Weekly review 3 October 2022: The final quarter of a difficult investment year starts in a recession mood

5.10.2022

This weekly review looks into expectations for the rest of the year. The most important questions during the final quarter of the year will be central banks’ inflation measures, the depth of the upcoming recession and the new challenges and opportunities brought about by an evolving investment environment.

The year has been a difficult one in the investment markets, with both fixed income and equity investments coming sharply down. That means there have been few places to escape.

The inflation figures for the euro zone published last Friday revealed that prices continued to rise compared to last month. Year-on-year inflation hit the 10% mark for the first time, and the answer to the question of whether inflation has peaked or whether it will continue to rise is not certain at all. In Europe, energy prices have driven the bulk of overall inflation, and since the energy supply problems are expected to continue throughout the winter, it is possible that the inflation spike will only take place in a few months’ time.

In the USA, in contrast, inflation shows signs of cooling. Thanks to the strict monetary measures carried out by the Fed, the question is no longer whether but how fast inflation will slow. The country’s high employment figures may be an obstacle to the stabilisation of prices: when labour is in short supply, new workers can demand more pay from employers, which in turn drives inflation.

The pace at which inflation will slow is also impacted by the fact that the rise in prices has shifted from goods to services. The supply chain challenges experienced in spring have now been overcome also when it comes to the less readily available components, such as microchips. In service inflation, the challenge lies in its “stickiness”: once the prices have risen, it is more difficult to lower them than the prices of goods.

A recession will happen, but what will it be like?

Growth expectations have suffered from global tight monetary policy, the erosion of consumers’ purchasing power due to inflation and the energy crisis in Europe. Market performance in line with the weak expectations has already been priced in beforehand based on the assumption that the economy will contract also during the next few months. By definition, a recession can only be declared after the fact, when the economy has contracted during two consecutive quarters, but it is totally possible that we already find ourselves in the midst of recession.

Various economic indicators can give some indication of the future economic development. The Chicago Purchasing Managers’ Index (PMI) published on Friday was at its lowest since the worst depths of the pandemic in June 2020, suggesting a slowdown in economic growth. PMI data from Europe, USA, China and emerging markets has told the same story, but based on it, the slowdown in growth would be more gradual than expected.

Recession + inflation = stagflation

The worst possible situation for the economy is when the economy is contracting and inflation is high. This situation is referred to as stagflation, which is a combination of the words stagnation (slowing economic growth) and inflation. This is a tricky situation: high inflation on one hand requires central banks to tighten monetary policy, while on the other hand, slow economic growth demands expansionary monetary policy from decision-makers, which in turn drives inflation.

In these circumstances, the economic rules are different than in normal times. This means that good economic news may be bad news for investors, if it drives inflation. In contrast, investors are not necessarily alarmed by news about a recession, because they have prepared for it.

Profoundly changed investment environment offers new opportunities

When comparing the current investment environment with the situation a year ago, many fundamentals have changed. The interest rate level has risen substantially higher, and it will likely take many years before a return to zero interest rates is possible.

Weak markets have raised the return expectations on fixed income investments almost to the same level as equities. At the same time, market volatility has increased, however. The investment environment will probably also remain volatile until the central banks have cut their key interest rates.

The dwindling of the economy has also pushed stock prices down. That means that stocks have become cheaper in relation to return expectations, i.e. their P/E (price/earnings) ratio has declined. In Europe, P/E ratios are now clearly below the average for the past 20 years, meaning that European equities are now cheap also from a historical perspective. In the USA, P/E ratios have also fallen dramatically in recent months, but they are still at the average level for the past 20 years. The prices of European equities have thus fallen relatively more compared to the US market.

 

 

Nothing presented here is or should be taken as an investment recommendation or solicitation to subscribe for, buy or sell securities. When making investment decisions, the investor must carefully familiarise themselves with the information given on the financial instruments and understand the related risks. The investor must base their decision on their own assessment, goals and financial situation. Risk is always inherent in investment activities. The value of the investment instruments may increase or decrease. The past performance of investment instruments is no guarantee of future performance.


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