Between a Rock and a Hard Place
May 10, 2022

So far, 2022 has not been a good year for investors. All at once, slowing growth, surging inflation, monetary tightening, high energy prices, lockdowns in China, and a war in Europe have been thrown at them.

It is not so much the rising bond yield that surprised markets but a confluence of factors that made bond yields rise much faster than expected. 

Specifically, bond yields are rising while the Fed Funds Rate is still only at 0.75%, and even though the Fed says they will continue raising, that is still to be seen. It wouldn’t be the first time they change their mind.

The combination of tightening monetary policy by the Fed, with higher energy and commodity prices caused by the war, and the unclear impact of lockdowns in China on the global supply chain have made the market fearful of much higher inflation going forward (from the current already high levels).

Equities are a real asset and, theoretically, should not be affected by inflation as sales and earnings growth are reported in nominal terms, and underlying economic growth is, by far, more important than inflation. 

Of course, the reality is often different from theory, and businesses hate very high inflation. Not only do they have difficulty budgeting and planning, but they are also often not able to convert sales growth into earnings growth, i.e., their costs may grow faster than their revenues.

In addition, high inflation typically leads to hawkish central banks and rising interest rates. Hence, on balance, while moderate inflation is good for equities, very high inflation is usually bad news. As inflation climbs beyond tolerable levels, equity returns decline as multiples contract in anticipation of lower earnings and higher discount rates. 

Where to from here?

Fewer pandemic-related disruptions, and hopefully a stabilization in the situation in Ukraine, could set the stage for sharply lower inflation and a revival in global growth in the second half of this year.

When it comes to inflation, it is both the level of inflation and the direction of change that matter. While, overall, high inflation is bad for equities, it is necessary to differentiate between “inflation high and rising” and “inflation high and falling” regimes. We do anticipate a rebound in equities once the tighter monetary regime is priced in, and inflation shows signs of abating.

Unfortunately, in the current environment, there are not many places to hide. Fixed income has been even harder hit than equities with the price of U.S. Treasuries down 14% since the start of the year. Municipal bonds, which are popular as a tax-efficient investment for Americans, are down more than 20%.

Only commodities are showing positive performance and we remain positive on holding commodities as part of a diversified portfolio. 

The financial market sell-off intensified in April, testing again the March lows, but not much further. Except for the US dollar, all global financial assets performed poorly, and so far, May has not seen a change in direction. Despite the higher volatility, the S&P 500 as we write this is only ~4% below its March 8 low, which happened at the height of Russia/Ukraine concerns.

U.S. stocks led global equity indices lower. Japanese stocks also underperformed their global peers, diverging from their historically inverse relationship with the yen, which collapsed in April. 

High inflation is often accompanied by rising rates because strong economic growth leads to imminent monetary tightening, which aims to soften growth and combat inflation. As a result, high inflation comes hand in hand with elevated risk aversion and the repricing of growth sectors, as evidenced by the sharp sell-off in tech stocks globally.

Unlike developed markets, Chinese stocks benefited on a relative basis from a late-month rally due to expectations of an easing policy and regulatory environment. However, it remains to be seen if these policy pledges are sufficient to lift the economy. 

Brighter Days Ahead

Things should improve in the second half of the year. We believe that inflation will come down, potentially more than what markets are currently discounting. Global growth will reaccelerate as pandemic headwinds disappear. The return of a ‘Goldilocks’ scenario of economic growth with falling inflation will allow the Fed and other central banks to temper their hawkish rhetoric, helping to support equity prices while restraining bond yields.

The latest employment numbers in the U.S. are encouraging. The number of new jobs keeps growing at a higher than expected rate, while wage growth is solid but not accelerating. More importantly, the unemployment rate went up slightly, which is a sign that more people are entering the workforce. This is a sign of a healthy underlying economy.

Also, the outlook for U.S. consumption and investment remains robust. Although consumer confidence has deteriorated, consumption remains resilient which reflects the lagging impact of pandemic stimulus measures. Meanwhile, U.S. businesses are signaling that they intend to increase capex. In fact, the Atlanta Fed GDPNow forecast for Q2 is already starting to trend up.

We find that, despite being a real asset, equity performance deteriorates when inflation is on the rise. However, once inflation goes past its peak, historically the equity market rebounds. The market is currently in a “high inflation and rising rates” regime but is about to transition to the “inflation is high but falling” regime, and today’s winners may turn into tomorrow’s losers. The new winners are likely to be the Financials, Consumer Discretionary, and Technology sectors.

We ultimately expect the impact of current headwinds to fade and give way to a leg up in stocks in the second half of the year. This improvement in the performance of risk assets will also benefit the price of cryptocurrencies, which have become increasingly correlated with the direction of equities.

Peak Inflation

The recent sell-off in markets was caused by fears of ever-rising inflation. The war in Ukraine could continue to generate supply disruptions over the coming months. The Covid outbreak in China could also play havoc with the global supply chain.

Nevertheless, the peak in inflation has probably been reached in the U.S. For one thing, base effects will push down year-over-year inflation. Monthly core CPI growth rates were 0.86% in April, 0.75% in May, and 0.80% in June of 2021. In contrast, March 2022 saw monthly core CPI of 0.32%. The exceptionally high 2021 prints will fall out of the 12-month average during the next few months.
More importantly, goods inflation will soften as spending shifts back toward services. Core goods prices fell in March for the first time since February 2021.

Fewer pandemic-related disruptions in the U.S. and China, and hopefully a stabilization in the situation in Ukraine, could set the stage for sharply lower inflation and a revival in global growth in the second half of this year.

In addition, aggressive monetary policy is likely to slow economic growth and demand for labor further. With all of that, inflation will trend down, and it could reach 3-4% later this year, which will be less of a concern for companies and central banks.

As we transition into the “inflation is above 3.5% but falling” regime, equity returns are likely to normalize. We do anticipate a rebound in equities once the tighter monetary regime is priced in and inflation starts to show signs of slowing down. In fact, nearly every Fed tightening regime has been characterized by equity weakness in the first few months of tightening only to see an upward trend resuming within 12 months.

For now, investors should remain invested in stocks as we expect to see positive returns over a 6- to 12-month time horizon. Within a global equity allocation, we recommend that investors maintain a neutral regional stance. The larger risk of a recession in Europe than in the U.S. would normally imply that investors should be overweight U.S. stocks, but Euro area stocks have already underperformed global stocks significantly since Russia’s invasion of Ukraine.

Chinese Stocks Rally On Policy Guidance

Chinese tech stocks outperformed in recent weeks, following the Politburo’s softening rhetoric on the technology regulation campaign and its pledge to support the growth of platform companies. More broadly, the statement also noted that the government will step up support for the economy going forward.

While an easing regulatory and policy environment offers Chinese tech stocks a reprieve, significant hurdles will limit their potential further upside. Domestic consumption remains weak, the housing market is sluggish, the online retail sector is saturated and Chinese stocks continue to face the risk of being delisted from foreign exchanges.

The announcement of new infrastructure spending projects is a positive first step but the plan lacks specifics and is likely not sufficient to make a real difference in economic growth. What the Chinese economy needs right now is an impulse in credit creation to support the real estate market and increase consumer spending.

We think the Chinese stock market will need to see more specific fiscal economic support measures coupled with much more stimulative monetary policy before its negative sentiment can turn around.

Fixed Income

Global bond markets were once again the top underperformers as bond yields are rising much faster than the market was anticipating. As an illustration, some of the longest dated fixed income ETFs are down 25-30% this year.  This is worse than any equity market.

Given the fact that higher bond yields start to hurt stock and real estate prices, combined with potentially lower inflation going forward, we think the Fed will be less aggressive than the market now fears.

Therefore, we do not expect bond yields to rise much further this year. With 10Y U.S. Treasury yields back at 3% investors are starting to get a decent yield again. After being very short duration in our fixed income portfolios in the past few years, we now favor a neutral position as the yield will compensate any short-term fluctuations.

For U.S. investors, the municipal bond market also starts to look attractive after a 20% sell-off this year.

Commodity Markets

The Q1 commodity rally fizzled in April. However, the situation in Ukraine has not yet stabilized and continues to pose a threat to commodity supplies. Thus, negative surprises stemming from the conflict remain a potential source of upside risk to commodity prices over the near term.

Longer-term, there is going to be structural demand for commodities because of the energy transition but also higher demand in other sectors like the defense industry. At the same time, investment in new commodity supply has been low over the past decade and this supply-demand dynamic will support commodity prices in our opinion.

We believe commodities should be part of a diversified global portfolio.

Currencies

Finally, the U.S. dollar benefitted from a flight to safety amid heightened geopolitical risks and global growth concerns. These forces could continue to underpin the dollar over the near term. Over a longer investment horizon, further USD strength will require more upside surprises in U.S. interest rates, which we do not expect. In other words, we believe the U.S. dollar is likely to weaken against the Euro, Sterling, and Yen over the next 12 months.

Portfolio Action

In the past 4 months, very defensive sectors have strongly outperformed more growth-sensitive market segments, especially tech stocks. We keep a neutral positioning in our portfolios as we think that a change in inflation expectations could potentially create a fast turnaround in sentiment, and then yesterday’s losers will be tomorrow’s winners again.

The major change we made in our core portfolio is in fixed income. After keeping duration very short in the past few years and holding a significant position in U.S. Treasury Inflation-Protected Securities (TIPS), in recent weeks we changed direction. We sold our position in TIPS completely as we think inflation expectations will come down and we bought 7-10Y U.S. Treasuries.

We also reduced our holdings in Chinese government bonds as these are no longer the highest-yielding investment-grade government bonds and we expect the Renminbi to weaken going forward.

Lastly, in non-USD denominated portfolios we started to hedge USD positions with the view that the U.S. Dollar will eventually give back some of its recent gains.


DISCLAIMERS & DEFINITIONS

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. 

Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.

Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.

The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock's weight in the index proportionate to its market value.

The Consumer Price Index (CPI) is a measure of inflation compiled by the US Bureau of Labor Studies

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