Positioning for a “pricey” recession scenario

In last week’s blog post, we tackled one of the most pressing questions being debated within the investment community these days: recession risk. Our take was (and still is) that the global economy appears to be on the cusp of what we’re calling a “pricey” recession, which could be markedly different in some ways from past recessionary periods. In this follow-up piece, we share our thoughts on how investors might position for the potential recession scenario we described last week.

Five positioning ideas

1. Tactically trade select global interest-rate markets. Some countries’ yield curves could further flatten (or even invert in certain instances) in the short term until major global central banks begin to slow their monetary policy tightening trajectories, including the paces at which they continue to hike interest rates in the battle against inflation. It will be difficult for markets to price terminal interest rates higher if/when central banks keep hiking rates into more “recession-like” economic conditions. With that challenge in mind, look for investment opportunities to position for steeper global yield curves and potentially weaker currencies in countries that seem to be facing a worsening growth/inflation trade-off in the months ahead.
   
   
2. Exploit country divergences in core vs peripheral European countries. Going forward, the market is likely to test the European Central Bank (ECB) on its willingness to deploy its new “anti-fragmentation” tool, designed (as the term implies) to combat so-called financial “fragmentation” among eurozone countries. The region is also grappling with the very real risk of a complete loss of Russian gas supplies for the coming winter. Russia has historically been the European Union’s (EU’s) leading supplier of all the primary energy commodities; however, Europe is now racing to secure new energy sources. The EU nations’ different energy and import mixes create vastly divergent country-specific energy dependencies on Russia. Further Russian energy disruption would exacerbate negative supply shocks and result in much higher inflation for the region.
   
   
3. Focus on policy convergence amid transition from inflation concerns to recession fears. In an environment of rising geopolitical risk, we believe the Japanese yen (JPY) looks attractive relative to other global currencies, especially if there is further narrowing in the monetary policy differential between the Bank of Japan (BOJ) and other major central banks amid increasing signs of a global growth slowdown. The BOJ has recently reinforced its position as a policy “outlier” among the G10 central banks, stating that it currently has no intention of hiking its policy rate — a stance that has contributed to the JPY’s underperformance so far this year. However, we suspect the macro backdrop for the JPY could change for the better in the latter months of 2022 and beyond.
   
   
4. Look at capital flows and business investment reorientation. We think the currencies of some commodity-exporting countries are likely to prove resilient versus the US dollar over the medium term, driven by ongoing global supply shortages. That being said, we are also wary of mounting global recession signals that could lead to sharp declines in select currencies over the shorter term. We suggest a defensive bias in Asia ex-Japan currencies at this time, given rising geopolitical tensions and developed-market consumption patterns shifting from goods to services. Seek to capitalize on potential performance dispersions between favorable trade-oriented and commodity exporters versus importers based on geographical proximity, geopolitical considerations, and so-called “friend-shoring” (aimed at insulating global supply chains from external shocks or disruptions).
   
   
5. Rethink your credit allocation: This year will mark the first time in recent history that the major global central banks are, in aggregate, effectively net sellers of assets — with material implications for both government bond yields and credit spreads. In this new environment, we expect the volatility of global credit assets to increase, making agility ever more important to identifying and exploiting cyclical inflection points in pursuit of outperformance. More volatile markets should also lead to greater dispersion among credit sectors and individual issuers, potentially providing compelling opportunities to add value from idiosyncratic security selection. To gain exposure to higher-yielding, diversified yield/income solutions in public markets, partner with investment managers that are skilled in sector rotation and/or relative value, as well as in bottom-up security selection.

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