Barometer of financial markets march investment outlook

Just as the Covid crisis has begun to fade, a conflict in Ukraine is erupting. The question investors now face is the degree to which Russia’s invasion will undermine the global economic recovery. The next few weeks will offer some clarity.

Even so, as long as Russia’s invasion doesn’t result in a drawn-out conflict, any consequences to global markets are likely to be manageable. Neither the Ukraine crisis nor the spike in oil prices is enough to derail what continues to be robust global growth. 

Both countries make up only a small proportion of world GDP and, apart from Russian energy exports to Europe alongside some other commodities, have fairly modest roles to play in global trade. Some global industries will be potentially affected – apart from commodities: car manufacturers, food producers, steelmaking and chipmaking – but it is the second-round effects on European inflation and consumer confidence that need to be monitored.

Fig. 1 - Monthly asset allocation grid

March 2022

The conflict might prove concerning enough to stay some of the more hawkish elements at the world's major central banks, not least the US Federal Reserve. So while the trend clearly remains towards monetary tightening, it could be at a slower pace than the markets have been pricing recently.

With all that in mind, in the very short term, it makes sense for investors to show some caution. Which is why we have taken a few risk mitigation measures within our equity positioning. But overall, our main asset allocations – overweight equities, underweight bonds - remain unchanged. 

Our business cycle indicators point to a positive outlook for the global economy during the next year, with all major economies expected to grow at between 3 per cent and 5 per cent. World retail sales may have peaked, but they remain above  trend. Industrial production and exports are accelerating. And services affected by Covid are poised to boom – not least travel and mass events. 

The US economy, which is least likely to be affected by Ukraine, shows strong underlying consumer demand and a resilient housing sector. Europe is vulnerable to its reliance on Russian gas, but the overall trend is towards recovery and monetary policy is likely to remain supportive. And China is starting to recover. 

Meanwhile, even with the latest spike in oil prices, inflation should peak towards the end of the first quarter or early in the second across all major regions.

Fig. 2 - Stocks' earnings multiples could stop contracting this year

Change in MSCI All Country World Index 12m trailing price-to-earnings ratio, actual vs. Pictet model estimate* (%)

Our liquidity indicators offer mixed signals. Set against a the vast pool of global liquidity that has been built up during the Covid pandemic, central banks are starting not only to turn off the taps, but to drain some of the excess – we expect a net contraction of central bank liquidity this year to reach 3 per cent of global GDP. The Fed is poised to undertake a quadruple tightening – exiting quantitative easing, starting quantitative tightening and hiking rates even as inflation peaks and starts to slow. Offsetting this, however, is growth in the provision of credit from private sector banks. And central banks might find it prudent to talk down some of the markets’ excess hawkishness, particularly in light of global events.

Our short-term valuation indicators show that both equities and bonds are trading at close to fair value, with only commodities looking expensive among the major asset classes. For the first time in a long time equity markets do not exhibit extreme relative valuation readings in either regions or sectors. The US remains the most expensive stock market, but only moderately so. The upward move in real rates was behind the recent outperformance of value stocks over growth – future earnings are worth less today as rates head higher – but that trade might be running its course. And while there may be further downward pressure on price to earnings (P/E) ratios, a 20 per cent decline in 12 month P/Es since September 2020 suggests there’s limited scope for further contraction in stocks' earnings multiples for the rest of this year – so, for instance, our model suggests P/E ratios will stabilise over the coming year (see Fig. 2).

Our technical indicators suggest that equities are oversold – particularly after the Ukraine-inspired drops. But there are no real signs of market panic. US equity sentiment is particularly gloomy, a bearish shift that’s been confirmed by the latest Bank of America fund manager survey. To us, this indicates the scope for a further sharp decline in US stocks is limited.

In the face of the conflict in Ukraine and increased market volatility, we have reduced exposure to those areas of the equity market most at risk from the fallout from Russia’s invasion. 

We have, for example, become more cautious on the prospects for European equities. In Europe, the impact of sanctions against Russia will likely lead to higher inflation and lower growth, putting pressure on both stocks’ earnings multiples and corporate profits. Our analysis shows that 21 per cent of the euro zone’s energy imports come from Russia. Combine that with the more hawkish tone from the European Central Bank in recent weeks, and we think an overweight position in European equities is no longer warranted.

However, it is important to point out that the euro zone’s trade ties are not strong outside energy, which accounts for two-thirds of the value of euro zone’s Russian imports. Europe does have some exposure via its banking sector but that, too, is modest. Even in Austria, whose banks have by far the closest links to Russia within the euro zone, exposure is equivalent to just 1.7 per cent of GDP, according to our analysis. On the other side of trade, meanwhile, Russia consumes 2.6 per cent of euro zone’s exports.

Those mitigating factors, coupled with Europe’s strong economic data, prevent us from turning underweight on the region; instead we shift from overweight to neutral.

Fig. 3 - Value outperforming growth

Relative performance of growth vs value stocks and reopening vs lockdown plays, MSCI World constituents

We continue to favour overweight positions in cheap cyclical value markets like the UK and China. China’s economic recovery on the back of a coordinated policy shift is confirmed by the latest data and we expect growth to accelerate in the second half of the year. Chinese equities also offer a good level of diversification and hedge against any further deepening of the crisis in Ukraine and continued global monetary tightening.

In the US, we expect both corporate profit margins and stocks’ earnings multiples to remain flat for the rest of the year, which supports our neutral stance. The US is still the most expensive equity market on our valuation scorecard, even though it is the cheapest it has been in a year following its steep decline so far in 2022. 

Among sectors, we maintain a clear value tilt with overweight positions in both materials and financials. 

Financials will be supported by rising interest rates. Materials, meanwhile, should benefit from higher commodity prices and China’s economic recovery. Valuations are still relatively cheap – unlike in the energy sector which is looking increasingly expensive and where technical indicators appear stretched.

Although government bonds have suffered their worst start to the year since 1980 the economic fallout from the Ukraine crisis may encourage investors to revisit their expectations for a sustained and agressive monetary tightening campaign. Fixed income markets had priced in at least six interest rate hikes from the Fed this year, but as the conflict enters a more unpredictable phase, it opens up the possibility of a gentler rise in US borrowing costs. In our view, any more than six 25 basis point hikes would risk derailing the US economy’s recovery from the pandemic.

Still, moving to overweight position in US Treasuries at this point carries considerable risks – particularly if US policymakers choose to ‘front load’ rate increases in response to a spike in US inflation. As Fig.4 shows, when comparing the current real US interest rate to the level implied at year end, the Fed's interest rate hiking campaign looks to be the most aggressive of all the major central banks.  Taking all this into account, we have chosen to remain neutral US government bonds.

Fig. 4 - Fed behind the curve

Real interest rates: current vs year end level by country

We are also neutral emerging market bonds. At first glance, the economic sanctions imposed on Russia in response to its attack on Ukraine appears to be a bearish development for the entire asset class. The picture is more nuanced on closer inspection, however. Russia’s weighting in major emerging market fixed income bond indices has fallen sharply in recent years; it accounts for just 2 per cent of JPMorgan’s US dollar index and only 5 per cent of the local currency equivalent. At the same time, surging commodity prices will benefit emerging countries that are exporters of raw materials, improving their terms of trade. So while being overweight emerging market bonds is risky, the case for being underweight is not particularly strong either. We are, however, more optimistic on the prospects for Chinese local currency bonds, not least because China’s central bank is loosening monetary policy to support economic growth.

When it comes to currencies, we continue to believe sterling looks particularly vulnerable to a sell-off. The unit has held up as the Bank of England has signalled its intention to hike rates to contain inflation. But with the economic recovery still in its early stages, we believe interest rates will rise more modestly than the market is currently projecting, undermining yield support for the currency. We continue to hold a neutral stance on the US dollar. Although we believe its valuation looks high relative to both cyclical and structural factors, the conflict in Ukraine will reinforce its status as the world’s primary haven.

Equities ended the month sharply lower for a second time in a row after Russia’s invasion of Ukraine triggered severe Western sanctions, which include blocking Russian banks from the SWIFT global payments system.

Emerging European stocks were hit the hardest with a loss of over 6 per cent, while European equity markets also suffered a decline of over 5 per cent in local currency terms. 

Stocks in the UK, Latin America, Pacific Asia defied selling pressure and ended the month slightly higher.

IT and communication stocks were the worst performing sectors after US tech giants reported mixed earnings results.

Facebook parent Meta recorded the worst single-day fall in its history after reporting slower user growth in its Facebook app, with the sell-off erasing gains over the past two years. Netflix and Spotify also suffered a heavy sell-off.

Energy and material stocks ended the month higher by over 2 per cent after oil prices jumped 11 per cent following the Russian crisis.

Defensive sectors such as healthcare, staples and utilities were flat.

Fig. 5 - Oil surge

YTD total return in local currency terms (%)

Global bonds failed to capitalise on heightened investor risk aversion as concerns persisted over the possibility of aggressive interest rate hikes in the US and higher global inflation.

Government bonds in the US, euro zone, Switzerland and UK fell around 2 per cent local currency terms; emerging local and dollar currency debt saw sharper declines.  

In foreign exchange, the Russian ruble fell to a record low against the dollar, losing a third of its value at one point.

The Russian removal from SWIFT and measures to limit Moscow's ability to deploy its USD630 billion foreign reserves paralysed domestic financial markets.

Currencies of commodity-exporting Brazil and Australia were among the best-performers with gains of around 3 per cent.

The safe-haven Swiss franc rose 1.5 per cent while the dollar ended the month little changed.