CIO spring update: Stress test

During the passage from winter to spring, markets have continued to be swayed by the same drama that dominated investor attention in 2022: central bankers’ high-stakes efforts to rein in inflation, without sabotaging financial stability.

Episodes such as last year’s gilt market volatility and this year’s banking sector turbulence underscore the perilous nature of this balancing act. Indeed, the removal of unprecedented levels of monetary stimulus has proved to be a global stress test for financial markets.

In our latest outlook, teams from across LGIM examine what this means for the world economy, asset classes and a variety of investment capabilities. Key points include:

• Tightening credit conditions lead us to expect global growth to fall short of consensus estimates
• The US debt ceiling impasse might pose the next test for markets
• We don’t view the banking woes as a re-run of the global financial crisis, even as the most leveraged corporates face refinancing risk
• Some sectors in commercial real estate may prove surprisingly resilient

We also look at how defined benefit (DB) pension schemes – which were in the eye of the market storm last autumn – are now preparing for the endgame.

Entry points

In recent publications, from our 2023 outlook to our regular podcasts, we have stressed that bouts of volatility are probably the only constant that investors can expect this year. These have generated, and will continue to create, tactical opportunities.

But given our dim view on the macro outlook, we retain an overall bearish stance on risk assets. With inflation likely to prove stickier than hoped, and the crude tool of interest rate increases operating with a distinct lag, corporate earnings are likely to suffer in the ensuing slowdown – regardless of whether the economic landing is ‘soft’ or ‘hard’.

That’s why we continue to believe there will be better entry points to risk assets for investors later this year.

Geopolitics and climate change

Looking further ahead, the pandemic and Russia’s invasion of Ukraine have accelerated two key trends that we expect to shape the investment landscape over the coming years.

The first has been the shift to a multipolar world, which threatens to undermine the benefits of globalisation that have been reaped over the last thirty years. The second is the growing appetite to secure reliable energy sources – at the same time as transitioning to a low-carbon world.

Our latest research suggests that this transition has become more affordable, but we need to boost investment significantly to achieve net-zero carbon emissions by 2050. In this spring update, we highlight the vital role that metals and minerals will need to play.

Goodbye, easy money

Drawing all this together, we think markets face a world of lower growth, higher inflation, structurally higher bond yields and lower equity returns – absent a productivity miracle (with the adoption of AI technology an obvious candidate).

As such, we believe investors need a mindset shift away from chasing asset appreciation in a world of easy money. Rather, we should focus on allocating capital to companies that advance the global energy transition, re-shore production, provide stable supply chains and bolster global security.

And if we do not see a return to easy liquidity and low inflation in the near or even medium term, at least the resultant higher bond yields mean that fixed income investors may expect a return that’s higher than long-term inflation expectations. Moreover, unlike in 2022, bonds should provide multi-asset portfolios with a performance cushion when recession risk grows.

As a result, we think diversification will remain an important part of investors’ toolkit in the coming years – both during this current stress test for markets, and in its aftermath.

Read our full CIO Outlook.