2022 is one of the worst years on record for investors so far. It may not be seen to live up to the infamous stock market crashes of 1987, 2000 or 2008, but what makes it so painful is elsewhere: all major asset classes are in the red, wiping out earnings of diversification. Yes, the golden rule of portfolio construction does not work in 2022. Today we will discuss the reasons and share our views on the outlook.
A correlation shock centered on inflation
Let’s start with the numbers. Over the first nine months of 2022, the stock markets and listed real estate worldwide are down between -25% and -30%. Have bonds performed their typical protective role? Not this time. The bond asset class is down -20% on average. The safest segments such as government bonds and high quality corporate bonds even underperformed. It doesn’t happen often. Since 1926, only three calendar years have seen (US) bonds and stocks in the red at the same time: 1931, 1969 and most likely 2022.
The main driver of this correlation shock is obviously inflation in the West. The latest consumer price indices show an annual jump of +8.2% in the United States and +9.9% in the euro zone. Multi-decade highs. What began in 2021 with a combination of generous pandemic relief funds with disrupted supply chains and factories has become more persistent. In the United States, inflation spread to services and especially wages, with a very tight labor market. Europe has an energy problem with the sanctions against Russia, and finds itself importing inflation due to a soaring dollar. With the dollar being the juggernaut of global trade and finance, inflation is a global and persistent problem.
Price stability is the primary mission of central banks. Simplistically, the Fed is drastically raising interest rates to break the price/wage spiral by slowing down the economy. The others follow to avoid importing more inflation if their currency weakens further. They all say they won’t stop until the mission is completed.
This is a terrible combination for investments. The fixed income asset class plummets as interest rates rise. But higher risk-free returns also lead to lower equity valuation multiples, while corporate earnings are threatened by pressure on margins and a slowing economy. Finally, uncertainty, geopolitics and the risk of political error weigh heavily on investors’ risk appetite. There is nowhere to hide: as inflation snowballs, so do correlations between asset classes. They are all deep in the red.
Ultimately, it’s all about inflation and central banks. No lasting shift in correlations and market direction can occur until market consensus materializes for an imminent end to monetary tightening. Markets stop panicking when central banks start panicking. The problem is that the timing is unknown. In our view, the inflection should occur around mid-2023 and the markets could anticipate. But central banks are data driven. The pivot could force the US unemployment rate, currently at a 50-year low of 3.5%, to rise above the 4% mark. We have little doubt that inflation will eventually normalize.
Not an easy trip
Monetary tightening is a powerful tool, but it only really started six months ago and it takes time to seep into the economy. Supply chains will also return to normal and base effects will fade. The level of inflation could remain higher than in the past decade, but it should stabilize at acceptable levels as growth slows. It will not be an easy journey with damage to jobs and asset prices. But central banks will change course, which means that asset classes will behave according to their fundamental pattern. Diversification will be back, making asset allocation excellent again with a difference between defensive and cyclical asset classes.
The key question then will be the state of the economy at that unknown but hopefully not too distant point in time. This is where we find comfort in the impressive resilience of the US economy, and hope in the likely reacceleration of China. The fate of Europe is obviously more uncertain from a growth point of view, and geopolitical risks remain significant. However, central banks will by this stage have reloaded their ammunition to be able to support growth if necessary.
Record of pessimism
Until then, we continue to expect extreme volatility. Volatility, not a bear market: Sudden bounces are just as possible, and just as unpredictable, as sudden crashes. The reason for this is that investor sentiment and positioning are at record levels of pessimism. Bank of America’s latest global fund manager survey is “screaming capitulation” with professional investor cash levels at their highest levels since 2001.
Last but not least, the current turmoil has reshaped the valuation landscape. Expected long-term returns are arguably higher than they were a year ago, and now is definitely a good time to reassess strategic asset allocation for the decade ahead. Gone are the negative interest rates and some dislocations that should correct themselves over time. This is what we are working on, because we remain convinced of the merits of a diversified and robust asset allocation.