At the start of March we increased our US duration short after bond yields rallied due to economic growth worries stemming from the conflict in Ukraine. Although government bond yields rose significantly in the second half of March, our negative view on core bonds is unaltered. On the basis that ‘peak’ inflation remains some way off we further increased our duration underweight in the second half of the month.
We reduced our remaining overweight to European stocks in early March. We felt markets were too optimistic about the potential for the EU to reduce its dependence on Russian energy. Moreover, earnings expectations for the region had been rising, despite greater growth and inflation worries, when we anticipated they would ultimately decline. Analysts were swift to increase earnings-per-share (EPS) estimates for commodity sectors while downgrades in other sectors will likely be slower to materialise. As a result, price-earnings ratios appeared better than they actually are.
We also took profits on our commodities overweight position, reverting to neutral. This move was a consequence of valuations rather than any change in our fundamental view per se.
Later in March we upgraded our position in emerging market (EM) equities via the MSCI China index. We already had an existing overweight to EM equities. The change was driven both by valuation and fundamental factors:
- Chinese equity valuations are extremely cheap – more than 1 standard deviation cheaper than global equities
– The fundamental ‘trigger’ came in mid-March with China Vice Premier Liu He’s ‘whatever it takes’ announcement and strongly coordinated policy response/communication. The announcement should unlock a potentially meaningful rerating, particularly for Chinese technology companies (see below for more detail).
We funded this overweight by selling down our remaining modest US equity exposure, taking profit 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 couple of weeks, shrugging off the US Federal Reserve’s (Fed’s) more hawkish commentary and a broader discount rate shock.
Finally, we decided to raise European credit, both high yield and investment grade, to favour. This was not a call on broader credit, or indeed European credit, but rather a move to seek more granularity for pure fixed-income mandates where we see European credit, on balance, as more attractive than US or emerging market credit.
Getting to neutral
In first quarter 2022, two main factors drove equity market volatility: A reassessment of the policy rate outlook in the US, and the war in Ukraine.
Initially, equities fell as real yields rose and multiples compressed. Once the earnings reporting season began, the focus returned to GDP growth still being positive. Then, with the outbreak of hostilities in Ukraine in late February, real yields fell well below where they had started the year. Equities followed suit on investor concerns about growth.
In the second half of March, worries about the war’s impact on economic growth (if not on inflation) eased somewhat on the possibility of a negotiated end to the conflict, leading to a relief rally. As the first quarter closed, 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 cash. Any challenge to that assumption, however, could swiftly turn markets back down.
Meanwhile, central banks have signalled that they are more concerned about the inflation outlook than they are about risks to growth from the conflict. As a result, monetary policy will tighten more – and sooner – than previously expected.
One might have anticipated that consequent rise in policy rate expectations would lead to a renewed decline in equity markets, as it had at the beginning of the year. So far, however, equities seem to be ignoring the threat. This may be because the policy rate outlook has not yet been entirely reflected in real yields as worries about Ukraine are still weighing on market sentiment (see Exhibit 1). In any event, we have used the surprising resilience of markets in this environment to take profits in our multi-asset portfolios. We did this most recently in US equities, which are heavily skewed towards long-duration technology companies and hence particularly vulnerable to higher discount rates. Valuations are comfortably above the 10-year median for both the S&P 500 and Nasdaq, and with more negative earnings yet to come, multiples are higher than they appear.
More broadly, financial conditions remain very loose. The Fed has belatedly acknowledged that they are in fact far too loose given the level of inflation and US economic capacity, but there is a limit to how fast the central bank can normalise. To judge by the most recent Fed ‘dot plot’, policy rates will return to above the Fed’s own estimate of neutral within the next couple of years. The risk to equities (alongside the risk of recession), should meaningfully increase only if the Fed needs to move further into restrictive territory in order to return inflation to its target. Though the recent inversion of the parts of the US yield curve has raised worries about an imminent recession, the signal is far from clear: Less than 15% of the US yield curve is currently inverted versus the 60% that tends to precede recessions.
In the meantime, the focus is on expectations for corporate earnings, particularly in Europe. Despite the economic growth environment being poorer than a month ago, aggregate EPS forecasts have not fallen. The upcoming earnings season will be highly important.
The jump in commodity prices stemming from the war in Ukraine will challenge earnings growth in Europe more than that in any other region. Even if, as one hopes, the situation improves soon, the pressures on prices will linger. While we do not anticipate a recession in Europe, higher inflation will nonetheless slow growth.
China stands out for us as a market where equity valuations are particularly attractive. Last year, emerging market equities deeply underperformed developed market (DM) equities. There were reasons for this: The post-lockdown reopening trade was patchier in emerging markets than in developed economies; EM policy, particularly monetary policy, was broadly tightening as DM continued to ease; and China ‘got tough’ on regulations in a highly unpredictable manner.
March’s coordinated policy turn — where senior Chinese policymakers announced a more measured regulatory focus, with some focus on asset prices — could be a game changer. This view of our multi-asset investment committee is shared by our strategy team and colleagues managing bottom-up equity portfolios. Although the longevity of the market opportunity is less clear given the variety of structural challenges China faces, the short-term opportunity is, on balance, attractive.
We also believe Chinese equities will perform better given the significant divergence in monetary policy. Markets anticipate policy rates rising by 250 basis points (bp) in the US, and by 100bp even in the eurozone over the next year. By contrast in China, they should rise by just 40bp. A combination of looser monetary policy, currently negative sentiment, and a strong earnings recovery could be a powerful driver of returns this year. We also favour Japan, where rates should be flat.
Any views expressed here 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 hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because 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 international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.