We are witnessing significant divergences in the economic outlook (we have revised down the EU and Chinese economic outlooks vs. the more resilient US economy) and in market performances. In particular:
- Inflation expectations – short-term peak vs. long-term rise: While short-term inflation may start to decelerate, the long-term view is increasingly showing that sticky inflation (e.g., shelter inflation) remains high (harder to reverse) in light of geopolitical risks and the supply chain stress amid Shanghai’s lockdown.
- Recession risks: The US economy remains solid while the Eurozone is the most exposed to stagflationary risk. We will most likely see at least a short-lived recession in H2, triggered by Germany and Italy, while France and Spain might show some resilience. In China we see the official target of 5.5% growth for 2022 as being difficult to reach.
- Central banks on diverging paths: The Fed might join the club of CBs raising rates by 50bps in order to move to a neutral policy stance as rapidly as possible, while the ECB will be even more data dependent. The BoJ remains in its easing stance, and in China the PBoC remains ready to cut the key rate.
- Earnings – still strong expectations (with regional differences) vs. weak consumer sentiment. This is certainly a key earnings season to watch as any sign of strength from corporates, signaling a further inflationary push, may add pressure on the Fed to act. In Europe the earnings season will focus on guidance as a profit recession is increasingly likely on the back of the effects of the war though these are not likely to be reflected in this season’s numbers.
From an investment standpoint, while investors should maintain a neutral risk stance, there is room to play these divergences across the different asset classes:
- In bonds, the market has moved fast in repricing a more aggressive stance from the Fed. The initial moves were concentrated on the short part of the curve, but more recently the 10-year part has also started rising further, with the 10-year yield reaching the 2.9% level. While longer term the rate trajectory remains upwards, it no longer makes sense to remain as short as we have been in the recent past, especially on the front end of the curve given the latest market movements, and therefore we are tactically adjusting our duration stance. There is room to play tactical relative value opportunities and curve opportunities in Australia and Canada, as well as in France, where the uncertainty over the presidential election outcome has driven spreads higher.
- In FX, the rise in commodity prices should benefit the Brazilian real vs. the US dollar, while the Russia-Ukraine conflict continues to benefit the Swiss franc vs. the Euro. We also favour the USD vs. the Euro.
- Equities remain favoured vs. credit at this stage, but within equities selection is key. The approaching earnings season appears more challenging for Europe, for which we keep a short relative bias vs. the US as the latter should prove more resilient. We continue to hold the view that a combination of value and quality (with a less cyclical bias and a tilt towards financials and more defensive value) is the best way to find opportunities in names that could have less volatile earnings and be less sensitive to rising rates. The growth repricing (down), especially on the most extremely valued names, is not finished yet, in our view.
- In credit, we remain cautious and have moved further towards less risky names across the fixed income dedicated allocations. In our search for income, we are becoming more positive in EMBI. After the recent yield rise, the EMBI market should be supported by the stabilising US 10-year yields, oil gradually moving down and the improving EM-DM gap. The EMBI composition, tilted towards LatAm and towards commodity exporters, is also a positive contributor.
- Diversification remains crucial. We believe adding real asset exposure in areas more resilient to inflation (infrastructure, loans with floating rates and real estate) and using strategies that offer low correlation compared with traditional asset classes could help navigate this unfriendly market environment.
To conclude, as the great asset repricing unfolds, investors should be ready to adjust their allocations to deal with inflation. So far, we have seen most of the repricing taking place in bonds. We expect more to come in the longer part of the curve and in the most fragile equity markets, those where recession risks are on the rise (for example, European equities). However, the divergences in the markets will offer opportunities to tactically calibrate risk towards the most resilient areas.