Richard Dunbar, head of Multi-Asset Research, abrdn, provides his thoughts on the road ahead.
The global economy is facing multiple headwinds; the single most likely outcome of which is recession.
Our central scenario considers higher rates in the near-term and eventual rate cuts further out; above consensus inflation in the near-term but lower as the recession bites; and well below consensus growth throughout, strongly informing our asset allocation.
More optimistically, there is a narrow path to monetary policy tightening that is enough to bring inflation under control but not enough to generate recession. But this Fed “walks the tightrope” scenario requires a lot to go right – it is plausible but overly complacent.
This central scenario is not fully priced by most financial markets. Bond curves incorporate large rate hikes, but don’t price the subsequent monetary policy loosening cycle that would be needed in a recession. The drawdown in equity markets and widening of credit spreads in the higher risk areas of credit so far this year, primarily reflects a valuation rerating together with some moderation in earnings growth, rather than the earnings contraction that would occur in a recession.
This prompts caution in allocation and careful portfolio construction. Portfolios should acknowledge the downside risks to growth, earnings, and therefore, cashflows, but should also have some protection should the Fed indeed “walk the tightrope”.
Security selection also remains important in this environment where investors are likely to ascribe increasing value to ‘quality’.
