Overview
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 uncertainties 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 financial markets, banks and supply chains. Elevated commodity prices will exacerbate stagflationary dynamics and, in Europe, increase the risk of recession.
Waiting for the pivot on rates
Central banks are facing a treacherous set of policy decisions this year and a mistake will have serious consequences. The European Central Bank was more hawkish than we expected at its meeting last week. However, we expect its governing council 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 12-24 month horizon - labour markets are still strong, consumer balance sheets are healthy even if sentiment dips, and China is easing policy gradually.
Patience needed 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 for global portfolios in the current context. 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 the US/EU and other aligned economies with China is many times higher than that with Russia, across both economic and financial dimensions, and the cost of outright conflict (military or economic) would be catastrophic. Recognition of this reality in itself opens the door for compromise.
Asset allocation shifts
We have responded robustly to the swift changes in environment of the past week, upgrading our view of US equities to neutral from underweight, as we believe that the US economy is more insulated from the disruptions in commodity markets. The safe haven nature of Japanese yen has led us to remove our underweight, although we are monitoring events closely as the Bank of Japan is likely to remain accommodative. We have neutralised risk in government bonds as we await better entry points.
We have cut Japan equities to neutral from overweight and moved to a defensive position within credit by moving underweight in HY and overweight in IG. Emerging market debt spreads ex Russia have widened significantly, meaning some regions not directly affected by the war could offer decent value.
By contrast, we are now underweight both the euro and European equities as the region faces a significant growth shock.
