Investment Institute
Viewpoint CIO

Don't speak

  • 11 March 2022 (7 min read)

Valuations are adjusting in markets in response to higher economic misery. Growth is set to be weaker and inflation is unacceptably high. That means the central bank put is further away than it was. As such valuations may need to get very cheap. But equity multiples and credit spreads have moved a long way. Positive returns can’t be guaranteed in the short-term but the combination of better valuation levels with some improvement in the news flow, when and if it comes, should generate a better environment for credit and equities. Don’t speak yet, but we need to think about market recovery.

Day tripper

Traders can’t affect the news, but they certainly respond to it. When the news flow is rapid and concerns a historical event like the war in Ukraine, that responsiveness causes elevated volatility in markets. There is an unconscious temptation for investors to also be reactive to the news itself or the volatility it creates. Being overly reactive is not necessarily the best choice. Of course, it’s difficult in times such as these to take the medium or long-term view when markets round-trip in a day what often they only do in a month. It’s also tempting to come to conclusions about markets based on uncertainties around the big macro drivers – future economic growth, inflation and interest rates. The links between economic themes and precisely how they play out in markets is very nuanced and often not straightforward. Some people also like to say that markets are forward looking. That doesn’t mean they are correct about what is ahead, but it does mean that markets don’t always respond in a predictable way to real time information.


It helps for longer term investors to have a framework. My focus has always been on markets rather than individual stocks or bonds. A top-down approach to trying to understand the drivers and expected returns from the major asset classes and the markets within them. Hence, the starting point is always the macro outlook. That sets the narrative and also ensures that there is an understanding of how investors will respond to that narrative. If GDP growth forecasts are being revised down, as they are today, then equity analysts are also likely to cut their forward looking earnings-per-share numbers. The expected response in markets is then to be bearish on equities. Even if that doesn’t play out, macro expectations have to be priced in. Similarly, with policy expectations.

Bad moon rising

The current macro environment is tough. Forecasts are being cut and in our most recent quarterly review of the outlook with a selection of economists there was the first mention of recession. The ECB press conference this week also highlighted official reductions in growth forecasts and the US Federal Reserve (Fed) is likely to do the same in the coming week. It has been a long time since investors have had to contend with both inflation and weakening growth. The more dramatic commentators in the market have already dubbed this period as “stagflation” (they clearly don’t have the memory of sitting in the bath as a nine-year old in candlelight during one of the rolling 4-hour power cuts!) What it does mean is that central banks are constrained in their ability to “come to the rescue”. The number one song in heaven for central banks is inflation and the need to prevent a total loss of credibility. With inflation so high, it makes no sense for Europe to have a -0.5% policy rate. The ECB has to and will raise rates (I will leave the timing of those moves to others) and for most Europeans there is much more to worry about.

Get it done

The Fed is even stronger in its resolve to normalize policy. Interestingly, interest rate futures markets are starting to price in cuts in rates in the second half of 2023 with the peak in the Fed Funds rate and bond yields coming in at much lower levels than we saw in the last tightening cycle. But that does not negate the strong expectation of up-front interest rate increases. Clearly the conditions for growth in the US are not as powerful as they were in 2020 and 2021 but the emergence from COVID still brings with it some momentum, some possible shift in spending towards services and some purchasing power from accumulated savings and strong household balance sheets. Inflation and war on the news is not good for consumer confidence but the jobs market is roaring and people entering employment – as the participation rate improves – are doing so for wages that just were not there pre-the pandemic. Leaving aside global events, if the Fed raises rates to the extent that is currently priced in, I doubt the US has a recession.


However, the macro outlook is tough. The effects of the energy shock will be felt globally. There will be some negative wealth effects at the margin. Investment decisions might be delayed until the geo-political outlook becomes clearer. Supply chain disruption might remain a problem – particularly for European energy and commodity importers. The investment narrative will remain poor and there will be a tendency to think it will remain so, especially in the absence of the central bank put. It was fashionable a few years ago to talk about the “misery index” – the sum of the inflation and unemployment rates. This index is higher when there is stagflation. In the US it reached 10% last year. In the 1970s it printed in the 10%-20% range. Based on 2022 consensus forecasts, it will fall a little bit this year but will still be above recent annual averages. There is more economic misery around, mostly coming from inflation. However, there is no correlation between this and subsequent one-year ahead stock market returns. Moreover, misery could be worse if it was unemployment that was increasing as well as inflation. Thanks for not so small mercies.


The rating of global stock markets has already fallen to an extent that is consistent with previous recessions. Credit spreads – while not at shock and crisis levels – have spiked to levels indicating a degree of corporate stress is on the horizon. In the rates markets, yield curves are flat in a textbook recession-signalling way. All of these moves could extend in the short-term, especially if the macro-economic data starts to move in the direction of some of the more bearish expectations. I am not discounting the importance of the macro backdrop, but we also have to consider what has already happened to prices. Valuation is the next important pillar of any investment analysis.

It could be worse

I’ve said recently that based on a simple relative value model between stock markets and bonds, equities are arguably back to fair-value or below in many cases. The US remains the most highly valued but there has been a decline in forward earnings multiples of over four points since the peak in mid-2020. There is possibly more downside, especially if EPS forecasts are cut (they have not been so far) and/or if risk-free rates move up meaningfully above the current 2.0% level. To get a peak-to-trough move equivalent to those seen in the early 2000S (post and the 2007-2008 period (great financial crisis), we would need bond yields at 2.5% or above and S&P500 earnings-per-share estimates to come down a further 10% from here.   

There is upside

With that in mind it may be still too early to sound the all-clear on equities. Of course, an end to the war in Ukraine would turn sentiment around rapidly and would likely lead to better news on growth (and less need to cut earnings forecasts) and better news on inflation (lower energy prices). An end to the war would improve the macro score and considerably improve sentiment, against a backdrop of valuations having already improved. In the absence of that, however, we need to keep an eye on the bear-market gap.

Gimme credit

It might be a slightly different story in credit. Spreads have widened significantly over the last month or so. Credit has underperformed government bonds by around 2.5% in investment grade, 2.0% in US high yield and 3.5% in European high yield. Recession or low growth and rising default expectations are reflected in these new higher spread levels. When I look at the current “break-even spread” – the number of basis points spreads would have to widen from here to underperform the appropriate government bond benchmark – they are at levels today which, historically, have generated meaningfully positive excess returns in the year ahead (meaning credit outperforms government bonds). It is true in investment grade and in high yield. It might be painful in the short-term but credit (spreads) are flashing an early entry point.

Probe the put

I’ve discussed macro, valuation and sentiment as key drivers of forming an investment view. We also have to take into account technical factors. These are things that impact on the supply and demand (beyond the immediate economic influences), liquidity and market functioning. The biggest “technical” factor in recent years has been QE. Central banks want to reverse it. Can they and will they as global growth dips? A complete reversal of QE era central bank holdings of debt is unrealistic, so long-term real rates likely do not rise all the way back to the pre-GFC levels. That ultimately may mean the central bank put is still alive, just deeper out of the money right now, and that equity and credit performance will not plumb the depths of the bear markets of the past.


Meanwhile, beyond the war, inflation is the story and inflation-linked bonds remain the most obvious defensive asset class. Since the invasion, they have performed best and as inflation is to remain high for a good few months to come, the carry that investors will get from holding inflation linked bonds remains an important attraction.

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