In our multi-asset portfolios, we reduced tactical risk positions in European and emerging market equities to neutral and opted for cash, while keeping the option open for further reductions should the situation deteriorate. Our main equity exposure is in Japan. We are long commodities and long the yen against the euro.
We increased our short duration position in US Treasuries given our cautious fundamental view on core bonds. The conflict is expected to add to already strong domestic inflationary pressures. Bond yields with longer maturities seem far too low to us.
Offsetting the impact of rising inflation on nominal yields, geopolitical risks pushed real rates lower. European real forward rates are 350 basis points lower than in 2011, when oil prices were last at these levels. US real forward rates are 125 basis points below levels associated with secular stagnation, which was already a fairly pessimistic assessment of the global economy.
Looking further ahead, we think the role of government bonds as a source of diversification for multi-asset portfolios is questionable. Yields at or around 50-year lows lock in potential low returns and offer little protection. Second, all the ingredients for higher yields are here:
- Acute labor shortages
- Large-scale stimulus measures are rolled back faster than expected
- Globalization in reverse
- An oil shock superimposed on a larger and longer lasting inflationary shock from Covid-19 than expected.
It is not clear to us that it is time to buy broader equity risk; a further escalation of the conflict will have a significant impact on earnings, with Europe being the hardest hit. Alternatively, any de-escalation would likely result in a strong price rally. The longer the conflict lasts, the greater the risk of lower growth and earnings.
A risk of stagflation
History teaches us that most geopolitical crises have only a transitory effect. This geopolitical event could affect macroeconomic variables. A sustained rise in energy prices will lead to higher inflation and slower growth. Oil prices have so far increased by 50% compared to the end of 2021; this is unlikely to hold even if prices eventually settle higher. A similar price increase in 2011 slowed growth, but did not lead to a recession.
The risk of stagflation has certainly increased, but fortunately most of the world’s major economies were expected to experience above-trend growth this year and next, so there is a cushion to absorb any slowdown.
So far, markets have fallen more than an objective estimate of the economic impact would suggest. This reflects concerns about more sanctions and restrictions on Russian oil and gas exports. Until the market senses that this risk has diminished, we can expect volatility and possibly further declines in risky assets.
Central bank tightening and real yields
A deeper and more persistent factor affecting asset prices is the expected tightening of monetary policy. Although the conflict in Ukraine has made central bankers more cautious about the outlook, it seems unlikely that they will change course significantly. While the threat to growth would suggest that they hold off on rate hikes or quantitative tightening, rising inflation expectations would call for more hikes. As a result, the markets barely changed their forecasts for the level of key interest rates over one year (see chart 1).
We expect the “pre-Ukraine” pattern of rising real yields to reassert itself. We believe the outlook for medium-term growth and inflation is above the “new normal” of secular stagnation of the decade before the pandemic. Real yields are expected to rebound towards pre-pandemic levels. Therefore, we are underweight US duration.
Equity valuation: further normalization?
We expect equity analysts to start factoring a more pessimistic growth outlook into their forecasts. Similar to the GDP growth forecast, there is a possibility that earnings will decline while posting growth in 2022 and 2023. The earnings growth forecast remained strong, with 14% yoy expected for Japan, 9 % for US, 7% for emerging markets; Europe looks better next year.
Japanese companies stand out for their high cash levels, attractive valuations and local political support. They take advantage of their distance from the Ukrainian conflict. Emerging market returns may diverge between commodity-exporting EMEA and Latin America versus commodity-importing Asia. Regulatory developments in China remain a concern.
The declines in equities so far this year have been mainly due to the normalization of valuations. Yet, with the exception of Japan and the UK, stocks are still not particularly cheap. We will need a stabilization of the geopolitical situation and a clearer assessment of the earnings outlook before we can determine where valuations are truly attractive.
All opinions expressed herein are those of the author as of the date of publication, are based on available information and are subject to change without notice. Individual portfolio management teams may have different views and make different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income from them can go down as well as up and investors may not get back their initial investment. Past performance does not guarantee future returns.
Investing in emerging markets, or in specialized or restricted sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of developed international markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds investing in emerging markets may involve greater risk.