Panorama - May 2022 -
Are stagflation fears giving way to concerns about a mere slowdown?
Head of Investment Strategies
Deputy Chief Executive Officer, Chief Investment Officer
The year has got off to a tricky start. The war in Ukraine has pushed commodity prices sharply upwards while the restrictions on movement brought in by China are once again taking a toll on supply chains, leading to more inflation and less growth.
Central banks have been quick to step in, especially the US Federal Reserve. Long-term inflation expectations do indeed appear to be calming down now, while the risk of an economic slowdown is increasing.
What is the best investment strategy to adopt in such circumstances?
Context and analysis
Bond yields have risen spectacularly, in terms of both speed and magnitude, but this is by no means unusual as interest rates often move abruptly. This can be seen clearly in the trajectory taken by US bond yields in recent months. Since the US Fed first adopted a more hawkish tone on inflation and began to prepare the market for a series of interest rate hikes this year, the yield on 10-year T-Notes has jumped from 1.55% in January to close to 3.00% at present. Bear in mind that it stood at just 0.50% back in mid-2020.
This sudden and remarkable rise could soon draw to an end, however: the Fed was quick to take action so that the markets would not panic in the midst of an inflationary surge. It appears to have been successful in this respect as long-term inflation expectations priced into index-linked bonds have now settled at close to 3%. In the meantime, Fed Fund expectations for the end of the monetary tightening cycle also lie in the region of 3%. So there is not really much reason to expect US bond yields to continue expanding in the near term. It is true that inflation might remain very high over the coming months, with commodity prices rising due to the war in Ukraine and further supply bottlenecks being created by the restrictions on movement in China as it pursues its strict zero-Covid policy. Medium-term, however, the base effects created by rising energy prices should ease off. And, above all, we need to consider the risks of an economic slowdown over the coming months. Incidentally, it is worth noting that the Fed’s speedy intervention appears to have successfully reassured the markets with respect to inflation while also giving itself some headroom to lower interest rates again if necessary should the slowdown prove too steep for comfort.
Global growth forecasts are trending downwards. Bloomberg’s latest survey of economists indicates that economic growth forecasts have been cut by close to 1.0% since December, from 4.4% to 3.5%, and these downward revisions are mostly attributable to higher energy and food prices. Bear in mind that a $10 increase in the oil price shaves around 0.2% off the economic growth rate, according to the most commonly used economic models. From this perspective, it is the euro zone that appears to be most vulnerable, especially in the current climate as it is more heavily dependent on Russia. The economic growth forecast for Europe in 2022 now lies at 2.9% compared with 4.2% at the start of the year. The USA looks more resilient, with growth now expected at 3.3% versus 3.9% initially.
Further downward revisions seem likely. Certain real-time trackers of economic activity do look rather worrying: road freight transport in the USA is slowing down sharply and stocks of consumer durables such as furniture and electronics are increasing. Consumers, especially the less well-off, appear to be feeling the effects of higher gasoline and food prices. The Bank of America Research Institute reports that spending on bank debt and credit cards is up 15% from a year ago, particularly among households with annual income of less than USD50,000. Such spending is 33% above pre-pandemic levels. And although the wealth effect is at its highest point since 2006, the wealthiest households could find themselves affected by falling property prices as interest rates rise.
But the big unknown these days is China. The country has set itself an ambitious economic growth target of between 5.0% and 5.5%, but this seems out of reach right now as the Omicron virus is spreading and prompting several large cities to enforce restrictions. We estimate that there are lockdown measures currently in place in 23 different cities, corresponding to a total population of about 190 million. Local Covid cases have been identified in 30 of China’s 31 provinces since the start of March, leading to restrictions on movement between regions. Economic measures are therefore expected and anticipated in a number of areas: tax cuts, lower interest rates, programmes to invest in “green” infrastructure, the reallocation of property development programmes run by failing developers to solvent developers managed by local governments... We have also noted a certain shift in the language used to refer to China’s Covid public health policy, suggesting that the government might announce a more pragmatic approach seeing as the latest strains are not as dangerous as previous ones. Officials are now talking about “a dynamic zero-Covid policy”, and they could adjust their discourse further. Future forms of the virus will no longer be referred to as “Covid”, which means that China will be able to claim victory over Covid… All in all, the big market research institutes have revised their economic growth forecasts for China downwards, with the IMF’s estimate now at 4.4%. But we should not overlook the interventionist capacity of China’s public authorities or the country’s ability to achieve its objectives.
What is surprising in such circumstances is that corporate earnings outlooks remain stable. Earnings forecasts have not been revised downwards despite the complicated circumstances, and earnings growth estimates lie within the 8-9% range in the USA and euro zone alike. Companies appear to have seen no reason so far to reconsider their rather upbeat guidance targets or their investment plans. So there are two possibilities: the first is that analysts began the year underestimating the capacity of companies to generate earnings and have therefore not had to revise their forecasts downwards, despite the risks that have arisen in the meantime; the second is that we will begin to see downward revisions in the coming weeks once companies report their earnings. Rising input prices and wage pressures are certainly expected to erode margins at some point. This is a big issue that will have to be monitored closely over the coming weeks.
In short, the environment is clearly not conducive to risk taking and visibility is still quite poor all things considered. Inflation concerns could ease off and give way to worries about growth instead, in which case bond yields might stabilise or even fall back. This could initially trigger erratic movements in equities until the markets are able to get a more reliable perspective on future earnings.
A trade-off between inflation and growth: the big dilemma for central banks
The markets had for a long time assumed that monetary policies would normalise at a leisurely pace, but they now expect central banks to go much further than they initially thought. The ECB’s tightening is unlikely to be as gradual as it claims once it discontinues its net asset purchases (probably early summer). The market sees the money market ESTR rate moving back into positive territory by December and reaching +0.50% by this time next year versus -0.58% at present. The Fed, meanwhile, is expected to raise interest rates by 50 basis points at each of its upcoming meetings scheduled in May and June, which means that key interest rates will approach the 2.5% mark by the end of the year.
The ECB’s approach looks conservative when compared with the Fed’s much more hawkish stance on interest rate hikes. As a result, US and EUR interest rates have one thing in common and one thing that sets them apart: bond yields have indeed risen in the USA and Europe alike, by about 100 basis points since early March, but this increase applies mainly to real interest rates in the USA as opposed to mainly inflation breakeven (1) rates in Europe. This shows that the market is giving more credit to the Fed’s ability to curb inflation whereas the ECB is going to have to beef up its communication (and its action) or risk de-anchoring inflation expectations. In this case, the ECB would risk fuelling the wage/price spiral and triggering self-sustaining inflation.
It is difficult at this stage to say exactly which factors might be capable of stemming, or perhaps even reversing, today’s forceful uptrend in very short-term interest rates. Inflation statistics would probably have to abate before this happens. Experts say this is likely in the not-too-distant future, so we might soon see bond yields reaching a temporary peak level before falling back on concerns about economic growth rates which are continually being revised downwards for 2022.
The credit market’s performance, meanwhile, is being penalised by higher interest rates. But risk premiums (spreads) have proved highly resilient and are moving back to the levels that prevailed before the invasion of Ukraine. We reiterate our positive stance on private debt, for both the Investment Grade and High Yield segments. These segments offer average yields of respectively 2% and 5%, so carry strategies are attractive.
The equity markets are still holding up well
If someone had told us 6 months ago that bond yields would approach 3% in the USA and 1% in Europe, that oil would exceed $100 a barrel after having peaked at $140, and that we would see armed conflict on European soil, we would never have imagined that the subsequent consolidation would be so mild on both the US and European equity markets. The markets have proved relatively resilient for two main reasons. First of all we have the infamous TINA (There Is No Alternative) effect.
As long as investors expect short and long-term interest rates to remain stretched for the near future, they will steer clear of them and instead turn to assets that can provide a hedge against inflation: equities are one such class. The second factor, for the time being, involves the remarkable resilience being shown by companies and their capacity to pass on higher commodity prices. Admittedly, the earnings season has only just begun, but financial analysts have so far refrained from revising their 2022 earnings growth forecasts to zero versus 2021. To be perfectly honest, we do not share their optimism. But downward revisions are ultimately likely to be moderate as financial analysts were too conservative at the start of the year. An analysis by investment style shows that cyclical/value stocks have outperformed defensive stocks year-to-date, despite a steep consolidation by the banking sector which has had to book provisions on account of the war in Ukraine. Higher interest rates are obviously responsible for this poor performance as such stocks are considered bond proxies. If we are right in thinking that bond yields are about to peak and that global economic growth rates will continue being revised downwards, then the performance gap should eventually reverse at the expense of cyclical stocks. A geographic analysis reaches the same conclusion as the S&P 500 is proving resilient unlike the Nasdaq which is more heavily weighted towards growth stocks. In light of this, we would rather stick with our neutral position on the equity markets which we adopted at the start of the year. It is true that we see only moderate upside potential, but equity valuations are back at their median levels and will provide support should the volatility continue. All else being equal, we would be tempted to upgrade our rating by a notch if the markets were to drop by a further 10% whereas we would no doubt reduce our positions if they were to revert back to their year-start levels. But this is not the case for the time being, and geopolitical and microeconomic news flow will have to be watched more closely than usual.
Our central scenario
The central banks continue to step up their efforts to tighten future monetary conditions in an attempt to tackle this persistent bout of inflation. It would appear that the markets find the Fed convincing as inflation expectations have stabilised along the curve, which is not the case in Europe.
Bond yields therefore continue to rise. This uptrend should lose momentum, however, as economic growth rates eventually slow down and inflation indices fall back, unless energy prices increase again due to further sanctions.
Yields which have already been affected in the credit markets still seem attractive to us.
Equities continue to offer upside potential for the medium term in absolute and especially relative terms, but there is little visibility for the short term and so we are reluctant to overweight this asset class. We are therefore sticking with our neutral position. The markets will remain highly volatile, which will no doubt create more attractive entry points for investors with a medium-term investment horizon.
Document completed on 21/04/2022
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com