The first month of the Russia-Ukraine war has driven volatility up across the board, though with some recent signs of stabilisation in equity markets. Europe is the area most exposed to the war – in particular, through the effects of higher energy prices, supply chain disruptions, and geographic proximity, but the commodity squeeze goes far beyond energy to include agricultural commodities and metals. Against this backdrop, safe-haven demand remains strong for gold while Treasury yields have recently been driven by higher inflation and rate expectations, with the yields moving upwards across the curve. While uncertainty on the war front remains high, markets are trying to assess what additional sanctions could be put in place against Russia or if the next diplomatic steps could become more productive – or, in the bear case, the risks of an extension in terms of time and geographical reach of the crisis.
At this stage, four hot questions are crucial to reassessing the investment stance:
- Are we heading towards a global recession? Taking into account the impact of the rise in commodity prices, we have revised down global growth by 0.5% in 2022 (now in a 3.3-3.7% range), but the impact is not homogenous across countries. The US, while not immune, appears to be more resilient to the shock than the EZ. A global recession should be averted while Europe is more at risk for a technical one.
- How high is the risk of central bank (CB) policy mistakes? The task of CBs is not easy and the potential for policy mistakes is high, especially at the ECB level amid a more uncertain economic outlook (also at a single country level) and rising risks of fragmentation in the Eurozone. It’s not easy for the Fed either. Despite hiking rates for the first time since 2018, it continues to stay behind the curve and it may have to adjust its policy path in an environment in which the inflation topic is hot in the political debate.
- What is the risk of a liquidity crunch? Liquidity has been deteriorating across all main asset classes, with market depth worsening across the board. While at the moment, we don’t see significant risk of a liquidity crunch, the need to remain vigilant and build liquidity cushions is high.
- Markets: How far along is the process of restoration of value? We confirm a cautious stance, but recognise that buying opportunities may open up in the near future and therefore we stay ready to tactically adjust our risk stance. While a process of restoration of value is under way, it is incomplete and fragmented. In particular, the real-life impacts of the movements from the Fed and ECB remain to be seen. This argues in favour of a bit of patience as additional volatility going forward will offer entry points.
Against this backdrop, our main convictions are as follows:
- Long-term rates remain too low in a persistently high inflationary environment. Recent hawkish turns by CBs confirm that the rate direction is up. We continue to hold a short duration bias and remain tactical in adjusting our duration stance, as this can assist with hedging during periods of turbulence.
- In equities, we stick to a value tilt, with a further marked focus on quality as a way to navigate this crisis. It remains important to be highly selective and look at names with strong business models and the ability to pass through higher prices to consumers. At the regional level, the US should continue to be more resilient compared to Europe, given the higher risk of an earnings recession, and therefore we are turning relatively positive on US vs European equity. The outlook for Chinese equity is tactically more cautious, due to the heightened regulatory risks and extreme volatility.
- In credit, risks are more related to liquidity than fundamentals at this stage. Financial conditions are tightening, so it’s important to stay on the lookout for liquidity risk. We are more cautious in general on the high yield space – in particular, in Europe, where a further widening of credit spreads is possible.
- Volatility will remain high, and despite strong market corrections, we maintain hedges in place against the uncertain outcome of the crisis. In addition, to build more resilient portfolios, investors should continue to focus on areas of diversification. With this aim, they could explore Chinese government bonds with a long-term perspective. Currencies can also play a role regarding diversification. Here, we favour the Swiss franc, given its appeal in times of market stress.
In conclusion, we believe it’s important to resist the temptation to go for an aggressive asset allocation, as visibility is still too low, and continue to look at portfolio construction through the inflation (and real rates) lens in the search for areas of resilience.