The last few weeks have been particularly eventful. Most major equity indices are flat or negative year to date, thanks in large part to the ongoing war in Ukraine. The war has raised inflation expectations and dented growth projections. However, March saw a recovery for some equity markets.
Inflation is still the main focus for financial markets, with geopolitical issues adding to already high energy and food prices.
The Fed and the Bank of England raise rates
The Federal Reserve and the Bank of England both raised rates last month, as expected. Their respective tones were, however, slightly different, with the Fed adopting a more hawkish tone than the Bank of England.
Fed Chair Jerome Powell stressed that the US economy was performing well and that the labour market – which is usually a good indicator of the health of an economic cycle – was strong. Job openings in the US are at a 10-year high.
The Bank of England went with a slightly more cautious narrative, highlighting a fear that inflation would damage consumer spending in the coming months. There is a concern that bolder rate increases could send the economy into a recessionary spiral.
In the European Union, inflation is more linked to supply than demand, with energy prices in particular driving up prices. The ECB, however, seems determined to raise rates at least once before the end of the year. The key question is whether Christine Lagarde, the European Central Bank president, is ready to backtrack in the event of a deterioration in economic conditions.
Fixed income struggles over the quarter
The fixed income space has been the most affected by the change in rhetoric from Central Banks, having one of its worst quarters in living memory. Remarkably, the yield curve for US treasuries has inverted, with long term bonds recording lower rates than short term bonds.
On paper, this signal can be taken badly, often signalling a coming recession. The equity market has, however, largely ignored it. This may be due to the fact that high inflation expectations have already been priced in for the short term, and this will normalise over time. If we look at real – rather than nominal – rates, the yield curve is not inverted.
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The big question is whether or not bond evaluations have bottomed out and if portfolios will enjoy some sort of uplift from fixed income rebalancing. This will largely depend on inflation. In the meantime, our exposure to commodities, Chinese government bonds and linkers is helping to offset negative equity performance.
Equity markets showing positive signs
On the upside, equity markets seem to have largely shaken off the geopolitical uncertainty. Particularly in the US, some major equity indexes have delivered a positive performance.
The fundamentals seem robust. First of all, as I mentioned earlier, real rates remain low, a sign of expansionary financial conditions. Secondly, macroeconomic data doesn’t yet suggest a significant slowdown in the business cycle. Finally, looking at expected profits and margins of listed companies, we can that see they’re benefiting from the higher revenues brought by increased prices.
In terms of equities, we’d argue that starting valuations today look better than in the recent past, and this is good news for long term investors. The risk to earnings is also probably greater, especially in Europe. We believe that this is a case for cautious positioning. Our recent rebalance reflected this, but we are wary of being too conservative.
We continue to favor greater equity exposure in the US than in Europe. However, again due to low real rates, equities continue to represent a better opportunity than bonds, and our outlook over both the medium and long term remains positive for equity.
China makes headlines
Finally, it’s worth taking a look at China. The last month or so has been turbulent, with fresh surges of Covid-19 causing uncertainty. Chinese equity has, however, underperformed for some time despite Beijing’s increasing role in the global economy. There are a number of factors to consider here, from the tug of war between government and big tech to the excessive debt in the real estate sector.
We have talked in detail about them in a deep dive article you’ll find as part of this market update. From our perspective, we stick to our view that times are still not ready to take advantage of great evaluation you can find in Chinese equity marketing. We’re also happy with our exposure to government bonds, which has consistently offered us decent returns and remains a good avenue for diversification.
As usual, if you want to discuss market conditions in more detail or have specific questions about your portfolio, book an appointment with a member of our investment consultancy team.