A key debate about the stock market concerns the likelihood and proximity of a US recession. Equity bears think an end to the expansion is imminent. Bulls expect a substantial rebound in the stock market so long as the economy avoids such a negative scenario. “I disagree with both camps”, says Evan Brown, head multi-asset at UBS Asset Management in his latest Macro Monthly.
“It is unlikely the US enters a recession within the next year – but even so, I continue to find equities unattractive at the index level”, says Brown. “Market pricing of recession risk is more likely to increase rather than decrease from here, and still expensive valuations do not provide adequate compensation for the downside risks to activity and earnings. For asset allocation purposes, this sequencing is critical: Before investors can position for economic resilience, it is first appropriate to position for a growth scare.”
Historically, according to Brown, risk assets have not troughed until there is a positive inflection in manufacturing purchasing managers’ indexes or there has been a dovish pivot from the Federal Reserve. “Neither catalyst is imminent, in our view. The sharp tightening in financial conditions year-to-date is consistent with below trend growth later this calendar year. And even if inflation decelerates, it will likely remain elevated, making it difficult for the Fed to pivot in a less hawkish direction.”
Brown finds the environment for asset allocation challenging. “Investors are likely to continue to take a glass-half empty view of economic developments in the near term – not distinguishing between deceleration and an outright downturn. It is optimal to trade that path before we trade the destination. That means staying underweight stocks, where health care is our preferred defensive sector.”
Selectively embracing cyclicality, particularly in commodities and energy equities, is a smart thing to do, finds Brown. “If consumer demand holds up, oil prices are likely to remain firm. And if energy markets suffer additional negative supply shocks, we believe that spending on other more discretionary items is likely to come under more pressure than fuel – a development already cited by several major retailers on their first-quarter earnings calls.”
The most attractive investment to play for an unexpected increase in global economic momentum is Chinese risk assets, finds Brown. “Markets are cheap, and unlike other major economies, policy is easing rather than tightening. Of the three largest headwinds we see for markets this year (aggressive Fed tightening, Russian invasion, and Chinese activity), we believe this final one is the most likely to be first to turn into a tailwind.”