out our expectations for a hard landing in the US to mid-2023.
“Recession in Europe, meanwhile, appears more imminent. The region faces a severe energy crisis that we estimate could lead to a 4-5% hit to euro area GDP. High prices and threat of gas storage depletion are sapping consumer spending and hobbling industry. The ECB has hiked rates to 0.75 per cent, but the window for further tightening is closing quickly given the deteriorating outlook.
- China – all eyes on the Party Congress
“While Europe and the US wrestle with recession, Chinese policy is heading in a very different direction. China is continuing to loosen policy where most developed markets tighten, and it has room to go further still. Nevertheless, several challenges remain this winter and the economic recovery following zero-Covid policy lockdowns has been mixed. Activity has improved, but recurring lockdowns and a property sector in transition have left a dent in China’s economy. In response, China has ramped up both fiscal and monetary support. This support should improve the outlook for China as we head into Q4. We also expect Chinese earnings to improve, as companies begin to enjoy a post-Covid recovery and lower commodity prices.
“We believe sentiment could improve further following October’s 20th party Congress and we are closely watching for clues of how the forward path of economic policy could serve as a catalyst for a more progressive growth policy. Expectations heading into the Congress remain muted, meaning any positive news could provide an immediate boost to sentiment.
- From monetisation to fiscalisation
“Europe faces a bleak winter. Much now depends on how governments, many of which face their own separate domestic challenges, will try to support households and businesses over a winter of severely elevated gas prices. The risk of fiscal largesse in an environment of high inflation and rates has been underscored by the UK, where recent radical policy changes triggered a collapse in sterling and a sharp rise in gilt yields necessitating BoE interventions. The ECB meanwhile is trying to normalise monetary policy, despite the near certainty of recession across Europe.
“At the same time, there are reasons not to be too pessimistic. Governments are likely to increase their fiscal support for households, many of which still have a pot of lockdown-induced savings to draw upon (though these are dwindling fast). Confidence across the region might be at rock bottom but retail sales are holding up for now and unemployment remains low, though deterioration in hard data looks to be in the pipeline.
“We don’t know yet how cold this winter will be, along with the knock-on implications on gas demand, nor how the current phase of global financial conditions tightening will impact future policy settings and specific regions pose their own questions.”
Implications for investments
Fidelity International’s core investment view remains defensive. Nonetheless, in an environment where attractive investment options appear scarce, pockets of opportunity and higher hopes for 2023 could be found in Asia.
Taosha Wang, Portfolio Manager, Multi Asset at Fidelity International, comments: “In a number of ways, Asia will be on a different path this winter. The region’s key economies serve as a useful diversifier that is insulated to a degree from the struggles facing Europe, with less inflationary headwinds. This implies more headroom for growth-oriented policies in the region, which differs from many other parts of the world where high inflation is forcing central banks to tighten financial conditions.
“Additionally, the 20th Party Congress in China could herald more policy certainty heading into 2023 and increased assertiveness in government stimulus. China has already eased various property policies in response to a soft housing market. That said, overhangs from zero-Covid policy in China, FX volatility due to dollar strength, and uncertainties related to the Bank of Japan’s (BoJ) yield curve control regime still warrant some caution. But overall, we are turning more positive on Asia.
“Overall, we remain defensive. With a tighter monetary policy required to combat inflation, we expect further weakness in risk assets. With growth slowing and real yields surging, we are conservatively positioned with an overweight to cash. Within equities, we prefer US equities to Europe, as Europe faces a uniquely negative economic outlook driven by energy prices. Nonetheless, we continue to identify thematic investment opportunities that can withstand the fluctuation in economic cycles. Renewables is an interesting example where we are seeing a long-term sustainable growth theme intersect with near-term demand from the ongoing inflation energy crisis.”