Micro meets macro

We’ve identified five calls we believe will be key for the economy and markets for the remainder of the year and beyond:

Call #1: companies | When the going gets tough: The future is always uncertain, but it feels more uncertain today than it has for some time. It would be understandable if investors felt that equities were an asset class to be avoided or reduced. Cost pressures, supply-chain issues and the spectre of trade wars are key challenges to corporate profits. We believe that not only can the best companies continue to prosper in difficult environments, but they can often lay the seeds for the next season of growth through step-changes in their market position. The key to success in a difficult environment is flexibility and long-term focus. This comes in a number of forms. Most important is financial flexibility. We have a strong preference for companies with robust balance sheets and high levels of free cash flow. This gives quality growth companies the flexibility to continue to invest through a downturn.

Call #2: sectors | Reshoring, restoring and reassuring: The reversal of globalisation has long been spoken about. However, over the past decade, companies have been underinvesting in their local markets in favour of lower-cost production centres. This is beginning to change and it’s more nuanced than ‘deglobalisation’. Governments and companies across the Western world are taking active steps to address the frailties exposed in recent years by decades of offshoring, particularly in the US. We believe this will spur significant investment across strategically important industries to develop more robust supply chains, improve national security and encourage greater energy independence. In emerging markets, China has long focused on rebalancing its economy towards self-reliance, while upgrading its manufacturing industry from cheap goods to advanced technologies.

Call #3: the economy | Learning to live with inflation: If there are no further shocks such as those we’ve seen in 2022 (extra Covid-19 lockdowns in China and the conflict in Ukraine) – which have significantly and unexpectedly disrupted supply chains and commodity markets – we think inflation will likely slow later this year. The drivers are demand moderating, monetary policy tightening, fiscal stimulus waning and supply chains gradually improving. We already see some tentative signs of inflation peaking (at high levels) in the US. This should allow central banks to slow the pace of tightening in 2023. But inflation is unlikely to return to the low levels of the pre-Covid decade, which was characterised by fiscal austerity and balance-sheet repair. Longer term, any inflation from the green transition and more local supply chains is unlikely to be met with sharp interest rate rises, as slowing down demand won’t do much about this (and shouldn’t). Plus, technological innovation and demographic ageing remain disinflationary forces.

Call #4: energy | Renewable and reliable: The market is focused on the short-term need to secure fossil fuel supplies other than from Russia. Both fossil fuel and clean energy themes have been outperforming the broader market since the war started. This makes sense to us, taking a near-term view. However, if we consider the long-term implications of what’s happening, accelerated investment in clean energy and sustainable solutions are much more likely than a major revival of fortunes for fossil fuels. Europe has a more acute need to reduce fossil fuel imports from Russia, but other regions have also been affected by higher costs. Gasoline prices have risen in many countries, while emerging market growth is particularly sensitive to elevated energy prices. As the impact of the war subsides over time, enthusiasm for fossil fuel energy may diminish. Clean energy and sustainable solutions can enjoy a more robust investment runway for many years.

Call #5: technology | Powering through thick and thin: High-growth disrupters like video conferencing, fintech and biotech companies that gained during the first year of Covid have corrected significantly since 2021. But the long-term outlook for technology remains robust. Investment in innovation continue across multiple areas. Technologies keep improving, from better devices and functionalities to new products and services. Globally, billions of new users are expected to connect online this decade – as digitalisation continues apace. Companies with exposure to future technologies could grow earnings faster than the broader market. Many disruptive technologies are likely to become mainstream, so a diversified and long-term exposure to disruptive companies could enhance future investment returns. Technology themes like cybersecurity, robotics and automation are likely to accelerate as digital security and supply-chain repair remain in focus.

Here’s how all this fits together:

The micro bit: The first call (‘when the going gets tough’) reiterates our preference for balance-sheet strength and free cash flow – key drivers of our allocation to direct equities in our US and European equity holdings. The regions poised to benefit from the second call (‘reshoring, restoring and reassuring’) are those with the highest levels of free cash flow and that have been growing tangible and intangible assets: the US and emerging markets – our preferred equity regions.

The macro bit: ‘Learning to live with inflation’ supports a slight duration underweight for now (which we’ve recently reduced). But, while policy mistakes remain a risk, we expect central banks to refrain from ending the cycle and/or to cause a deep global recession, which is likely to mitigate the bond yield rise, limit credit spread widening and support corporate bond performance. Emerging markets are closer to the end of the tightening cycle and have more potential to outperform. This supports our cautious positioning in government bonds, preference for credit, and tactical bias towards emerging market debt.

The thematic bit: For our flagship strategy, ‘renewable and reliable’ and ‘powering through thick and thin’ relate to areas that are either embedded in our approach to sustainable investing or to themes we access through our direct equity exposure. We allocate to funds that access lower-carbon equities and have lower exposure to more traditional energy sectors. In our international equity strategy, we continue to take a long-term horizon with a distinct focus on disruptive and innovative technologies.

Meanwhile, lots of key events and data this week…

Watching the cycle: Two stories could become important: first, it looks as if the G7 is discussing a price cap on Russian oil; second, Russia may have defaulted on its foreign debt – however, it seems it has the money to pay, but sanctions make it impossible to get the sum to international creditors. Investors will likely focus on whether China’s purchasing managers’ indices (Thursday, Friday) improve after the partial reopening and whether the ISM survey for the US (Friday) shows a further loss of momentum but still positive manufacturing activity (our base case). US consumer confidence (Tuesday) should drop. The Fed’s preferred inflation measure, core PCE (ex food and energy), will be key to see whether the year-on-year rate continues to decline slightly, possibly pointing to a peak in US inflation (Thursday). This still looks tentative as the month-on-month rate should have accelerated a bit and overall inflation is likely to have trended somewhat higher in June. Friday’s euro area inflation should pick up, mostly driven by energy. Oil prices, though, have been declining recently. Russian gas rationing remains a risk. The ECB Forum on Central Banking, held in Sintra from this afternoon until Wednesday, gathers the main monetary policymakers. In Sweden, the central bank (Thursday) is likely to hike by 50 bps to 0.75%, still a low rate.

Daniele Antonucci | Chief Economist & Macro Strategist