A bear market rally? Or not?

Equity and credit markets have been cheered of late. Better US employment, a decent second quarter corporate earnings season and the Federal Reserve (Fed) hinting that it was monitoring downside economic risks, suggestive of a possible softening in hawkish rhetoric, have all been cited as reasons why.

We prefer stretched positioning and cheap valuations at the end of the first half as the most likely explanations. It’s only taken a modest catalyst to trigger a market bounce.

The consensus opinion among investors is that it’s a bear market rally and will soon fade. While that may be the case, it suggests that many are still cautiously positioned, and the ‘pain trade’ is a further rally in equities and credit.

Bond yields have fallen during the rally, reversing the trend of the first half of the year and boosting total returns for fixed income asset classes. This has helped stem credit outflows for now.

A dip in US headline inflation could fuel the rally further

For the US, we think the risk asset rally could continue a little longer if a dip in headline inflation allows the Fed to reduce its tightening pace in the second half of this year. We worry that declining nominal GDP growth will undermine corporate profitability, but this will likely only happen towards the middle of next year, and equity investors don’t usually consider events like this so far in advance.

Indeed, we think it will be hard to disprove the potential for a soft landing in the near term. The situation is more difficult in Europe where there is heightened recession risk in 2022, while central banks continue to tighten policy in the face of elevated inflation.

The fiscal response is mixed, but unlikely to be a game changer in the near term, in our view. The UK potentially risks adding fuel to the inflation fire, while the European Central Bank appears to have a tighter control of government finances given the conditionality of the Transition Protection Instrument bond-buying support programme.

The US could struggle to provide pre-emptive fiscal support given the upcoming election but would presumably act under a severe economic downturn.

Keep an eye on China’s fiscal policy response

We see China’s fiscal policy as possibly the most important in the near term. The autumn Party Congress is a potential catalyst for this, as well as changes to the country’s zero-COVID policy, but there have been no indications of any changes yet. Watch this space.

In sum, we think the current equity and credit market recovery could continue over the summer, driven by hopes of a US soft landing as headline inflation reduces. But we believe momentum might fade as valuations become less attractive. In addition, downside growth risks in Europe and policy inertia in China could also weigh on sentiment. We therefore have a bias to sell into this strength, preparing ourselves for a more difficult market backdrop towards the end of the year as the likely US recession approaches.