MEDIA RELEASE: As central banks remain hawkish on the back of persistent inflationary pressure, the likelihood of a soft landing is falling, in contrast to some parts of the market which are moving into overbought territory. With financial markets oscillating between resilience and fragility, investors should consider lowering overall risk appetite while taking both tactical and strategic advantage of undervalued opportunities in the emerging world, according to Fidelity International’s third quarter 2023 investment outlook.

“For the last year, my colleagues and I have been trying to navigate our way through the ‘polycrisis’ – a confluence of pressures which we believe could force central banks into overtightening and trigger sharp recessions”, says Andrew McCaffery, global chief investment officer, Fidelity International. “That polycrisis has now left markets oscillating between resilience and fragility: still abundant liquidity and tight labour markets on the one hand, and the lagged effects of policy and tightening lending standards on the other.”

Andrew McCaffery highlights the three trends expected to dominate the markets as we enter Q3 2023:

Resilience now, fragility later

“The ‘best flagged recession in history’ still isn’t upon us. Excess savings accrued during the pandemic, as well as continued tightness in labour markets, mean that financial conditions are taking longer than expected to bite. But that recession will come when the lagged effects of policies eventually take hold. Resilience now is sowing the seeds for fragility down the line.

“A cyclical recession, in which unemployment in the US rises to around five per cent over the next 12 months, is the most likely outcome. A soft landing now looks highly unlikely, in our view.

“It is time for investors to be more proactive and capture mispriced equity valuations. Some scenarios priced into markets in terms of valuations are extreme. With the US and Europe having already seen strong gains as central banks become more hawkish again, this backdrop looks attractive for parts of the emerging world, particularly in relative value terms.

“From an asset allocation perspective, I think investors should be wary of taking on too much risk at this late stage of the cycle. Here, Investment grade credit provides yield and flexibility.

The long game in China

“After a bumper start, China’s rebound since the end of its zero-Covid policy is underwhelming investors. Earnings estimates are on a downward path, youth unemployment is at record highs, and Chinese consumers haven’t resumed their zeal for spending.

“This does not mean China’s rebound has run its course. It is perhaps no surprise that consumer confidence is muted after three years of severe restrictions. And there are positives elsewhere, including accommodative monetary – which is being eased again – and fiscal policies and an improving regulatory backdrop. Further stimulus measures may arrive soon. Meanwhile, the disconnect between the market’s expectation and the reality of the recovery has left Chinese equities trading at a significant discount.

“While it may feel like China has taken two steps back, the next move could be three forward. This may feel slightly contrarian at present, but it is an attractive entry point, especially as there are some signs of stabilisation in the US/China relationship.

“In Asia more broadly, Japan’s long-term trend of improving governance has been beneficial. Buyback activity has improved and there is now a better focus on return on equity. On a structural basis, the market looks much more interesting than it has been in recent decades, although we are mindful it has also already performed very well so far this year.

Corporate sentiment stabilising

“Our analysts had observed the mood at the companies’ they follow worsening earlier in the year, prompting us to ask whether corporate sentiment was merely resting, or stalling. An uptick in June suggests the former, especially as a full-blown financial sector meltdown seems to have been averted.

“Nevertheless, we view improving corporate management sentiment as a possible sign of complacency given the policy lags. Persistently high wage cost pressures throughout developed markets suggest that central banks are far from done, even if non-labour costs are likely to turn disinflationary this quarter. We will be monitoring closely how the sentiment and price trends, at both input and pass on to customers, evolves in the next few months.”

Fidelity International’s full Q3 2023 investment outlook