The second quarter of the year is becoming increasingly painful for stocks, recalling memories of the 2000s tech bubble bursting. The repricing of a more aggressive Fed stance has been brutal. But even more significant is the frontloading of interest rate hike expectations outside the US.
The key themes to follow to detect future market moves are:
- Stagflation risks: the growth/inflation battle is evolving unevenly across the world and leading to a more aggressive central bank hiking cycle.
- China’s economic outlook: given the extended lockdowns in Shanghai and the ongoing restructuring of the real estate sector, we expect a broad slowdown with growth below potential this year. That said, we expect a rebound in 2H22 thanks to more policy support.
- Central banks: in their fight against inflation and, most importantly, to preserve their credibility, central banks will continue frontloading the rate-hiking cycle, and we believe they will overshoot their estimated neutral level of rates.
- Markets and earnings growth expectations: we believe earnings expectations are still too optimistic across the board.
All of this means that it is difficult to see an imminent end to the current weak market environment and, as such, we maintain an overall neutral to negative risk stance. According to our models, the probability of entering a recessionary stage in the next six months has risen to c.40%.
We have become slightly more cautious on equities. Regionally, we have also moderated our stance in Europe as we continue to increase the quality tilt, overweighting investment strategies linked to dividends and undervalued quality stocks. In EM, we remain selectively overweight in China and commodity-producing countries in Asia, although we remain positive on Brazil and Mexico in relative terms.
We have further reduced our short duration stance in bonds – we believe we should get closer to neutrality. In credit, we continue to focus on quality and are more cautious about higher-risk segments. We maintain our positive valuation call on EM bonds in hard currency. Regarding currencies, we still believe the USD is overvalued, but there are not enough catalysts for a reversal of this trend given the greater resilience of the US economy.
All in all, although the ‘great repricing’ in equities and bonds may not be over yet, we are likely to see short-term volatility and rotation inside the market as it awaits more clarity to look for opportunities that may have been excessively penalised during the repricing phase.