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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. How much of last week’s rebound of risk assets was driven by short covering 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 investment grade and underweight high yield.
Recent tactical positioning has focused on increasing exposure to the dollar. We feel it will find support 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, though we remain cautious on potential tail risks. Nonetheless, should Chinese growth improve it would provide more support 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.