investment insights
Markets at an important crossroads
The first five months of the year have been challenging for investors. In a marked turnaround from the constructive 2021 market conditions, 2022 so far represents the worst start, in terms of performance, for both equities and fixed income markets, in at least 30 years. So a fair question is: what changed – and what happens from here?
We went into the year with the expectation that growth was going to slow down somewhat from exceptional levels and that the inflation spike was being led by mostly temporary post-pandemic supply constraints in the context of very strong demand. Together, that was consistent with the start of monetary policy normalisation, particularly in the US, with market consensus pricing in three interest rate hikes by the Federal Reserve in 2022. Corporate earnings were strong and margins solid despite the hiccups to production.
Russia’s invasion of Ukraine and China’s commitment to its zero-Covid policy likely have something to do with the change in sentiment, as both help feed concerns around slower growth and stickier inflation. The Fed, in turn, has made clear its intention to rein in inflation having achieved full employment. It has pivoted decisively in a hawkish direction as a result, with 150 bps of rate hikes so far. We now foresee rates peaking around 3.6% this cycle. Other central banks are following suit. Interest rates have fast reflected this new scenario, with over 160 bps of increases in the yield of 10-year US Treasuries and the equivalent German bunds.
The aggressive move higher in interest rates had knock-on implications across a range of assets, with high-growth, high-valuation stocks a prime target. Credit spreads also widened, though not aggressively, but losses from interest rate exposures meant corporate bonds still imposed significant losses on investors. The US dollar has been one of the few beneficiaries of market moves, strengthening strongly versus most other currencies.
Looking forward, markets feel at an important crossroads. The initial driver of the negative returns, via tightening of financial conditions (higher interest rates), feels somewhat closer to an end. However, concerns have morphed from inflation towards growth, the rising risk of a recession and the potential for a significant slowdown in corporate earnings.
Our base case is that despite the slowdown in growth the global economy will avoid a recession this year, but that a mild downturn could be ahead in 2023. Similarly, we expect corporate margins to remain elevated – even if they have peaked – and earnings growth to remain positive though miss what is now, in our view, too optimistic a consensus forecast.
Meanwhile, market sentiment has turned negative, although investor de-risking of portfolios is following with a lag. We believe we will need to see decisive signs of US inflation peaking and rolling over – including in ‘core’ measures for services – before we see meaningful, sustained improvement in risk appetite.
With these elements in mind, our portfolio positioning is broadly balanced, reflecting a cautious approach. We recommend a mix of growth-oriented and interest rate sensitive assets. Value-oriented and defensive stocks feature among the former, while investment grade corporate bonds feature increasingly among the latter. We round this off with various portfolio diversifiers, and focus on relative value opportunities within asset classes.
In equities, global indexes have been on the back foot since hitting new highs early in 2022. Valuations have adjusted lower to reflect a higher cost of capital, which explains part of the move, as do increasing concerns around the health of the consumer in a context of high and persistent inflation. Meanwhile, earnings have continued to grow strongly in Q1, but investors have heavily penalised earnings misses or disappointing guidance. Broader earnings disappointment or real rates repricing higher represent risks to the outlook.
Value stocks and the UK market have been more insulated from recent declines, and we think both segments could remain well supported going forward, benefiting among other things from higher commodity prices. We maintain our exposures here as well as in selected defensive names, particularly in the healthcare and utilities sectors. We have reduced exposure to small cap names as well as European and emerging market (EM) stocks outside of China. While EM equity valuations remain attractive versus other regions, the outlook has deteriorated, given the backdrop of a stronger US dollar, high inflation and tighter financial conditions that should weigh on growth and earnings. Meanwhile, Chinese equities have underperformed their emerging market peers over the last year, significantly narrowing the valuation gap. We believe this trend could reverse if Chinese authorities’ Covid management shows stronger signs of success, or policy stimulus reverses the credit contraction, and boosts growth and earnings prospects. China is among only a handful of EMs to be cutting rather than raising rates, and at current levels, risks around Chinese equities may be skewed to the upside.
After starting the year decidedly cautious on fixed income, we have gradually turned more constructive on the asset class, as a result of the rapid and significant repricing of interest rates and widening corporate credit spreads. Fixed income markets have now anticipated a large part of the upcoming US rate hikes. Similar dynamics are evident in Europe, where despite there being no change to negative policy rates by the European Central Bank, German bunds with maturities of two years or more now offer positive yields (while maturities up to 20 years had a yield of zero or lower back in December 2021).
Similarly, with credit spreads having widened as a result of the more uncertain outlook, all-in yields for global investment grade credit are the highest they have been in over a decade. We have thus started reducing our longstanding underweight to this segment as risk-reward improves. We prefer investment grade bonds to high yield for now, as the former is less at risk from a potential deterioration in the economic outlook, and from corporate defaults.
In emerging markets, we maintain a rather neutral stance overall but see selective opportunities in Brazilian government bonds, where the interest rate cycle is advanced, yields look attractive, and the currency benefits from positive terms of trade given strength in commodity prices. Our less negative stance does not extend to all segments, and we have now closed our longstanding preference for Chinese government bonds, where we are now modestly underweight. Here, the interest rate differential with equivalent US government bonds no longer favours China and the outlook for the renminbi is more mixed given still-strong pressures on growth.
We see selective opportunities in Brazilian government bonds, where the interest rate cycle is advanced, yields look attractive, and the currency benefits from positive terms of trade given strength in commodity prices.
Incurrencies, radical shifts in monetary policy and general uncertainty have propelled the US dollar to 20-year highs, appreciating broadly against most currencies, and arguably faster than we anticipated. From here, the pace of gains could moderate, but we retain a USD bias, reflecting our theme of tightening global liquidity and moderating global growth, but also a likely prolonged Russia-Ukraine conflict. Having some long USD exposure may provide a cushion to portfolios. While the renminbi (RMB) has been extremely stable over Q1, USDRMB has since risen sharply, while seeing little pushback from the Chinese authorities. We remain cautious here and in the broader EM currency complex.
Commodities have been a standout performer this year and an area of activity in portfolios. We remain underweight gold, which has seen mixed impulses from increased inflation and market uncertainty on the one hand, versus normalising real interest rates and a strong dollar on the other. Given supply disruptions to a number of commodities (many of which are linked to the Russia-Ukraine conflict) in the context of still strong demand, we continue to see value in holding a broad basket of commodities for diversification benefits.
Along similar lines, we find macro strategies in the hedge fund space attractive in the current context. These types of strategies have historically been able to benefit from rising interest rates, higher market volatility and generally higher differentiation across assets’ returns. They display low correlation to other asset classes, which we expect to remain helpful for portfolios as we progress through the cycle.
Overall, our investment positioning remains broadly balanced, with an underweight in fixed income, a neutral position in equities – with options strategies on major indices to help cushion portfolios from downside risks – and overweight positions in real estate, the USD and a broad basket of commodities as portfolio diversifiers.
To read our full second half 2022 outlook, with asset class views and macroeconomic forecasts, please click on the pdf in the top right-hand corner of the screen.
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