Stagflationary dynamics still in the background

Market sentiment improved last week despite the Federal Reserve doubling down on inflation at its 16 March meeting, leaving the MSCI World slightly higher than it was before the invasion began. It has been an extremely volatile few weeks and how much of last week’s rebound of risks assets was driven by short covering or oversold dynamics and how much was driven by investors prepared to buy the dip is unclear at this stage. 

We are yet to be convinced the outlook has improved. Behind the market’s volatility, we believe the challenging stagflationary dynamics are unchanged. Inflation was high in the West even before the war, while growth was under threat from a consumer squeeze and tighter financial conditions. Both of these have already been exacerbated by the war, and the extent of further economic damage will be determined by when and in what form a resolution arrives. Our quantitative models are still pointing to risk off, while lockdowns in China pose another danger to supply chains and growth.

We made no changes to our core views last week. We are still cautious on risk assets, expressed through underweights to equities and credit. We are underweight Europe equities and the euro, a reflection of the acute impact of the war in the region. Within credit we are positioned defensively, overweight IG and underweight HY.

Recent tactical positioning has focused on increasing exposure to the dollar. We feel it will find support as a safe-haven asset if the outlook deteriorates, while the Fed will have a licence to keep tightening if the outlook improves. We are also currently looking for areas of the market less impacted by the stagflationary dynamics. Europe and Japan are vulnerable to high commodity prices, but selected emerging markets, especially India, and countries in the Pacific region should be more resilient.

Over a slightly longer time horizon, we see reasons to be more optimistic. China is easing monetary and fiscal policy and there were further indications last week that the government will focus on growth this year. This boosts the case for emerging markets overall. Inflation in the West should peak, potentially allowing central banks to take a softer approach. Labour markets are tight and consumer balance sheets are still healthy. But for now, we prefer to be underweight risk.

Core Asset Allocation

Asset class View Change Rationale
Multi Asset  
Equity  
Credit -  
Duration -  
Cash  
Equity Regional      
US  Covid looks to be past the worst but consumers, the backbone of the US economy, are feeling the pinch from inflation and sentiment is weakening. Rising real yields as a result of a more hawkish Fed are still putting pressure on high multiple growth stocks.
UK - We believe that political problems are on the rise - local elections are coming in May and consumers are feeling the pinch from rising prices and the end of furlough. However, the large cap index benefits from higher commodity prices and rising rates, which keeps us neutral for now.
Europe ex. UK - Within equity regions, we move underweight Europe as the risk of recession in the region is now high, with the most immediate effects felt through high commodity prices, which will increase inflation and lower growth.
Japan Valuations are cheap, earnings growth is picking up, and monetary policy and fiscal policy should remain accommodative. However, we are monitoring the situation closely because Covid cases are once again accelerating, while rising US yields could negatively impact equity market sentiment.
Pacific ex. Japan ▲▲ We move overweight Asia Pacific ex Japan, based on a more positive outlook for Australia as a result of its high exposure to commodity producers.
EM - Our overweight view is driven by China policy easing. We are watching the Covid situation in China closely for its impact on supply chains and further monetary and fiscal support. We have a positive view on Latin America - monetary policy ease going forward as inflation appears to be peaking.
Credit      
IG Credit Fundamentals might be strong, but QT has historical hurt IG flow more than HY and although valuations are improving, spreads are still low compared to history.
Global High Yield Earnings continue to be strong, defaults should stay low, and the high oil price supports US HY. However, spreads are still below historical averages and therefore have scope to widen further as central banks turn hawkish.
EMD $ The Russia-Ukraine conflict is a source of unpredictable volatility for the asset class. Other than that, Covid cases are stabilising and vaccination rates are improving, although investor concerns about rates volatility or a stronger USD may worsen sentiment and cause more outflows.
Rates      
US Treasuries   - Another big upside surprise on US CPI cements the view that the Fed is well behind the curve. However, we feel the underweight to the US is better expressed through real rates (via TIPS) than through nominal rates (via Treasuries).
Euro core (Bund) - The ECB performed a hawkish pivot as inflation continues to surprise to the upside. The ECB must also contend with credit and periphery spread pressures, introducing two way risks for European bond investors. We prefer to be neutral until more clarity emerges.
UK Gilts - The team sees a lot of specific headwinds for the UK (inflation, Brexit etc), yet we do not expect gilts to disconnect from Treasuries. We remain neutral on gilts for now.
Japan We re-establish our long JGBs position as the funding source for the higher conviction stance on shorting US (real) duration. The BoJ has quickly put to rest to market concerns that it might follow other central banks into a more hawkish stance.
US TIPS Tapering QE followed by a rapid move to QT is expected to put upward pressure on TIPs although the Fed will be keen to avoid a repeat of the 2013 taper tantrum. The Fed is suppressing rates and wants to keep real rates negative, but there remains room for real rates to rise while still achieving this aim.
Currency   -  
USD - The Fed has become even more hawkish over the past month. This should support a higher USD, especially against the low yielding JPY. Our quant model is unsupportive however, and we may be approaching a USD peak when the Fed finally starts hiking.
EUR ▼▼ In rates, we have downgraded our view of the euro to underweight in anticipation of the ECB moving away from the more hawkish position it adopted at the start of February.
JPY ▲▲ We have closed the underweight to the Japanese yen in view of the current risk off environment.
GBP - The BoE is very hawkish and is hiking into the biggest disposable income squeeze in over 30yrs. We don’t expect the BoE to hike another 4x this year as data could be more challenging in H2.
EM Fx - Many EMs have hiked ahead of the curve and inflation may be starting to come off, supporting higher real yields. Also, higher commodities and China easing is supportive of EM.

Source: Fidelity International, as at February 2022. Change as at 22 March 2022 reflects directional tactical difference in view versus previous month. Views reflect a typical time horizon of 12–18 months and provide a broad starting point for asset allocation decisions. However, they do not reflect current positions for investment strategies, which will be implemented according to specific objectives and parameters.

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