In early March, we increased our short duration in the US after bond yields rallied on concerns over economic growth stemming from the conflict in Ukraine. Although government bond yields rose significantly in the second half of March, our negative view on core bonds remains unchanged. Assuming that the “peak” of inflation is still far from being reached, we further increased our duration underweight during the second half of the month.
We reduced our residual overweight in European equities in early March. We felt that the markets were too optimistic about the possibility of the EU reducing its dependence on Russian energy. Additionally, earnings expectations for the region had risen, despite stronger growth and inflation concerns, when we expected them to eventually decline. Analysts were quick to raise earnings per share (EPS) estimates for the materials sectors, while downgrades in other sectors are likely to be slower to materialize. As a result, price/earnings ratios appeared better than they actually are.
We also took profits on our overweight position in commodities, returning to neutral. This move was a consequence of valuations rather than a change in our fundamental view per se.
Later in March, we added to our position in emerging market (EM) equities via the MSCI China Index. We already had an overweight in emerging equities. The change was driven by both valuation and fundamental factors:
– Valuations of Chinese stocks are extremely cheap – more than one standard deviation cheaper than global stocks
– The fundamental “trigger” came in mid-March with Chinese Vice Premier Liu He’s “whatever it takes” announcement and a strongly coordinated policy response/communication. The announcement should unlock a potentially significant revaluation, especially for Chinese tech companies (see below for more details).
We financed this overweight by selling our modest remaining exposure to US equities, taking profits after a strong rally. The S&P 500 was less than 6% below its all-time high and had gained almost 9% in the previous two weeks, ignoring more hawkish comments from the US Federal Reserve (Fed) and a broader shock to the rate discount.
Finally, we have decided to favor European credit, both high yield and investment grade. This was not a call for broader credit, or even European credit, but rather a search for more granularity for pure fixed income mandates where we consider European credit, as a whole, as more attractive than US or emerging market credit.
Go to neutral
In the first quarter of 2022, two main factors fueled equity market volatility: a reassessment of the outlook for key rates in the United States and the war in Ukraine.
Initially, stocks fell as real yields rose and multiples contracted. Once the earnings season started, the focus shifted back to GDP growth, which was still positive. Then, with the outbreak of hostilities in Ukraine at the end of February, real yields fell well below their level at the start of the year. Stocks followed suit on investor concerns about growth.
In the second half of March, concerns about the impact of the war on economic growth (if not inflation) eased somewhat on the possibility of a negotiated end to the conflict, leading to a resumption of relief. At the end of the first quarter, investors continued to count on an uninterrupted flow of Russian oil and natural gas to Europe. Europe needs Russian gas as much as Russia needs European liquidity. However, any questioning of this assumption could quickly send the markets back.
Meanwhile, central banks have signaled that they are more concerned about the inflation outlook than the risks to growth from the conflict. As a result, monetary policy will tighten more – and sooner – than expected.
We might have expected that the consequent rise in key rate expectations would lead to a further drop in the stock markets, as it had done at the start of the year. So far, however, actions seem to ignore the threat. This can be explained by the fact that the outlook for policy rates has not yet fully reflected in real yields, with concerns over Ukraine still weighing on market sentiment (see Chart 1). In any case, we took advantage of the markets’ surprising resilience in this environment to take profits in our multi-asset portfolios. We have done this more recently on US equities, which are heavily biased towards long-term tech companies and therefore particularly vulnerable to higher discount rates. Valuations are comfortably above the 10-year median for the S&P 500 and Nasdaq, and with more negative earnings to come, multiples are higher than they look.
More broadly, financial conditions remain very flexible. The Fed has belatedly acknowledged that they are in fact far too loose given the level of inflation and the economic capacity of the United States, but there is a limit to how quickly the central bank can normalize. Judging by the Fed’s latest ‘dot chart’, policy rates will move back above the Fed’s own neutral estimate over the next two years. The risk to equities (alongside the risk of recession) should only increase significantly if the Fed has to move further into restrictive territory in order to bring inflation back to its target. Although the recent inversion of parts of the US yield curve has raised concerns of an impending recession, the signal is far from clear: less than 15% of the US yield curve is currently inverted compared to the 60% that tend to precede recessions.
In the meantime, the focus is on corporate earnings expectations, particularly in Europe. Although the economic growth environment is less favorable than a month ago, aggregate EPS forecasts have not declined. The next earnings season will be very important.
The spike in commodity prices resulting from the war in Ukraine will test earnings growth in Europe more than in any other region. Even if, as hoped, the situation improves soon, price pressures will persist. Although we do not expect a recession in Europe, rising inflation will nevertheless slow growth.
China stands out for us as a market where equity valuations are particularly attractive. Last year, emerging market stocks significantly underperformed developed market (DM) stocks. There were reasons for this: trade after the reopening of the lockdown was more unequal in emerging markets than in developed economies; Emerging market politics, especially monetary policy, tightened overall as the DM continued to ease; and China has “tightened” regulations in very unpredictable ways.
The coordinated policy shift in March – where senior Chinese politicians announced a more measured regulatory stance, with some focus on asset prices – could be a game-changer. This vision of our multi-asset investment committee is shared by our strategy team and our colleagues managing bottom-up equity portfolios. Although the longevity of the market opportunity is less clear given the variety of structural challenges facing China, the short-term opportunity is, overall, attractive.
We also think Chinese equities will fare better given the significant divergence in monetary policy. Markets expect policy rates to rise by 250 basis points (bps) in the United States and by 100 bps even in the eurozone over the next year. In China, on the other hand, they should only increase by 40bp. The combination of looser monetary policy, currently negative sentiment and a strong earnings recovery could be a powerful driver of performance this year. We also favor Japan, where rates should be stable.
All opinions expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may have different views and make different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income from them can go down as well as up and investors may not get back their initial investment. Past performance does not guarantee future returns.
Investing in emerging markets, or in specialized or restricted sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of developed international markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds investing in emerging markets may involve greater risk.