Forecasting the economy and markets can be hard at the best of times, let alone when policy is changing so rapidly.
Today, however, uncertainty is not just a descriptor of predicting challenges; it is actively influencing the US economy. CEOs face a choice: make major hiring or investment decisions now or ‘wait and see’ for a few months, in the hope that greater clarity will emerge.
While sentiment has improved somewhat recently, US businesses following April’s tariff announcements highlighted hesitancy to invest as great as during the depths of the Covid-19 pandemic in April 2020. We expect this temptation to pause decision making to weigh on growth ahead.
For the Federal Reserve, life would be relatively straightforward if the only uncertainty was around downside risks to growth. Interest rates could be cut pre-emptively to guard against the risk of recession.
Yet with tariff-related price pressures likely to emerge in the coming months, the situation is clearly not that simple. Like CEOs, Fed chair Jerome Powell is quite rightly opting to be patient in planning his next policy move.
Businesses, not investors, can afford to wait and see
Investors do not have the same luxury of simply hitting pause. With inflation eroding the purchasing power of cash, there is a clear need to put cash to work. And of course, if investment decisions are only taken at times when uncertainty is low, it is likely that markets will already have efficiently priced in what is to come.
It is therefore imperative to focus on strategies that can perform well in multiple states of the world. Today we see five themes that will help investors thrive in these unstable times.
First and foremost, within equity markets, regional equity diversification is arguably more important today than at any point since the global financial crisis. After an incredibly strong run for US equity markets, we believe that, unlike the last 10-15 years, investors will see better risk-adjusted returns ahead from being well regionally diversified than from running concentrated US portfolios. With the US economy appearing somewhat less exceptional, and with new fiscal stimulus improving Europe’s medium-term growth outlook, the gap in earnings between the two regions is likely to narrow.
Second, we expect income-oriented strategies to prove relatively defensive if volatility picks up again. Dividend growth is typically more resilient than earnings growth, and with corporates pulling back from capex, this resilience may be even greater than usual if earnings do slow.
Diversifying the diversifiers
Third, for the more defensive aspects of a portfolio, government bond markets have been caught in a tug of war for the last two years. When growth concerns have come to the fore, bond yields have fallen in anticipation of more central bank easing ahead. Yet these rallies in bond prices have not been sustained, with the market still wary of inflation risks, and governments around the world keen to hit the fiscal accelerator.
While we expect some of this volatility in bond yields to persist, core bonds absolutely deserve their place in providing income and downside protection against a growth shock. UK gilts appear better positioned than their regional peers, given a relatively weak growth backdrop and a UK government that is much more constrained by its own fiscal rules.
Our fourth theme focuses on investors needing to consider diversification against the global economy proving too hot rather than too cold. Rising trade barriers threaten a classic negative supply shock, at a time where fiscal policy is already taking a more expansionary turn.
While 2022 may be a year that many investors are keen to forget, it also provides a helpful template for how markets may respond to an inflation shock.
Alternative assets, and core real assets in particular, provided the best places to hide in a period where stocks and bonds sold off simultaneously. For investors unable to access less liquid strategies, commodities, macro hedge funds and large cap UK equities were also relatively resilient. In a world where inflation and growth risks are more evenly balanced, these alternative tools are an increasingly essential part of a well-diversified portfolio.
Finally, currency considerations cannot be overlooked. Since 2010, the FX exposure of unhedged US assets has provided something of a ‘free lunch’. US dollar appreciation has added an additional 1.9% per annum for sterling investors, while also often providing a diversification benefit during risk-off periods. With the US dollar’s safe haven status no longer as solid, a different balance of currency risks may be required.
By focusing on strategies that perform well in various scenarios, investors can position themselves to succeed amidst the complexities of today's global economy. Establishing stable foundations for an unstable world will therefore be crucial.
Hugh Gimber is global market strategist at JP Morgan Asset Management. The views expressed above should not be taken as investment advice.