From an economic perspective, inflation is likely to take center stage in the second quarter of 2022. The war in Ukraine has been raging for more than a month now and has tended to increase uncertainty regarding inflation and growth prospects. When and with what consequences this war will end is pure speculation, but capital markets will build up a certain immunity to the headline risks in the coming weeks. The medium- to long-term consequences, on the other hand, could be enormous. It is possible that we are at the beginning of a new bloc formation or a new Cold War. This would put a significant damper on globalization and further fuel higher structural inflation.
Consumers on both sides of the Atlantic are already today struggling with high inflation. In the US, annual inflation is almost 8% and in the eurozone it is around 6%. Prices are thus growing as fast as they last did forty years ago. There is a steady and gradual erosion of consumers’ purchasing power – it is therefore understandable that consumer confidence has virtually collapsed in recent months.
With inflation this high, consumers’ purchasing power is literally melting away like snow in the sun. In the US, private consumption accounts for 70% of gross domestic product and is therefore the main driver of economic growth. Thus, the big question now is how strongly rising prices will dampen consumption and impact growth. At the same time, the Federal Reserve (Fed) is determined to fight inflation by all means. But if it tightens monetary policy too quickly, this could slow corporate activity and lead to an increase in unemployment.
The risk of stagflation – the combination of weak economic growth and high inflation – has increased in recent weeks. On the one hand, the growth outlook for the second half of the year has been reduced and, on the other hand, inflationary pressure remains high due to the Ukraine war. In the coming two to three quarters, the threat of stagflation could reappear on financial markets. By contrast, medium- to long-term inflation expectations in the US remain anchored between 2% and 2.5%, which speaks for the Fed’s credibility.
Global growth estimates are continuously being reduced. For example, the Fed has reduced the GDP growth forecast for 2022 from 4% to 2.8%. Although this is still above the expected potential growth, the anticipated interest rate hikes during the year could further weaken consumer confidence and strain investors’ nerves again. The big unknown is when and how quickly inflationary pressure will ease again. This could be driven by an easing on the supply side, because the supply chains are functioning again, or on the demand side, triggered by lower growth. We still think the first scenario is possible, but the war in Ukraine could delay or even stall the synchronization of supply chains.
In an inflationary environment, the focus of the investment strategy should increasingly be on real assets. Nominal asset classes tend to appear unattractive. This is also the reason why we increase the positioning in alternative assets to “attractive” across all assets while reducing liquidity to “neutral”. Within alternatives, gold stands out in particular as it will serve as a good diversifier in the upcoming quarters. With the friendly markets in March, investors had once again the opportunity to get rid of risk positions and focus on defensive positioning, as well as pay attention to quality in each asset class.
With the sharp rise in long-term interest rates in recent weeks, the equity risk premium in some indices has melted, confirming our defensive positioning. This has also led us to favor the US over Europe and emerging markets in the short-term. Weakening global economic momentum and the war in Ukraine argue in favor of the defensive US market, even though it has a relatively higher valuation at the moment. At sector level, we are realizing gains in the commodity sector and reduce the rating to “neutral”. The erosion of purchasing power is hitting companies in the cyclical consumer goods sector disproportionately hard. Therefore, we reduce the sector to “unattractive”.
The expected increase in key interest rates and high inflationary pressure have pushed up the yield curves on both sides of the Atlantic. As the short end of the curve has risen faster than the long end, the yield curves have flattened. In our cross-asset strategy, we confirm our rating with “unattractive” and recommend a short duration positioning. However, some areas have gained attractiveness in recent weeks, including two-year US Treasuries. As they are already yielding over 2.25%, they could soon be an alternative to cash. Hybrid bonds remain the only attractive segment in the fixed income space.
Publisher: LGT Bank (Switzerland) Ltd., Glärnischstrasse 36, CH-8027 Zurich
Author: Thomas Wille, Head Research & Strategy, Email: firstname.lastname@example.org
Editor: Alessandro Fezzi, E-Mail: email@example.com
Source: LGT Bank (Switzerland) Ltd.
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