High near-term uncertainty keeps us cautious
We are still cautious on risk assets overall, expressed through underweights to both equities and credit in our core portfolio. The war in Ukraine and the associated sanctions on Russia add significant near-term uncertainty to commodity markets and supply chains. News flow and the potential for short covering should make the market volatile even if conditions do not deteriorate from here. It is clear that unfolding events are causing a major realignment of positioning. Sanctions could lead to further disruptions to the financial market, banking sectors and supply chains. Elevated commodity prices will exacerbate stagflationary dynamics and increase the risk of recession in Europe.
Central banks are facing a treacherous set of policy decisions this year; any mistakes will have serious consequences. The ECB was more hawkish than we expected at its meeting last week. However we expect the ECB will become more dovish as the full extent of the damage to the European economy becomes clear over the coming months. To that end, we are watching flash PMIs for industrial sector weakness to provide an indication of when the ECB pivot will come and how far it will need to go.
There is now a high risk of at least a moderate recession in Europe. Even if the supply of commodities continues, the price rises alone have been enough to cause some rationing that will lower output in various sectors. However, we are more optimistic on global prospects over a 12-24m horizon - labour markets are still strong, consumer balance sheets are healthy even if sentiment dips, and China is easing policy gradually.
Need for patience in China
The lockdown in Shenzhen is a further blow for the global economy. Not only is the area home to nearly 30 million people, but it also produces a large amount of goods consumed globally. The lockdown raises the prospect of more supply chain issues that will add to price pressures. We still feel China should provide some diversification protection from the war in Ukraine. However, we are yet to see the sort of broad-based easing of previous policy cycles, and sentiment is being hurt by capitulation selling in equities.
Recent media reports that Russia has requested military aid from China have raised a tail risk of China being drawn in some form into the heavy sanctions now imposed on Russia. The interdependency of China and the West is multiple times higher than that of the West and Russia, across both economic and financial dimensions, and cost of outright conflict (military or economic) would be catastrophic for the globe. Recognition of this reality in itself opens the door for compromise.
Core Asset Allocation
|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.|
|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.|
|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.|
|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 16 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.
Recent changes to core views
- We have upgraded our view of US equity to neutral from underweight. The US economy is more insulated from the disruptions in the commodity markets, while the safe haven nature of the US market and USD could prove to be more resilient in the current climate.
- We have downgraded Japan equities to neutral from overweight. The Japanese economy is vulnerable to supply chain disruption and commodity shortages. Valuations are still cheap, however US monetary tightening could hurt sentiment.
- We have moved to a defensive position within credit by moving underweight in HY and overweight in IG. Spreads in IG have widened, making valuations a little more attractive. HY spreads are still tight, however, meaning they could widen further, while HY could also be hurt by tightening financial conditions.
- We have moved to overweight in EMD. We are mindful that the conflict could broaden. However, spreads in EMD ex Russia have widened significantly, even for regions not directly affected by the war, meaning there are now some areas that appear decent value.
- We have neutralised risk in government bonds by closing our underweight to US TIPS and our overweight to JGBs.
- We have moved underweight the euro as a result of the significant growth shock to the region. We are still underweight Europe equities.
- The risk environment is not conducive to a short yen position at the moment so we have neutralised our underweight for now.
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