·We recently cut risk, but stick with stocks over bonds for now. Equity prices now reflect much of the worsening macro outlook and hawkish Fed, in our view.
·Markets came to grips last week with the trade-off central banks face: choke off growth or live with inflation. Yields fell and stocks bounced off new 2022 lows.
·U.S. retail sales and other activity data will give investors a read on growth momentum. We believe the restart from pandemic lockdowns has room to run.
Equities have fallen hard this year on the prospect of rapid rate increases to rein in inflation, the tragic Ukraine war and a slowdown in China. We recently reduced risk, yet keep our modest stocks overweight. Why? The selloff means more of these risks are now priced. We also believe the Fed’s sum total of rate hikes will be historically low and see recession fears as overblown. We think equities remain more attractive than bonds, even as the historic sell-off in bonds has cut the gap between the two.
Caution: steep rate path ahead
We started the year with an overweight in equities and underweight in bonds. The macro outlook has worsened since then. The Ukraine war added to already high inflation stemming from pandemic-related supply constraints. The Fed started to talk tough on inflation, and the market has quickly priced in a series of steep rate rises (the red line in the chart), whereas it was still expecting a shallow trajectory in December (the yellow line). And we now see a rising risk the Fed will raise policy rates to a level that slows the economy. The latest: Growth in China has slowed amid widespread Covid lockdowns. Both stocks and bonds have sold off in the face of these mounting challenges. We stick with our equities overweight for now. Why? First, much of the risks to growth are now reflected in stock prices, we believe, keeping valuations attractive. Second, we still think the cumulative total of Fed rate hikes will be historically low, given the level of inflation. We see the Fed ultimately choosing to live with core inflation that’s a bit higher than its 2% target, rather than fight it because of the costs to growth and jobs.
The worsening economic outlook has prompted us to reduce portfolio risk this year. We downgraded European equities in March on the energy shock. We followed with a downgrade of Asian assets last week, coupled with an upgrade of investment grade credit and European government bonds. The sell-off in the bond market has narrowed the gap between the stocks and bonds, in our view, and created pockets of value. We still see longer-term yields rising further as investors demand a higher term premium, or compensation for the risk of holding government bonds amid high inflation and debt loads. As a result, we are not changing our overall bonds underweight and maintain our relative preference for equities.
What are the risks? Today’s inflation is very different from the past 30 years, and central banks need a new playbook. Inflation is always caused by excess demand over a certain amount of supply. That doesn’t mean excessive demand is driving inflation, as has been mostly the case since the 1990s. The real question: Is demand unusually high or is supply abnormally low? We think it’s the latter. The economy is working its way through two major shocks: the pandemic and the war in Ukraine. This has created supply constraints such as a tight labor market (caused by the “Great resignation”) that will take time to resolve. Why does all of this matter? If inflation is caused by supply factors, the Fed faces a stark choice: choke off growth with higher rates – the old playbook – or live with more persistent inflation. The risk is that the Fed fails to recognize the trade-off and pushes rates to such levels they destroy growth and jobs.
Markets are waking up to the risks surrounding this trade-off, and now look to be pricing in a fed funds rate of close to 3.5% in the very long run. If that’s true, equities may have more room to fall: Higher discount rates make future cash flows less attractive. We think the Fed ultimately won’t go this high for fear of hurting growth, but recognize hawkish policy pronouncements can lead markets to believe differently. This is why we brace for more volatility in the short run – and why we are not adding to our equities overweight despite improved valuations.
Our bottom line: We stay overweight equities and underweight bonds, but have reduced risk to reflect the worsening macro outlook. The momentum of the restart of economic activity is still strong, especially in the U.S., so we don’t see a recession ahead. We prefer developed market stocks, especially U.S. and Japanese equities. We particularly like the U.S. market’s quality bent featuring companies with strong cashflows and balance sheets. We would turn more negative on equities should the risk of the Fed slamming the brakes on the economy materialize and trigger a material slowdown.
Markets are coming to grips with the stark growth-inflation trade-off central banks are facing to rein in supply-driven inflation: choke off growth or live with higher inflation. Last week, markets started to price in the risk that the Fed will push ahead with the first option. Yields on 10-year U.S. Treasuries fell, and stocks bounced off new 2022 lows. We believe the sharp trade-off will ultimately give the Fed pause before taking rates up to levels that trigger a material slowdown.
1)Living with inflation
• Central banks are facing a growth-inflation trade-off. If they hike interest rates too much, they risk triggering a recession. If they tighten not enough, the risk becomes runaway inflation. It’s tough to see a perfect outcome.
• The Fed has projected a large and rapid increase in rates over the next two years, and raised rates by 0.5% in May – the largest increase since 2000. We see the Fed delivering on its projected rate path this year but then pausing to evaluate the effects on growth.
• Normalization means that central banks are unlikely to come to the rescue to halt a growth slowdown by cutting rates. The risk of inflation expectations becoming unanchored has increased as inflation becomes more persistent.
• The Bank of England of England warned of the poisonous combination of recession and high inflation as it raised interest rates to their highest level since 2009.
• The European Central Bank has also struck a hawkish tone, but we expect it to adopt a flexible stance in practice given the material hit to growth we see from higher energy prices.
• We believe the eventual sum total of rate hikes will be historically low, given the level of inflation.
• Investment implication: We prefer equities over fixed income and overweight inflation-linked bonds.
2)Cutting through confusion
• We had thought the unique mix of events – the restart of economic activity, virus strains, supply-driven inflation and new central bank frameworks – could cause markets and policymakers to misread the current surge in inflation.
• We saw the confusion play out with the hawkish repricing in markets this year – and central banks have sometimes been inconsistent in their messages and economic projections, in our view.
• The Russia-Ukraine conflict has aggravated inflation pressures and has put central banks in a bind. Trying to
contain inflation will be more costly to growth and employment, and they can’t cushion the growth shock.
• We see a worsening macro outlook because of the commodities price shock and a growth slowdown in China.
• Investment implication: We have slightly reduced our risk exposure.
3)Navigating net zero
• Climate risk is investment risk, and the narrowing window for governments to reach net-zero goals means that investors need to start adapting their portfolios today. The net-zero journey is not just a 2050 story; it’s a now story.
• The West’s decision to reduce reliance on Russian energy will encourage fossil fuel producers elsewhere to increase output, but we don’t expect an overall increase in global supply and demand. We see the drive for greater energy security accelerating the transition in the medium term, especially in Europe.
• The green transition comes with costs and higher inflation, yet the economic outlook is unambiguously brighter than a scenario of no climate action or a disorderly transition. Both would generate lower growth and higher inflation, in our view. Risks around a disorderly transition are high – particularly if execution fails to match governments’ ambitions to cut emissions.
• We favor sectors with clear transition plans. Over a strategic horizon, we like sectors that stand to benefit more from the transition, such as tech and healthcare, because of their relatively low carbon emissions.
• Investment implication: We favor DM equities over EM as we see them as better positioned in the green transition.