Stagflation, not recession, is the likely scenario
The first quarter has been challenging. Most importantly, the tragic events in Ukraine are an ongoing humanitarian disaster. For markets, the disruption to commodity supply chains feeds into broader inflationary fears.
Bond traders are pricing in an aggressive 10 Fed rate hikes this year compared to just three at the end of 2021 and this is stoking fears of recession. The 10-year minus 2-year yield curve (2s10s) inverted briefly, which has historically preceded economic contraction (although inversion should last for around 10 days for a clear signal). However, inversion is a poor timer - downturns have varied from 6 to 18 months thereafter.
Few Fed tightening cycles have avoided eventually triggering recession, although Fed officials will be hoping for a repeat of 1994-95 when Alan Greenspan raised rates by 300 basis points over 12 months and succeeded in containing inflation and avoiding recession. However, Greenspan’s actions largely anticipated accelerating inflation; today, the Fed is already facing high inflation. Despite data indicating robust growth, making it premature to forecast a US recession, the Fed only has a narrow strip to engineer a soft landing. Our base case for the US is stagflation.
For Europe, greater exposure to the commodity price shock is likely to lead to at least a mild recession. China appears more isolated from the conflict and its government has recently reaffirmed its pro-growth stance. However, the outlook is complicated by geopolitical concerns, its zero-Covid policy and its regulatory clampdown.
We will be watching the upcoming earnings season for signs of how consumers are coping with rising prices and the confidence of managers to invest. We’ll also be looking for confirmation that energy, utilities and staples are outperforming as these sectors have historically led during periods of stagflation (communication services, discretionary and technology have historically underperformed).
We expect 7.5% earnings growth in 2022, which is much lower than last year, but still respectable and should help offset lower equity multiples as bond yields rise. In an inflationary environment with negative real rates, equities as an asset class should be relatively well placed.
Ned Salter
Global Head of Investment Research
The Equities Outlook provides an overview of our investment team’s views and positioning in each of the key markets. Each of our portfolio managers has discretion over the positioning and holdings of their portfolios, and, as a result, there may at times be differences between strategies applied within a fund and the views shared in this document.
TRADING DESK UPDATE
Rollercoaster market taking cues from fixed income
A dream finish to 2021 turned into a nightmare start to 2022 - the worst ever start to a year for both US equities and treasuries. The end of March also marked the first down quarter since the start of the pandemic, and much of this is to do with cues from the fixed income market. Bond traders have priced in ten 25 basis point hikes this year compared to just three at the end of 2021.
Despite elevated levels of uncertainty, stocks bounced back in March (S&P 500 +3.7% total return), cutting the year’s losses to just 4.6% having been down 12.3% at one point. Stocks outperformed both long-term treasuries (-10.2%) and corporate bonds (-7.7%) amid higher rates with the 10-year bond yield climbing 83 basis points.
Volatility across all assets was elevated. WTI Crude swung wildly, peaking intraday at US$130.5 on 6 March, troughing at US$93.53 on the 15th and closed out the month at US$101.20 - a 33% rise in the first quarter. The VIX also fluctuated, peaking around 37.5 on the 8 March and troughing at 18.7 on the 29th.
Declining fear helps recover some losses
Source: Bloomberg, 5 April 2022.
At one point in March, a number of European markets traded in bear market territory (-20% from the highs). The Stoxx Europe 600, on huge volumes reached its most technically oversold level since the 2020 global market crash, and Europe had its largest weekly outflow ever in March. However, the second half of the month was, in stark contrast, a bear market rally. The index rose 1% overall for the month, leaving it 7% below the record high set in early January.
Asian indices were softer than global benchmarks in March. China and Hong Kong markets were significant laggards. China suffered its weakest quarter since 2015, and the CSI 300 Index lost nearly 15% over the period. The US Securities and Exchange Commission (SEC) published its first list under the Holding Foreign Companies Accountable Act (HFCAA), which triggered fears of ADR de-listings and led to corrections in many names, although sentiment did recover towards the end of the month.
Northbound connect investors withdrew money from Chinese stocks with outflows of around US$7 billion, while Southbound investors bought over US$6 billion in Hong Kong-listed stocks.
Biggest China underperformance since 2016
Source: Bloomberg, 31 March 2022.
Value continues to outpace growth
The Russell 1000 Value index outperformed the Growth index by 7.7%, clocking its best quarter since Q1 2021, and representing a 95th percentile quarter for value versus growth performance.
The top three sectors this year - energy, utilities, and consumer staples - are historically also the best performers during periods of stagflation, where GDP is below average and inflation is rising. In a mirror image, the bottom three sectors this year - communication services, consumer discretionary and technology - are historically the worst performers during stagflation.
In Europe, the mix of sector performance resulted in an underperformance of around 3% for cyclicals versus defensives and a 1% decline in European value versus growth stocks.
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