May 2022 - Monthly House Views
Equity markets were rattled throughout April given a myriad of factors driving uncertainty. The ongoing conflict in Ukraine – and the economic sanctions it entails – are weighing on the energy market. China’s zero-Covid policy and possible lockdowns in some of the world’s largest commercial hubs threaten further disruption to supply chains. If that were not enough, central banks of most developed economies have set in motion monetary tightening at levels not seen in decades, effectively ending the paradigm of ultra-easy money that has been in place since the Great Financial Crisis of 2007.
The short-term impact has been immense: Global equities, measured by the MSCI All-Country World Index, retracted by -8.7% in sterling terms during the year through 9th May. The toll has been especially heavy on investors’ former tech darlings. While the S&P 500 returned -7.8% this year, the NASDAQ – its growth-heavy counterpart – produced -18.4% in the same period. In this perfect storm of uncertainty and rising yields, bonds did not provide shelter either: Bloomberg’s Global-Aggregate Bond Index lost -12.4%.
Inflation on their minds
While the Russian war and Chinese Covid worries captured the headlines of news outlets across the globe, inflation is the topic remaining on most investors’ minds. The good news is that the pace of price increases have likely peaked in the US: a deceleration of the Chinese economy and steadily falling used car prices ought to put downward pressure on oil prices; and the ongoing shift of consumer demand from goods to services should give supply chains some reprieve. As a result, US Core Consumer Price Index (which strips out food and energy prices), is expected to drop to 6.2% from its March reading of 6.5%.
The bad news is that the consumption of goods and oil-related commodities such as motor fuel or airline fares, whose prices are expected to retract strongly from their pandemic highs, make up a rather small portion of the Consumer Price Index.
Prices for shelter however – with rent making up 32.7% of an average American’s monthly expenditure – at this point shows no sign of slowing from their most recent growth of 5.0% year-on-year. While house prices are not expected to accelerate significantly from here, the rent derived from real estate tends to be “sticky” and will likely prevent inflation from returning to central banks’ 2% target in the coming months. To avoid a dreaded wage-price spiral, the Fed is expected to aggressively tighten monetary policy, cool down the red-hot economy, and ease the price of everything from property to groceries – a delicate balancing act between reigning in inflation while at the same time ensuring a recession is not triggered in the process.
Inflation expectations remain anchored
However, investors’ expectations towards monetary tightening – projecting another eight hikes to a target rate of 3.0% by the end of this year – may well be overblown. Breakeven rates, an indication of inflation expectations over the next ten years, have already come down from their recent heights and remain anchored around the 3% mark. As price pressures ease naturally over the coming months the Fed may find itself with breathing room to lay off its most aggressive hiking path, giving both equity and bond markets some reprieve.
There is no recession on the horizon
Much like ourselves, the International Monetary Fund (IMF) is not expecting a recession in 2022 or beyond. While growth is going to slow in response to tighter monetary conditions, most major economies remain exceptionally robust: balance sheets remain strong for corporates and consumers, financing conditions are still loose by historical standards, and industry analysts continue to forecast record earnings and margins.
There is much moving in markets, some of which is described above. As always, we choose to rely on our investment process to guide our investment decisions. It is currently telling us the following:
The economic outlook remains robust judging by the forward-looking indicators we measure. Recession does not appear on the horizon, even in Europe, and economies are likely strong enough to absorb higher rates and a gradual “normalisation” of monetary policy. Purchasing Managers’ Indices (PMI) for most major global economies are in expansionary territory. While financial conditions are tightening, it remains relatively easy and cheap for most households and companies to borrow money. Jobs are plentiful. Corporate revenues, earnings and margins are all at (or near) record territory.
Valuations had been our biggest source of concern coming into this year but have moderated, as prices for equities have fallen this year while earnings expectations have remained anchored or even risen, leading to affordable if not cheap assets compared to their own recent history. Equities remain more attractive than government bonds, where the real yields remain negative (albeit less so). It is also worth remembering that equities tend to be a better hedge against inflation than bonds, as are commodities.
Momentum for equities remains unequivocally negative. Much air has come out of valuations and continues to drive equity prices lower. We are closely monitoring the situation and are prepared to act should the momentum of any asset class swing back into positive territory.
Sentiment in markets is neutral but has deteriorated sharply over the past weeks, mainly impacted by negative equity outflows. Over-bearishness would provide a strong buying signal; however we are not there yet.
On the balance of the factors above, we continue to maintain a Neutral stance to risk. We still believe the case for risk-taking is supported given the strong economic backdrop. However, increasing volatility and negative momentum give us cause for concern. We continue to hold a stable of diversifiers (cash, government bonds, gold, hedge funds and a Tail Risk Protection Note) in order to help offset downside risk.
As ever, we are constantly monitoring markets. Should conditions change, particularly with regards to the economic regime or signals from our valuation, momentum and sentiment framework, we will adjust our asset allocation accordingly.
Process and Convictions
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Unless otherwise specified, all statistics and figures in this report were taken from Bloomberg and Macrobond on 04/25/2022.