The geopolitical escalation at month’s end marks a further rise in volatility. Credit spreads (IG, HY and Euro peripherals) continued to widen while equity markets corrected further. The rotation towards value continued, but with a pause from the most cyclical segments, amid increasing economic growth risks from the Russia-Ukraine conflict. Markets continue to reassess the hawkish turns of the Fed and the ECB as well as the risks related to the escalating crisis in eastern Ukraine. On the macro front, US job market data were well above expectations; the January inflation reading was at its highest level in four decades. This complicates the route for central banks caught between possibly higher inflation and lower growth (stagflationary risk on the rise).
In contrast, the Chinese Year of the Tiger appears to be characterised by increasing policy accommodation, indicating the divergent policy trends versus the rest of the world on the easing side, once again pointing to a desynchronisation in the economic cycle of China versus the US that supports the role of Chinese assets as global diversifiers. At the current juncture, with significant price changes already being seen since the beginning of the year, there are two burning questions for investors to consider:
- Could the current volatility turn into a double bear market (in bonds and equities), therefore calling for structural de-risking in asset allocation? Volatility is certainly rising across the board (bonds, equity, commodities, currencies), and the investment landscape is looking riskier than one month ago. With growth expected to remain sound throughout 2022 amid economic reopening post the Omicron wave and the China soft landing, earnings growth should decelerate from the peak, but remain positive. The big risk relates to possible spillover from the Russia-Ukraine conflict, with significant impacts on the growth and the inflation outlook. This is the crucial point that investors need to keep track of. Equity bear markets occur during recessions (except during the 1987 crash). We don’t expect to see a recession, but the risk of it in Europe is increasing amid rising inflationary pressure at a time when the ECB plans to reduce its quantitative easing.
As geopolitical risks are very hard to assess (any positive changes could lead to a relief rally while further escalation could put further pressure on the market), investors should still seek to benefit from the recovery mainly through selective equity markets, but also be prepared for the worst (adjusting hedges to address even more unfavourable developments) outcomes. All in all, the inflation theme is seeing further reinforcement, again calling for a medium-term preference for value/quality in the equity space, although we may see some pauses short term regarding the value rotation. In credit, we have moved to a more cautious stance amid rising liquidity risks and a less appealing risk/return profile for credit compared with equity.
- Is 2% a target level for UST yields or is there more to come and therefore the duration stance should stay short? The Fed’s hawkish turn and the inflation surprise temporarily pushed 10Y Treasury yields above the 2% threshold for the first time since July 2019 and contributed to a restoration of value in particular on the short end of the curve.
The Russia-Ukraine conflict raises risks regarding financial systems and on inflation in primis, but also regarding the global economy. As the market is already pricing in significant Fed action, we believe that the rise in yields could pause awaiting the Fed’s March meeting. Some technical adjustments to duration are due, and therefore we recommend an active approach. For the time being, we confirm our cautious duration stance while we actively play opportunities at curve and country levels.
Market uncertainty will remain high. We are facing a period of low visibility on geopolitical developments and economic implications. Equity volatility will stay high, as given the high liquidity profile of equities, they will be the first target in case of fast risk adjustment, which could also offer opportunities to buy the dip and re-enter some oversold areas of the market.
The timeframe of the crisis will be crucial, as a prolonged period of uncertainty with rising escalations could lead to further repricing across global risk premia. Central banks will be in the spotlight and they may at some point have to adjust their agendas to address rising stagflationary risk. For investors, all this means they should stay well-diversified, increase their hedges, and focus on areas of resilience to high inflation.