What has happened?

Equity markets have started the week on a gloomy note. Until now, European stockmarkets have seen the biggest impact of the invasion of Ukraine. On Monday, it was the turn of US equity indices to play catch up, as the S&P 500 slid more than 3% during the day’s trading. It seems the markets realise that the US Federal Reserve’s famous “put” – its historical pledge to step in to support asset markets when needed – is definitively now history, or at least has a lower “strike price” than previously.

The central bank is using multiple channels to cool the broiling inflation pressures, and this will come at the cost of financial assets if necessary. Indeed, with real yields now in positive territory, the attractiveness of stocks – both on an absolute and relative basis – is starting to be challenged.

As for government bonds, it seems that risk-off is starting to trump inflation fears – at least in investors’ minds. While US government bonds have been seriously under pressure in recent months, the situation seems to have stabilised – at least temporarily – in recent days (see Exhibit 1).

Exhibit 1: US government bonds are the most oversold in at least 50 years

Source: Bloomberg. Data as at 9 May, 2022.

Alongside the Fed’s decisive action to curb inflation, which will likely hit the economy over time, international factors could also lead to a weaker global economy. Our assumption that Omicron would be hard to control in China is unfortunately materialising. Outbreaks are leading to further shutdowns of cities and productive activity in the world’s second-largest economy. This could lead to another round of international supply shocks, negatively impacting a global economy already disrupted by the attack on Ukraine.

Against this backdrop of inflation stresses and geopolitical uncertainty, investors have finally started to question valuations and earning expectations that have remained relatively lofty. In particular, they are challenging still optimistic assumptions concerning the solidity of margins in an environment of rising input prices, whether these are wages or energy prices. This reassessment of the economic situation also starts to spill over into credit spreads, which have crept up in the past few weeks. While not dramatic, this trend will further stress companies’ margins by increasing refinancing costs.

All in all, we are entering a difficult period where still worrying inflation rates will require central banks to reduce overall liquidity, while higher yields, input prices and supply shocks affect companies’ margins. The good news is that investor positioning is moving back to more attractive levels, while valuations have started to come down from what were too rich levels.

What this means for investors

In recent months, our Multi Asset view has been cautious on both fixed income and equity markets while favouring commodity markets. We continue to be positive on energy prices – a view supported by systemic under-investments in the sector.

From a tactical perspective, we expect the market negativity to roll over from bonds into equities in an even bigger way. We remain essentially cautious on bonds, amid worries that interest rates will trend higher over the long term. But we think much of these concerns are priced in in the short term. Therefore we have tactically reduced our underweights in US treasuries and UK gilts – shifting to a neutral stance – while remaining underweight on eurozone bonds and strong underweight on eurozone-periphery bonds.

We are adding to our negative view on equities. Having been very cautious on eurozone and emerging-market equities for some time, we have also moved US equities into negative territory in the past week. The only equity market where we still see some potential is the UK, which benefits from its exposure to energy and healthcare, and its defensive bias.

On emerging-market debt hard currency, our view is negative overall. This hides a split assessment due to the heterogeneity of the index: energy producers like Qatar, Saudi Arabia and even Mexico could prove resilient, while energy importers will increasingly feel the brunt of a stronger US dollar, rising energy prices and slowing global activity. Considering the potential for political disruptions due to higher agricultural prices, we would recommend only investments in actively managed solutions, not index-based ones.

Be ready for long-term opportunities amid the selloffs

Finally, we can only repeat our preference for adding alternative beta-type strategies that may profit from this type of environment. While commodity investments are an obvious choice to protect against rising inflation, commodity trading advisors (CTAs) are having an excellent run year-to-date as they can also short markets. We also see value in volatility investments in the kind of rapidly moving markets that we are currently experiencing. Finally, it may be wise to keep some cash on the sidelines as larger selloffs can open opportunities for longer-term investments at attractive levels.

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