The ongoing sharp rise in prices and subsequent erosion of purchasing power is not only keeping investors on edge in advanced economies, but also continues to weigh on the main driver of economic growth – the private consumer. This notable increase in recent quarters is primarily due to the aftermath of the corona pandemic – disrupted supply chains – and secondarily to the war in Ukraine. We expect higher structural inflation in the coming quarters, owing mostly to the conflict in Ukraine as well as the corona crisis. This can be demonstrated by a slowdown in globalization. The two events triggered a supply shock, which precipitates an enormous increase in inflation, as seen in the 1970s.
Capital markets expect a much shorter and faster cycle of interest rate hikes in the United States than in the past. Over the next four meetings of the Federal Open Market Committee (FOMC), 175 basis points are expected, meaning that the Fed will have to raise its key rates by 50 basis points several times. In addition, Federal Reserve Chairman Jerome Powell will start reducing the Fed's bloated balance sheet in May 2022. We anticipate the balance sheet to be reduced by over one trillion US dollars over the next twelve months. Both measures are likely to tighten financing conditions in the United States. Arguably, the tools of central banks have a high degree of effectiveness when it comes to demand shocks. In the current setup, however, the problem is on the supply side, as described. The G7 central banks will fight inflation with all means at their disposal, which may also be to the detriment of growth. In our view, the risk of an economic slowdown or even a recession has therefore increased in recent weeks. The bright spot in this very delicate situation for the monetary authorities certainly remains that the value chains will re-synchronize soon and thus the pandemic implications will be weakened. This remains our main scenario for the second half of 2022, while into the summer we expect continuously high degree of uncertainty due to stressed value chains, the war in Ukraine and the conflict with Russia.
The setup described is well known to investors and thus reflected to a large extent in today's prices. Therefore, it is not surprising that capital markets have already adopted a cautious or bearish positioning. The number of bulls is as low as it was last seen 30 years ago and the difference between bulls and bears is at a ten-year low. It can be argued, this indicates that for the overall market, much of the negative news has already been priced in. This contra-indicator certainly continues to posit for a very selective exposure to equities.
On a global basis, business and consumer sentiment indicators continue to weaken, while leading indicators (PMIs) remain relatively robust across the board. The ongoing war in Ukraine and uncertainty regarding the global supply chains will weigh on confidence and sentiment, respectively. Both fiscal and monetary policy will certainly be less supportive for the remainder of the year, with short rates expected to pick up quickly in the US due to high inflation (core and headline). Inflation is not only the dominant issue for central banks, but also their unbending will to fight it with all means and consequences. Therefore, we are expecting not only a slowdown in economic activity, but also observe a higher risk of recession in the coming year.
Even though price increases may have peaked in the second quarter, we expect inflation to be more “sticky” than expected. Also, the word “transitory” probably needs to be extended from months to quarters, if not years. In this environment, we clearly favor “real” assets over “nominal” ones. Across assets, this leads to a preference for alternative investments and equities over cash and bonds. The focus remains on selection within each asset class. For example, the German stock index Dax, representing 40 companies, has an enormous dispersion from +40% (best value) to -60% (worst value) in the first four months of this year. This performance behavior is typical of a late-cycle economic environment.
We maintain both our defensive positioning in equities and our neutral rating. In the current inflationary environment, equities continue to offer real value characteristics and thus real assets. We recommend selectively taking profits during periods of strength, as we see limited upside potential in equity indices now. Likewise, investors should divest from stocks that may face significant headwinds with lower economic growth. On a regional level, the US remains our defensive pole and on a sector level, consumer staples and utilities are our defensive poles. The focus on quality stocks with a corresponding dividend yield will remain a guarantee for success in the coming months.
Despite the recent sharp rise in yields, we do not yet see a turning point for government bonds and maintain our unattractive rating. We also see it as too premature to change our short duration positioning. Within the fixed income quota, we prefer hybrid bonds and prefer inflation- linked bonds to government bonds.
In the current environment, we continue to see potential in alternative investments. Gold continues to hold price potential and we maintain our attractive rating. We recommend accumulating the precious metal on any major price weakness.
Publisher: LGT Bank (Switzerland) Ltd., Glärnischstrasse 36, CH-8027 Zurich
Author: Thomas Wille, Chief Investment Officer, Email: firstname.lastname@example.org
Editor: Alessandro Fezzi, E-Mail: email@example.com
Source: LGT Bank (Switzerland) Ltd.
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