Fidelity International is preparing its portfolios for a hard landing and positioning itself defensively in developed markets, especially the US and the UK.
A soft landing, or a painless economic slowdown that limits inflation and unemployment, is only given as a 5% probability by the investment house’s models, leaving a 95% chance of a recession.
The most likely scenario under this model is a cyclical recession (80% probability), with downside risks, especially in developed markets. Here, the extent of the monetary tightening carried out by central banks, now evolving into credit tightening, is enough for macro and strategic asset allocation head Salman Ahmed to be confident in his hard-landing base case.
“Monetary tightening is now morphing into credit tightening, which will take time to manifest itself, but is likely to do the Fed’s job. However, banks will have to signal higher for longer, because inflation remains sticky and global markets are tight, which means that banks will have little room to make a pivot in their narratives,” he said.
“The historical relationship between lending standards and credit growth speaks for a contraction in the next six to nine months, and that is consistent with a cyclical recession outcome. Over the next 12 months, we see an 80% chance that the Fed’s tightening will push the economy into a cyclical recession.”
The other possibility is a balance sheet recession, which has a “non-trivial probability” of around 15%.
“Historically, in the US economy, if unemployment rate has gone up to at least three percentage points, there have been serious recessions. What can cause this today is, for example, if sticky inflation and a resilient labour market keep the Fed hawkish and continue the separation between financial stability and price stability goals,” said Ahmed.
“Entering 2024 with very high rates will put pressures on balance sheets, as there's a lot of refinancing coming up from 2024 onwards in the corporate sector. The reason why we don't see blood on the street right now is because not a lot of people are refinancing.”
On this negative backdrop for developed markets (DMs), Eugene Philalithis, Fidelity’s head of multi-asset investment management, is turning to government bonds and emerging markets (EMs) instead. He is particularly cautious in the US equity space, where the concerns around bank stability is higher, albeit far from the levels of the 2008 global crisis.
“This is more of a macro, slow-moving picture of how credit will unfold and what that means for markets,” he said.
“In some ways, corporates are responding to the outlook by not investing and borrowing as much as before. If we see a slowdown in the economy and impact on labour markets, that will feed through to a negative outlook for credit in general and we'll start seeing risk aversion increase.”
Within portfolios, this translated into a desire to move up in quality, said the manager, whether that means quality in equities from an earnings perspective, from a safety or a defensive perspective.
For this reason, he’s underweight US equities but overweight treasuries and gilts too, as “the UK is probably in terms of a probability of recession, along with the US, at the highest level”. At the same time, he’s more bullish on emerging markets.
“One of the reasons we like EMs in general is due to our positive view on China. China is coming out of its zero-Covid policy and it's not going to be a straight line in terms of economic data, but we do think that markets will respond,” Philalithis said.
“And as we move from a valuation story to more of an earnings story, we will see that come through in terms of better performance for the China market and EM markets in general, especially if they're going to move first in terms of policy, given the inflation outlook there. Services are picking up too, so we prefer EM equities over DM equities.”
in credit, Fidelity is currently favouring investment grade over high yield, as investment grade is pricing in a worse outlook in terms of the economy.
“We also like EM local currency debt. There are some markets that have very high real yields, for example Brazil, which is at about 8% and South Africa as well,” said Philalithis.
“So investors can invest in these markets, see the inflation picture unfold and earn that carry, the real yield. This is especially true as interest rate volatility overall is expected to come down.”