With inflation forecasts revised up and growth predictions downgraded in Europe and the US, the key issue for us is the impact on earnings and consumers’ purchasing power. We think a lot of negative newsflow is already priced in some corners and we could see some temporary rebounds.
However, we are still not directionally positive on risk assets because the economic environment is uncertain and so is monetary policy. We acknowledge that strong directional bets on risk assets are not easy to make and we remain slightly cautious overall. Instead, investors should explore the resilience of the US over Europe (in equities and credit), aim to benefit from (intermittent) economic reopening in China, and exploit relative value ideas. In addition, this is also a time to be well-diversified and maintain hedges.
High conviction ideas
We are slightly defensive on equities overall and believe Europe (cyclical and more open market) would suffer more than the US in case of a downturn and if Russia squeezes gas supply to countries such as Germany, causing the region to adopt gas rationing. Thus, we raised our regional preference for the US, including some growth. In EM, we are more positive on Chinese mainland shares owing to the supportive policy, economic reopening, and the focus on domestic growth. However, valuations in India look expensive. In FI, we maintain a very dynamic approach. Even though we are close to neutral on duration in the US and core Europe, we are monitoring pressures on inflation and growth across geographies. For instance, we are now positive on UK 5Y real rates which reflect our views on their attractive valuations and stagflation in the country. The market seems to have priced in a very hawkish Bank of England, but that is not justified by the UK’s weak economic backdrop. So, we think, the BoE is unlikely to hike as much as some other CBs, such as the Fed. Furthermore, inflation will remain high and would be exacerbated by a weak GBP.
On peripheral debt, we keep our 10Y BTP-Bund spread holding for now amid the ECB’s commitment to preventing fragmentation. However, we are closely following the situation after Mario Draghi’s resignation and ECB policy tightening. In EMBI, we remain neutral due to the fallout from Fed tightening on EM spreads. Corporate credit appears to be slightly attractive as valuations seem to discount a recession. But here, we prefer US resilience, maintaining our US IG preference owing to a relatively robust macroeconomic backdrop, corporate fundamentals (solid balance sheets, with high liquidity levels; good coverage ratios), and a low risk of refinancing debt in the near term. However, in Europe, although we acknowledge that valuations in HY are attractive, sentiment is now becoming negative on account of rising stagflation risks. FX is an area where diverging global trends are becoming more apparent. We stay positive on the CHF/EUR and cautious on the EUR/USD, despite the currencies reaching parity recently. The US/Europe rate differential, the Fed’s hawkish stance, and risks of a deceleration in growth globally are all positive for the greenback. The last factor is also supportive of the USD/CAD, which. In EM, we are particularly cautious on Eastern Europe and hold our BRL positions vs the PLN and HUF. Brazil could benefit from strong commodity exports, whereas the two latter currencies could suffer from a deterioration in outlook as the countries are net commodity importers and are close to the Russia/Ukraine war.
Risks and hedging
In light of a mild deterioration in the economic backdrop, and ensuing volatility and potential liquidity issues, investors should consider maintaining all their hedges, particularly on the equity side. Importantly, in the current environment, the USD/EUR would strengthen and investors’ FX hedges should reflect these FX dynamics.