Investors need to price the risk of recession in 2023
A recession in 2023 is not our central case, but investors ought to price the risk of it happening, in order to reduce the probability that it will. We would be surprised if the Federal Reserve were to raise rates seven times in 2022, mainly because that would automatically cause the consensus to reduce its forecasts for US growth in 2023. The Fed’s hawkishness in 2016 had a similar effect and we see early signs of this happening in two of our main models. Investment Grade has hit a five-year low in our US$ fixed income model. Investors are now concerned about credit quality for the first time in years. Industrials have just been downgraded to underweight in our US equity sector model, which nearly always indicates that investors are worried about the outlook for the real economy.
Time to look at European Energy equities
Generating an adequate income from euro-denominated bonds is next to impossible, so investors should abandon the attempt. They should embrace currency risk – not try to hedge it away. They should enjoy the fact that US dollar yields are structurally higher than those in the Eurozone. This means owning long-dated Treasuries and dollar-denominated EM sovereign bonds. Finally, they should consider the source currency of their equity dividends and take another look at the Energy sector.
Sector at multi-year lows in equity and fixed income models
Nobody likes the Energy sector. On a global basis the current sell-off is as bad as all the other major declines, apart from 2014. The difference is that oil prices are much more stable now than they were then. The medium-term challenges (ESG agenda, electric cars, balance sheet distress) are all well-known, but we would be really surprised if the sector wasn’t rated overweight again within the next two years – any maybe sooner.
High Yield weakness is not caused by the Energy sector
High Yield has peaked in our fixed income models and has fallen sharply against Investment Grade. We have checked our cross-asset sector models and it isn’t caused by a problem in Energy. It looks like a straightforward loss of confidence in the outlook for Industrial High Yield. This is potentially ominous for Equities as well, but we haven’t generated a sell signal just yet.