What our House View means for asset allocation and portfolio construction.
- The war in Ukraine has led to a price/supply commodity shock, worsening the growth-inflation mix
- Central banks’ focus on the latter not only supports government bond underweights, but impacts all asset classes
- Higher rates affect equity sectoral and regional performance, but are not reasons to be negative (yet)
- Valuations in emerging markets (EM) and Chinese policy support mean negative fundamentals are less mispriced
- Similarly, credit spreads have adjusted and now provide better risk-reward profile
In the three months since we published our 2022 Outlook we have been reminded – for the third year in a row – of the sagacious Yogi Berra’s warning: “It’s tough to make predictions, especially about the future.”
The market outlook continues to be coloured by the war in Ukraine and our assumptions could change rapidly. And yet, for all the horrors and surprises of late, the main themes of the House View and its investment implications remain intact.
Inflation is still a dominant theme, exacerbated by the commodities supply shock – existing demand and COVID-related supply issues have only been aggravated. We anticipated central banks would take further steps to remove accommodation, while growth was projected to slow from high rates; those trends have also intensified, while China’s internal redirection and reaction to the spread of COVID have proven impactful – and problematic.
Our strongest market conviction remains that yields continue to move higher, and while equities have weathered the storm, their elevated volatility warrants a more modest overweight.
Commodities were expected to trend higher through 2022 given depleted inventories, ongoing supply constraints and a pickup in demand. The outbreak of war between Russia and Ukraine accelerated the move, leading to rapid increases in the prices of oil, gas, metals and wheat which are more directly affected by the conflict (Figure 1).
Figure 1. War in Ukraine has pushed commodity prices higher
Commodities YTD per cent performance
The war has brought energy security into sharp focus in the West and led to the European Commission publishing their RePower EU plan on 8th March. The plan aims to cut Europe’s imports of Russian gas by two-thirds by the end of 2022, an ambitious goal. Longer term, the Commission wants to totally phase out dependency on Russian gas, oil and coal by 2027.
These policies will have significant ramifications for commodity prices. Even if there is a settlement between Ukraine and Russia, it is now highly unlikely that plans to diversify away from Russian energy supply will be reversed.
Robust growth, ongoing supply side issues, increased levels of uncertainty and policies around energy security will likely keep commodity prices elevated through 2022 and beyond. That said, if commodity prices stabilise even at high levels the direct pass through to inflation will decline rapidly through 2022 thanks to base effects, with the energy contribution to inflation falling to near zero by the end of the year.
Monetary policy tightening and the subsequent implications for economies will be key for markets over our investment horizon
Central banks’ policy responses to higher inflation and the subsequent implications for economies will be key for markets over our investment horizon. Even before the acceleration in commodity prices, rising inflation meant central banks were either starting or discussing monetary policy tightening.
While the war in Ukraine has increased economic and financial uncertainty particularly in Europe, policymakers have been consistent in their focus on inflation and have guided that policy normalisation remains the key priority. This is unsurprising given risks to the inflation outlook are firmly skewed to the upside. The longer supply side shocks persist, the greater the probability that they have second round effects and feed through into wage growth.
Near-term price shocks mask any potential structural break in the inflation regime towards higher baseline inflation. As discussed above changes in policy around energy security are likely to be long-lasting. De-globalisation of supply chains, climate change, decarbonisation and central banks who are actively targeting higher inflation levels bias us towards structurally higher inflation going forward.
The impact of higher inflation will be more apparent in economies such as the US, where growth is strong and labour markets are tight. Interestingly, while US financial conditions have tightened from the lows seen earlier this year, they remain very loose both by historical standards and on a relative basis (Figure 2). Central banks need to see financial conditions tighten significantly from here if they are to bring inflation sustainably back to target.
Figure 2. Financial conditions in the US remain relatively loose
US & European financial conditions
The degree of financial tightening required will depend on the extent inflation returns to target as supply side shocks abate. If underlying inflation dynamics return to the post GFC-pre-COVID era, then required central bank tightening will be more limited and inflation will decline quickly once supply side shocks fade. On the other hand, if higher inflation becomes more embedded in the economy, then it will be difficult for central banks to get inflation sustainably to target while growth remains above trend, even if the peak year-on-year rates are reached in coming months.
With risks to inflation to the upside, nominal yields are expected to rise further from current levels. While curves have flattened significantly as the market priced in tighter monetary policy, that process is likely to have further to play out as we proceed through the hiking cycle, arguing for underweight or short duration to be focused more on the front end of the curve.
The implications for breakevens and real yields are more complex as these markets reflect not only central banks’ actions, but also their ramifications on the economy. Supply shocks are still masking the underlying inflationary environment and which of the structural inflation environments we are in, will likely differ across economies.
Over the medium term real rates need to move higher. Whether we reach higher real yields via declining inflation or via more aggressive monetary tightening remains to be seen, but in most cases it is likely to be some of both. If the inflation baseline has indeed moved higher then real yields may struggle to move higher near term and may even move lower initially.
Despite the dramatic events and increased market volatility we have seen in 2022 the US dollar, the traditional currency of safety in uncertain times, has strengthened by less than two per cent in real effective terms. The Japanese yen, also traditionally a safe haven in times of stress, has depreciated more than six per cent year-to-date.
Across the G10 currencies, those whose economies are linked to energy prices and have seen a positive terms of trade shock (Figure 3) have appreciated this year. These moves highlight that the themes of commodity price strength and monetary policy reaction functions have returned as key drivers for currency markets, following reduced sensitivity throughout 2021.
Figure 3. FX moves driven by terms of trade shocks and relative monetary policy
YTD standardised change in Citi ToT & per cent REER move
The large and extended period over which we project the terms of trade shock to persist suggests increased appreciation pressure on currencies which benefit from exports and higher rates going forward.
Supply shocks such as the global pandemic and its aftermath, compounded recently by the war in Ukraine, created a challenging environment for equities. They now also face an additional significant headwind in the form of a tightening cycle from global central banks.
The Ukraine war and the sanctions which have followed have the capacity to introduce new disruptions, so far concentrated in Europe and emerging markets. Violent reactions to geopolitical events are not unusual for equity markets, and panic can present opportunistic entry levels if fundamentals are still supportive.
Medium-term growth prospects are still reasonable as post-COVID reopening eases supply side disruptions and benefits services and tourism; rates are rising in an orderly fashion and companies report satisfactory pricing power: that supports maintaining modest overweight exposure to equities overall.
Under the hood, in both Europe and the US, higher real rates are a challenge to high valuations in tech and other growth sectors, while rising interest rates and commodities favour banks, energy, and materials. The divergence between sectors is stark (Figure 4), and the trends have further to run.
Figure 4. Very large sector dispersion in equities, reversing earlier trends
S&P 500 sector GICS level 1 breakdown
For emerging markets, we move to neutral as China’s promises to support growth and to a less strict COVID policy remove some downside. Developed market policy normalisation and the potential economic/financial decoupling are headwinds for EM asset classes, with the shift to restrictive territory often causing major drawdowns (Figure 5). Latin America – Brazil in particular – and the Middle East, as well as ASEAN markets are notable exceptions, thanks to similar terms of trade trends mentioned above.
Figure 5. EM equities are volatile during Fed hiking cycles
MSCI EM local drawdowns and tight Fed policy
Corporate credit has been volatile, and the relatively low spread levels of 2021 adjusted sharply higher; fundamentals are not deteriorating at this early stage of the business cycle. The improved risk-reward, and corporate and household balance sheets being in good shape (Figure 6), warrant a modification to our asset allocation. Across investment grand and high yield, we move from our long-standing credit underweight to neutral.