Stocks: a highly advanced correction, but a new turbulence is coming – 06/21/2022 at 12:40

Fabiana Fedeli is Head of Equities and Diversified Management at M&G.  (photo credit: DR)

Fabiana Fedeli is Head of Equities and Diversified Management at M&G. (photo credit: DR)

Fabiana Fedeli, M&G Equity and Diversified Managing Director

The last few weeks have not been easy for the financial markets. Despite some signs of easing, more turbulence is likely as downside risks remain. Two fundamental questions arise: What are the trends currently priced in by the markets, and how should investors position themselves in the face of the diversity of possible outcomes?

At the beginning of April, the markets were already too soft and they were not taking into account the risks ahead. Potential demand erosion, especially due to the increase in inflationary pressures, was not taken into account by market participants. Growth forecasts are expected to be higher given supply-side bottlenecks, possible misdirection of central bank policies, and the impact of China’s zero-COVID policy.

First signs of softening in demand

There have been signs of weakening demand for some time now. Household confidence in the UK, Eurozone and US has deteriorated since 2021, when governments began withdrawing financial support aimed at combating the impact of COVID.

Despite demand from American households that have been doing relatively well so far, weaknesses are starting to emerge. Meanwhile, in manufacturing, overall PMI is below 50 (pointing to contraction in activity), while new orders are in expansion territory.

Are first quarter results misleading?

The first quarter earnings season was relatively benign. This does not mean that demand will remain strong. The first quarter was widely viewed in the rear view mirror. While listening to business leaders about 2022 prospects, the picture isn’t all that positive. In the US, UK and mainland Europe, some companies are observing that consumers are starting to cut back on their purchases, they are increasingly sensitive to promotions, and there are warning signs of a slowdown in demand for durable goods.

End of market complacency

Since the beginning of April, we have witnessed a huge drop in stock markets and an increase in bond yields. However, stock markets have hesitantly rebounded in recent weeks and bond yields have fallen. Can we conclude that all the bad news has already been taken into account in the prices? Only partially. Most of the price correction is already behind, but downside risks remain, especially in equity markets.

Markets will inevitably be more sensitive to good news. It could even be a partial solution to the war in Ukraine, a slowdown in inflation, or even more cautious central banks in monetary tightening. Bond markets have also benefited from growth fears that outweighed the prospect of increased inflationary pressures and tighter central bank policies.

However, risks remain: additional sanctions against Russia for natural gas, for example, the destruction of demand leading to recession, and the tightening of potentially excessive monetary policies by central banks trying to find a balance between inflation and growth, and most importantly, the impact on corporate profits. The main question is: Which of all these factors are integrated into stock prices? Primarily, prices are causing the outlook to deteriorate and a significant slowdown in growth, but declines are still possible, particularly for some stocks that remain high in valuations or whose low earnings have not yet been taken into account.

A significant recession caused by the new sanctions on natural gas originating from Europe will lead to a further decline, especially in the stock markets. A collapse or collapse is not expected in the credit markets as in 2008 and does not constitute our central scenario. In other words, a potential rebound in the markets will depend on data releases and news and may be short-lived.

We’ve talked a lot about the evolution of the relationship between stocks and bonds. Depending on whether growth or inflation is a priority for bond investors, we may see the two asset classes move in opposite or similar directions. When comparing yields, stocks still look noticeably cheap compared to bonds. However, everything will depend on future earnings expectations.