The hour of the Hawks

In a painful month for bonds and equities alike, rising inflation and hawkish central banks sent yields soaring while geopolitical and growth worries drove risk premia up in April. Global equities suffered their biggest monthly setback since the pandemic sell-off in March 2020, with our defensive stance on risk and duration paying off. Amid plentiful bearish news, it is easy to overlook some silver linings.

Following the slump in March, key confidence indicators (incl. PMIs, Ifo) defied expectations of a further fall in April, keeping economic surprises positive and even marginally rising. Services account for much of the relief, as eased lockdowns in Europe unleashed pent-up demand in sectors battered by the pandemic. Macron’s victory in French elections has also removed a key tail risk of extreme right populists undermining EU integration.

Yet, caution is set to prevail among investors over the coming weeks. The conflict is morphing into an attrition war, with human atrocities and increased western supply of weapons to Ukraine thrashing hopes of a quick negotiated solution. Sanctions on Russian energy exports are set to be extended towards oil, while Russia may extend curbs to gas proliferation. This keeps the risks for energy prices geared to the upside. Recent Covid worries in China are just adding to central banks’ stagflation dilemma. Lockdowns due to China’s increasingly desperate zero-Covid strategy are weighing on global growth while risking renewed supply chain disruptions and price increases. Inflation credentials trump growth worries – for now

Persistent inflation overshoots (and surprises) keep the hawks in the driving seat at central banks – at least for now as inflation credentials are prioritised over growth concerns. The Fed has brought forward its hiking cycle, with rate hikes of 50 basis points in May. We also see mounting risks that the ECB will bring its rates lift-off forward to as early as July.

Further out, however, the higher fragility of the recovery and markets alike may ultimately make the Fed and the ECB tread more carefully. Markets seem complacent on the growth risks from these combined headwinds (our forecasts are below consensus). With US rate hike expectations priced by summer 2023 looking excessive, we only see moderate further upside for yields from here.

Equities may find some support from already very bearish sentiment, with the share of bullish respondents in the AAII investor survey dropping to the lowest in three decades. Yet actual positioning is not aggressively defensive, with investors wary of cutting equity exposure more drastically as a shift into bonds is neither appealing amid persistent inflation worries. This keeps us tactically underweight, most so in cyclicals and euro area. We see residual value in Credit due to the attractive carry and spreads (e.g. large relative to country spreads), but we favour defensive segments. USD strength is stretched, but may extend short term amid persisting war concerns in Europe and a strikingly dovish BoJ eroding the yen.