First, a view on the outlook for US interest rates. Expectations for federal funds a year ahead fell about 40 basis points amid signs of weakening economic growth and worries about a recession. Growth needs to slow if inflation is to move closer to the US Federal Reserve’s long-term inflation target. Already, retail sales growth is running out of steam and purchasing managers’ indices (PMI) are falling. Investors fear that the deceleration may go too far.
A key indicator to watch will be US wage growth. Recent wage gains have been inconsistent with the Fed’s inflation target. Wage growth will need to start to decline by the fall for markets to continue to believe that another 200 basis points of fund rate hikes – as discounted – will be enough to manage inflation.
Consensus estimates of GDP growth are not reassuring. These suggest that growth will remain stable at around 2% each quarter until 2023. The most negative forecasts, which could signal a recession, suggest that this could happen towards the end of next year. Although our view is more pessimistic than the consensus, we expect a recession to be avoided.
Earnings forecasts were mostly flat, with analysts factoring in lower demand due to inflation and lower margins due to higher costs (see Appendix 1). Even so, we believe the outlook for Europe ex-UK is overly optimistic and expect significant downgrades ahead. The boost to earnings growth in the materials sector should only be temporary. Profits in Europe’s energy sector could nearly double in 2022 before plummeting over the next two years.
Admittedly, in the asset allocation portfolios, we would prefer to be only long on commodities, a position which has worked well for us and on which we are maintaining a clear overweight, restored in mid-April.
After a period of strong outperformance, we deepened our short in Europe. European cyclical equities face headwinds from slowing growth and rising inflation; an ECB clearly focused on inflation; geopolitical risks; and overly optimistic analyst earnings forecasts.
Our long exposures focus on Asia. We believe Japan offers quality value, with a supportive domestic policy environment and upside risks weighing on the consensus earnings outlook. In China, politics are also supportive amid very attractive valuations, particularly in the technology sector (see below).
China’s challenges and opportunities
Markets now seem to be looking beyond short-term challenges, assuming Covid-related lockdowns will eventually be lifted and activity will resume. Beijing has recently sought to follow through on its promise to do “whatever it takes” to support growth and we have seen better relative performance in Chinese equities.
We see three supports for a tactical allocation to China:
- First, valuations. Chinese equities remain nearly one standard deviation cheaper than global equities on forward price-to-earnings multiples. The discount is particularly marked in the technology sector.
- Second, more favorable prospects. We anticipate good earnings growth: in consumer discretionary, for example, consensus and BNPP AM research predict earnings gains of 40%. Additionally, positive market timing signals remained in place. We note the resilience of tech names now that the drive to regulate the sector seems to be behind us.
- Third, the reversal of the credit impulse in China as policy tightens elsewhere. This should create a favorable framework for Chinese companies.
The search for higher returns
Nominal 10-year US Treasury yields breached the meaningful 3% threshold in May for the first time since July 2018. Five-year/five-year forward real yields rose toward the post-GFC “new normal” associated with secular stagnation.
While a new regime of higher inflation should lead to higher policy rates and higher long-term yields, the immediate market moves have been intense. As a result, we gradually reduced our duration underweight.
In our view, there is room for inflation expectations to rise – that’s still a long way off for basic personal consumption spending (the Fed’s preferred measure of inflation) and inflation may not not decelerate as quickly. We also believe that term premia could rise further as the central bank steps up its inflation-fighting measures, including quantitative tightening (QT).
For valuation reasons, we reduced our short positions in the US and Europe, while maintaining our short position in Japanese sovereign bonds. Fundamentally, however, we remain cautious on long-duration assets.
Asset class views
|I do not like at all||Do not like||Neutral||Foster||Strongly supportive|
|Asset allocation||Government bonds||Real Estate Loan Cash||Equities Commodities|
|Equity regions||Europe excluding UK||WE||Japan GEM|
|Stock style/size||EU large cap EU small cap US large cap US small cap|
|Sovereign bonds||United States Europe Japan||Local EM Australia UK Linkers|
|Credit||United States investment-grade American high-yield Emerging markets||EU IG EU HY|
|Goods||Precious metals||Energy Base Metals|
|Effects||USD, AUD, GBP, EUR, emerging market currencies||JPY|
*Risk Appetite/Risk Return – Data as of May 27, 2022. Views reflect those of the MAQS Multi-Asset Team Investment Committee. Other specific/tactical professions can be implemented in addition.
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. The opinions expressed in this podcast do 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.