Equity sell-off resumes

Originally published as a CIO alert by Mark Haefele, Chief Investment Officer for UBS Global Wealth Management

The S&P 500 fell 2.11% on Thursday as markets refocused on the prospect for more aggressive central bank tightening and concerns over the fiscal sustainability of the UK. On Wednesday investors had been encouraged by intervention by the Bank of England to stem rising bond yields, lowering the risk of global contagion from a situation that had been spilling over into global fixed income markets. But comments from UK Prime Minister Liz Truss on Thursday indicated that her government planned to press ahead with a package of fiscal expansion, which includes GBP 45 billion of unfunded tax cuts. Speaking to the BBC, Truss said that “this is the right plan” and ruled out changing course.

Meanwhile, economic data and comments from top central bank officials in Europe and the US reinforced expectations for aggressive monetary tightening. German inflation climbed to 10.9% year-over-year in September, the nation’s first double-digit reading in more than 70 years. Eurozone consumer price data is due on Friday, and the consensus among economists is an acceleration to 9.7% in September from 9.1% in August. Gediminas Simkus, a member of the European Central Bank’s Governing Council, said that he now favored a 75-basis-point hike at the next policy meeting on 27 October, echoing hawkish comments from other policymakers over recent days.

In the US, data pointed to continued labor market strength, adding to pressure on the Federal Reserve to maintain a hawkish stance. The number of Americans filing new unemployment claims fell last week to a five-month low. This raises the prospect of a decline in the September jobless rate, due out next week, though the consensus forecast is for it to hold steady at 3.7%. Top Fed officials have long stressed that they will need to see signs of a cooling labor market—along with subdued month-over-month core inflation readings—before toning down their recent stance.

Robust US jobs numbers coincided with the release of further data confirming slowing economic growth. The third estimate for second-quarter GDP showed a contraction of 0.6% after the 1.6% decline in the first quarter. The Atlanta Fed’s GDPNow tracker is now only pointing to annualized growth of 0.3% in the third quarter. However, recent Fed comments underline that the Fed remains focused on combating inflation and is unwilling to deviate from tightening to protect growth or markets. Cleveland Fed President Loretta Mester indicated on Thursday that the Fed would not stop hiking rates even if this led to a recession.

What do we expect?

The latest developments underline our view that the conditions are not yet in place for a sustained turn in market sentiment. In our view, such an improvement will require compelling evidence that the threat from inflation is receding, permitting a more dovish twist from central banks.

Instead, the latest data from Germany also suggests that inflation has not yet turned a corner. UK inflation risks being accentuated by the recent steep fall in sterling. The personal consumption expenditures (PCE) inflation gauge, the Fed’s favored price measure, comes out on Friday. But recent US inflation data has failed to reassure investors. The August CPI reading was above forecasts and pointed to a rise in core consumer prices, with the month-over-month reading excluding food and energy rising to 0.6% from 0.3% in July. Inflation has also been relatively broad-based, according to measures that strip out extreme price moves on both sides of the spectrum. The Cleveland Fed’s trimmed mean CPI rose to 0.6% month-over-month in August from 0.4% in July.

Geopolitical risk is also a focus. Reports on Thursday suggested that Russian President Vladimir Putin will declare the annexation of four Ukrainian provinces on Friday, a move that the UN said would represent a “dangerous escalation.” The move further undermines the potential for peace talks in the near term, and potentially brings the provinces under Russia’s nuclear umbrella. This conflict continues to add to market volatility, energy insecurity, and downside risks for economic growth.

How do we invest?

Add defensive exposure.?Sitting on the sidelines in cash, as many investors are choosing to do, has long-term drawbacks, in our view, as inflation erodes the value of savings. The strategy also raises the risk of missing out on rebounds. Yet with both the macroeconomic and geopolitical backdrop uncertain, we favor defensive assets that could outperform as activity slows and volatility remains elevated. In equities, we favor tilting allocations toward parts of the market that should prove more resilient in the event of slowing economic activity. Within equities, this includes healthcare and consumer staples. In currencies, we like the US dollar and Swiss franc. In fixed income, we favor high-quality bonds and resilient credits. Capital protection strategies can also help make overall portfolios more defensive.

Invest in value.?The September German inflation release is just the latest in a long run of disappointing price readings from around the world. But periods of elevated inflation have historically been associated with outperformance by value stocks relative to growth stocks. In addition, we expect energy stocks—a value sector with attractive cash returns—to benefit from higher oil prices in the months ahead.

Diversify with hedge funds.?It has been difficult for investors to earn positive returns in 2022. But one bright spot has been hedge funds, where some strategies, like discretionary macro, have done well. Global macro funds, which can often thrive amid persistent uncertainty and heightened market volatility, delivered a positive return of 9.3% year-to-date up to the end of August, based on the HFRI Macro (Total) Index. In the current environment, we think “owning beta” is no longer sufficient to generate attractive risk-adjusted returns.

Position for the era of security.?While we retain a least preferred stance on growth stocks, we expect the era of security and the global transition toward stability and sustainability to continue to generate attractive long-term opportunities. Plans to improve energy security, environmental security, food security, and technological security are likely to be among the key long-term drivers in the years to come, supporting investments in areas ranging from greentech to agricultural yield solutions.

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