Rally fatigue: dichotomy between markets and economy too wide

Vincent Mortier, Group Chief Investment Officer, and Matteo Germano, Deputy Group Chief
Investment Officer at Amundi AM, give their views on how China’s reopening and the trajectory of inflation will affect the markets.

The year started with a rally mood amid short covering and the return of retail investors’ risk appetite. There were some supporting reasons for the situation, at least in Europe and China, where lower gas prices and China reopening helped to remove some of the downside economic risks that were on the table last year. However, the rally has gone too far based on assumptions that inflation is falling fast, the job of central banks is done, and the economy is well on track for a soft landing, with no earnings recession. 

The tricky part for investors starts now. The bears may not arrive, but some caution from here is necessary. The dichotomy between loose financial conditions and tight lending standards for the real economy is striking. Markets remain priced for perfection, despite high uncertainty and divergences on the economic front. In particular, while we recently upgraded our forecasts for 2023, the devil is in the detail. Regarding the US, our GDP forecast is unchanged, but we see deteriorating quarterly dynamics for the second part of the year. For the Eurozone, we upgraded our GDP projections for 2023, but this was mainly due to carry-over from last year and growth expectations remain flattish. China reopening is clearly a positive for the global economy, but we believe this will mainly support the domestic performance. 

Secondly, inflation is declining slowly, but markets see it falling rapidly and the path towards the 2% CB target appears to be long and bumpy. With regard to central banks, we see that the Fed is close to the end of tightening, but the ECB is still hawkish. Finally, appetite for emerging markets is returning, but regarding developed markets, caution prevails. 

Against this fragmented backdrop, we think investors should remain cautious but recognise that uncertainty is high on both sides (upside and downside).

Consequently, we updated some of our main convictions as follows:

• In cross assets, we stay cautious on equities, as the risk rally may have gone too far, given the pressures on corporate earnings. But, we see a possibility of benefitting from equity upside through options. We think subdued real wage growth is likely to keep demand and consumer spending in the US and Europe weak, eventually affecting earnings. Investors should maintain strong diversification through oil and FX and strengthen protection through equity hedges and gold.
• In bonds, investors should play curve opportunities from diverging monetary policies and favour IG credit. While we stay defensive on duration, mainly core Europe and Japan, we are back to a neutral view on the UK and China. In US fixed income, in contrast, we have a modest positive duration view on expectations of further weakening in the growth outlook, given the tightening in financial conditions over the last year. In credit, we confirm our prudence regarding HY, where the default outlook is deteriorating. We continue to favour IG credit ⎼ in particular, in Europe, where valuations are cheaper than in the US.
• In equities, we are cautious on the US, but prefer value and quality, industrial and financials to tech and consumer discretionary sectors. Although lower energy prices reduce pressure on households and consumers to some extent, the shocks to real wage growth and fiscal drag are substantial and will be more spread out over time. This means that consumption will remain subdued, and the current earnings season provides indications in the form of negative Q4 EPS growth so far for the S&P 500. From a style perspective, investors should combine value stocks with quality and dividend names, which can supplement income. Our overall assessment highlights the importance of identifying companies with strong pricing power.
• EM outlook improving. We have upgraded our view on EM FX now as the USD is weakening on the back of an expected less aggressive Fed this year, and it is likely that peak dollar is behind us. Although we are still neutral to slightly cautious on EM FX, we believe that the asset class can do well this year. Our views are partially moderated by a weak growth outlook for the year. We are more comfortable with local rates in EM, especially in LatAm. On equities, we have increased our positive stance on China and believe that the reopening should be positive for countries that have strong trade relations with China. On India, however, we have taken a cautious stance in the short term on valuations, but the long-term story remains intact.