Stagflation, reflation, soft landing or meltdown — what Wall Street expects in the second half of 2022

As the first half of 2022 draws to a close, Wall Street investment banks and their legions of strategists have been busy telling clients what to expect in the second half of what has been a extraordinary year for the markets as US equities head for their worst start in decades.

Investment banks like JP Morgan Chase & Co. JPM,
+2.98%,
BarclaysBCS,
+3.66%,
UBS UBS Group,
+6.59%,
Citigroup Inc. C,
+3.26%
and others have released over the past week or two their outlook on what investors should expect in the second half. MarketWatch has some of the strengths – with one theme that unites them: uncertainty.

This is largely because the markets will depend on Federal Reserve policy. With the authorities signaling their intention to remain data dependent, the stance of monetary policy will inevitably depend on inflation developments over the coming months.

Another thing many banks agreed on was that a US recession in the second half of the year seemed unlikely – or at the very least, not in their base case.

Here are some other highlights.

Stagflation, reflation, soft landing or slump?

The UBS team divided its outlook into four scenarios: “stagflation”, “reflation”, “soft landing” or “collapse”, and described what the reaction of stocks and bonds could look like in each case.

Their best-case scenario for equities would be either a “soft landing” or a “reflation,” but in either case, investors would see inflationary pressures ease as the US economy avoids a recession. In the “stagflation” scenario, stubborn inflation and tepid growth would drag both stocks and bonds lower, essentially marking a continuation of the trading patterns seen so far this year, where bonds and stocks were beaten.

Their worst-case scenario for equities would be the economic “slump,” which would likely involve a recession severe enough to cause a dramatic change in expectations for corporate earnings. However, in this scenario, the UBS team expects the growth shock to force the Federal Reserve to consider cutting interest rates more quickly.

The outlook for equities and bonds in the second half will depend on the economic backdrop. SOURCE: UBS

Mark Haefele, chief investment officer at UBS, said in the mid-year outlook that “there are a lot of potential outcomes for the markets, and the only virtual certainty is that the path to the end of the year will be volatile”. This can seem overwhelming for investors considering how to position their portfolios. »

Opportunity in investment grade bonds

One of the most frustrating aspects of the year so far – at least for individual investors – is the scarcity of investment strategies producing positive returns. Commodities performed well and any investor fearless enough to bet against equities or invest in volatility-related products likely made money. But investors who subscribe to the 60/40 portfolio rules have been beset by losses in their stock and bond portfolios.

How could investors guard against this in the future? Citigroup Chief Investment Officer David Bailin shared some thoughts on this in “Investing in the Afterglow of a Boom,” Citi Global Wealth Investment’s mid-year outlook.

As negative real rates weigh on equities, while undermining bond yields, Citi presents investment-grade bonds as something of a middle ground.

“Our view is that most of the expected tightening in the US is now priced into Treasury yields. We believe it is possible that rates will peak this year as US GDP growth decelerates rapidly. In turn, this will likely lead to lower inflation readings, perhaps
allowing the Fed to soften its hawkish stance. For investors, these higher yields may represent an attractive level to buy. We believe certain fixed income assets now offer an ‘antidote’ to the ‘money thief’, given their higher yields,” the team said.

The largest corporate bond exchange-traded funds ended the week higher, but with the big iShares iBoxx $Investment Grade Corporate Bond ET LQD,
+0.12%
still 16.9% lower than the year so far. The SPDR Bloomberg High Yield Bond ETF JNK,
+0.67%
was down 15.7% on the year and iShares iBoxx $ High Yield Corporate Bond ETF HYG,
+0.71%
was down 13.8%, according to FactSet.

Lily: Investment-grade U.S. corporate bond funds and ETFs suffer largest weekly outflows of the year

The S&P 500 SPX index,
+3.06%
closed higher on Friday as stocks rallied, but was still down 17.9% on the year. The Dow Jones Industrial Average DJIA,
+2.68%
was down 13.3% and the Nasdaq Composite Index COMP,
+3.34%
was 25.8% lower so far in 2022, according to FactSet data.

Stocks rebound in the second half

JP Morgan Global Research has carved out a position as one of the most bullish research centers on Wall Street. The bank’s equity strategists’ mid-year outlook was hardly an exception.

Put simply, the JP Morgan team recommends buying cyclicals and avoiding defensive stocks, arguing that cyclicals like the energy sector are more attractive right now. The team also sees opportunities in small caps and growth stocks.

Defensive stocks such as utilities and consumer staples are not as attractive as their growth counterparts. SOURCE: JMP

Defensive stocks like consumer staples and utilities, on the other hand, present less opportunity and more risk.

“…[T]These sectors remain crowded with a record relative valuation that we see as vulnerable to rotation in a scenario of a return to mid-cycle recovery and growth…and recession.

See: ‘Cyclical growth’ could drive 10% ‘relief rally’ for S&P 500 this summer, says Stifel’s Barry Bannister

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