MonthlyFlow - May 2022


  • While sentiment is very negative, markets are reacting less to war headlines

  • Many hurdles remain, suggesting a choppy quarter ahead

  • Over the medium term, we remain constructive as a lot of bad news is priced in already

With markets still under pressure from hawkish central bankers, persistently high inflation prints and
spreading growth concerns (from Chinese lockdowns, aggressive tightening, and the Ukraine war), May could start to bring answers to some of investors’ big questions.
Despite the futures market already pricing in 225 basis points in additional hikes from the Federal Reserve into the end of the year for a benchmark interest rate just below 3%, central bank hawkishness remains the biggest driver of markets, and the biggest point of fear for investors. The prospect of multiple 50bp hikes over the coming months has already led to a spike in Treasury yields. With the European Central Bank joining the hawkish train, fears have spread, with the Bank of Japan the outlier in maintaining ultra-accommodative monetary policy. Joining Japan, but only gradually, is the People’s Bank of China, which is slowly easing policy – but not aggressively enough to reassure markets on growth, especially with the risk of a Beijing lockdown looming while the Shanghai lockdown is not yet over. This, of course, is adding to inflation fears, as China’s zero-Covid policy has been one of the main sources of higher prices, and locking down factories and ports in Shanghai for longer periods risks reigniting supply chain woes, and higher prices.


In this context, the coming weeks will shed light on the Fed’s plans, with a few big inflation prints expected as well. Mrs. Lagarde’s statement that rate hikes won’t bring down energy prices is accurate, nor can central banks reduce supply-driven higher prices, but they still face decades-high inflation prints and need to be seen as addressing them. May should also bring more insights on any leniency plans in China’s Covid measures – or not –, on the end of the Shanghai lockdown, and on a Russia-Ukraine conflict that is still escalating.


Considering how much has been thrown at markets since the start of the year, we believe investors have shown remarkable resilience, with February lows still holding. Still, it will take a clear peak in inflation, central banks acknowledging they will keep an eye on growth, less worry about Chinese growth and improvements in the Ukraine war to provide a strong catalyst to the upside and lift investor sentiment.


In the meantime, markets may continue to seesaw, failing to break out of recent ranges. Nonetheless, we remain optimistic for the year as a whole, as we believe markets are pricing in too much tightening at this point, as central banks will need to look at 2023 growth prospects eventually. Additionally, the US economy should withstand rate hikes, suggesting a US recession – a fear that will likely only grow over the coming months – is not our base case scenario at this point. As such, we maintain our barbell approach, expecting value stocks to continue to do well, while tech should regain investor support with strong earnings, less hawkish Fed rhetoric and more defensive characteristics.


On the bond side, the sell-off has been massive already. Encouragingly, credit spreads have been relatively resilient, with only CCCs widening meaningfully. While we could see more stress there, as long as growth holds up, credit should hold in. We therefore still like credit risk better than duration, even though we are probably close to peaks in terms of sovereign yields. We therefore hold a more balanced allocation between credit and sovereigns. We also maintain some hedges such as gold, which should recover when the dollar eases, and crypto, which should benefit from improved risk appetite over time.


Equities

Market bounces have proven short-lived as concerns continue to pile on for investors. The ongoing Shanghai lockdown and the risk of other major regions following suit, including Beijing, have added to growth concerns, and weighed on sentiment. Still, with very negative sentiment, bearish positioning and very aggressive tightening expectations for the Fed, markets are already pricing in a very negative scenario.

Encouragingly, the February lows look like they are holding, the recent trading range remains close to intact, and the Q1 earnings seasons has shown solid results so far, with guidance holding up as well. The consumer remains healthy, and able to absorb higher prices, protecting margins. We therefore maintain our constructive outlook for the year as a whole, though the next few months are likely to remain painful.

We believe that the US will perform better than Europe given growth risks and the ongoing Ukraine conflict. We also expect emerging markets to suffer alongside China, as long as it sticks with its zero-Covid policy.


Fixed Income

Sovereign yields finally retreated as growth concerns from Europe to China have led to haven demand for Treasuries. The view that the Fed has reached “peak hawkishness” may also be contributing to lower yields, as the market may slowly retreat from such aggressive hiking expectations, especially as growth worries could rise in the US as well. Of course, yields can spike again, but we believe the bulk of the move is behind us. The impact of the Ukraine war on Europe suggests the ECB will not be able to tighten that much given the expected impact on growth. While we still prefer credit risk over duration risk, the picture appears more balanced as credit spreads could continue to widen on growth concerns over the coming months.

 

Currencies

Concerns surrounding Chinese growth have boosted haven demand for the dollar, coupled with worsening tensions between Russia and the West. USD is also benefitting from interest rate differentials versus Europe – which won’t be able to tighten if growth gets hit – and Japan, which wants to cap yields. Any improvement in the Ukraine or in risk appetite should support the euro, though it may time to materialise. Emerging markets are split between commodity importers and exporters, with China broadly holding up.


Commodities

The Shanghai lockdown and the risk of Beijing lockdowns have weighed on commodities as growth concerns outweigh supply issues. Ongoing war in Ukraine is likely to keep energy prices underpinned, while industrial metals might need an easing in Chinese Covid measures to move higher again. Gold could once again benefit from safe haven demand if the US dollar retreats, but tighter monetary policy remains an obstacle to much higher prices. Overall, while supply chain bottlenecks should slowly abate over the coming months, the conflict implies higher-for-longer prices across most commodities.


Crypto

Cryptocurrencies have been stuck in a range alongside equity markets, with crypto ETPs suffering outflows as risk-off sentiment impacts investor appetite. Still, they have held above resistance levels, and the second part of the year should prove more constructive for risk assets in general. The correlation to tech should eventually help, though it is further weighing on sentiment for now. Broad adoption continues, even if at a slower pace, which should bring longer-term support. Moreover, the growing adoption of NFTs and other blockchain-based innovations, will likely add to demand over time. 

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