Markets have had a difficult ride through 2022, and although inflation seems to be coming to a peak, the worst is yet to come, according to Virginie Maisonneuve, chief investment officer (CIO) of global equities at Allianz Global Investors.
Many companies have had their share prices downgraded this year due to declining investor sentiment, but investors have been reassured by the fact that revenues have stayed resilient.
That could be about to change, according to Maisonneuve, who said that a major downturn could happen within the next six months as revenues slow under the pressure of higher interest rates.
She added: “We’re not out of the woods yet – clearly the recession gap is coming.”
So far, inflation has acted as a booster to company earnings, she argued, but that may no longer be the case as central banks round off their interest rate cycles.
The damage would likely be scattered across all regions and sectors, with companies in “pockets of pressure” buckling under shrinking income streams.
Maisonneuve said: “Inflation was boosting revenues over the last quarter, which showed us the positive aspect of inflation, but we’re now expecting to see the negative side.
“Earnings have really not adjusted to the new environment – things have been so fast in terms of tightening, so this will be the first time we tighten into a slowing environment, which is quite unusual.”
Indeed, she anticipates steep interest rate hikes of 50 basis points by the Federal Reserve (Fed), followed by milder 25 basis point increases before the earnings recession begins.
“It might be mild in the US and bigger here in Europe, but either way we'll have a resetting of valuations and that is when you want to buy equities,” Maisonneuve added.
Rather than seeing a potential earnings recession as a bad thing, she said that it would be an ideal time for investors to buy assets at attractive prices.
Valuations have come down significantly in 2022, but the recession next year could be a reset point that would mark the bottom of the market downturn.
Maisonneuve said: “Ideally, I want to see earnings and valuations coming down because that's the best time to position. I can't tell you if it's going to be next month or in the next three months, but we’re going to have more volatility, and those are the moments you need to use to build your long-term portfolio.”
During that time, Maisonneuve aims to allocate towards assets in the climate, cyber security and AI space, which are supported by long-term growth themes but have been expensive in the past.
James Ragan, director of wealth management research at D.A. Davison, on the other hand, said that the earnings of companies that are historically sensitive to economic cycles tend to be more resilient in a recession and should be the assets to own in the coming years.
The consumer staples, utilities, and health care sectors could therefore provide some security ahead of an earnings recession.
Ragan said: “These sectors have significantly outperformed in 2022, an indication that investors have anticipated the slowing economy and perhaps expect some earnings challenges in other sectors.”
Sadiq Adatia, CIO at BMO Asset Management, argued that investors’ best course of action was to avoid markets altogether, highlighting his underweight position to equities ahead of a potential recession.
“Looking ahead to 2023, we believe the focus will shift back to the economy and a potential earnings slowdown, which could prompt markets to sell off further,” he added.
“If first quarter earnings in 2023 disappoint, we may see further job losses as companies look for ways to create margin growth, which is a trigger that could cause the economy to weaken enough for markets to react negatively.”
Nevertheless, investors with a strong risk appetite could benefit from jumping into markets and nabbing depressed assets, according to Maisonneuve.
Those who choose to invest during an earning recession could improve their long-term portfolio prospects substantially, she added.
Maisonneuve said: “It depends on your time horizon – do not sell growth if you hold growth in your portfolio (provided you’re happy with the holdings you have), but if you have cash, I would definitely start adding very slowly and looking for that volatile time to put money in the market.”