• We prefer equities even as bond yields have sprinted higher. Global growth is still solid, and we see central banks ultimately living with inflation.
• U.S. 10-year yields hit new three-year highs last week, and stocks fell. The European Central Bank affirmed our view it will normalize policy very slowly.
• Sentiment data this week could show the economic impact of the tragic war in Ukraine. Chinese GDP data may indicate how lockdowns are affecting growth.
Bond yields have sprinted higher on ballooning inflation and hawkish comments by central banks. Yield spikes have often spelled trouble for stocks, but we believe the past is an imperfect guide in a world shaped by supply shocks. We see central banks normalizing quickly – but not slamming the brakes on the economy. This should keep real yields low and underpin equity valuations. The inflationary backdrop and growth momentum led by the U.S. also favors stocks, we believe.
Historically low rates ahead
Fed funds rate and U.S. inflation, 1992-2027
Yields on benchmark 10-year U.S. Treasuries hit three-year highs last week after data showed inflation was still running at levels not seen since the early 1980s. This understandably created angst about equities, especially about stocks of fast- growing tech companies. Higher discount rates make future cash flows less attractive. We believe fears about a further downdraft in equities are overblown. The rate hikes we expected are happening faster, but we don’t see central banks raising policy rates beyond neutral levels that neither stimulate or restrain the economy. Markets have priced in a rapid rise of the fed fund rate to 3% in the next year, followed by a leveling out to 2.5% in five years’ time (the green dotted line in the chart). That’s markedly higher than a month ago (dotted pink line), just before the Fed raised rates and started to talk tough on inflation. We don’t see the Fed going this high. Even if it did, the level would still be historically low compared with previous hiking cycles (red line) and the level of inflation (yellow line).
The big picture: Markets have swiftly brought forward a rise in policy rates in the past year and now are pricing in a steep lift- off. Yet it’s the sum total of rate hikes that matters for equities, in our view, not the timing and speed. Why? We use the cumulative rate for determining future corporate cash flows, not the current rate or bond yields. And the higher the peak rate in this cycle, the bigger the impact because of the compounding effect over time. As a result, we believe equities can thrive when the end destination of policy rates is historically low. Central banks will be forced to live with inflation, in our view, to avoid destroying growth and employment. We see inflation settling higher than pre-Covid levels because of the supply shocks triggered by the restart of economic activity and the horrific Ukraine war. This means real yields, or inflation- adjusted yields, should remain low and underpin equity valuations. We could see long-term yields rising further as investors demand higher compensation for holding them in the inflationary backdrop. This is not necessarily bad news for equities as it could trigger a re-allocation away from bonds into equities.
How about equity fundamentals? Three things jump out at us as first-quarter results get underway this week. First, the powerful restart is providing a growth cushion for developed markets (DM economies), especially in the U.S. Second, record- high profit margins bear close watching. DM companies have been able to pass on increased input costs to consumers and kept labor costs in check – so far. Third, we see the economic fallout of the Ukraine war cutting into earnings even as analysts have been revising up estimates across the board. We expect estimates for European companies to come down in particular as analysts start factoring in the war’s effects. Companies in the MSCI Europe index are export-oriented and derive just half of their revenues domestically, we calculate, softening the impact a bit. A weaker euro helps, too. All in all, this led us to reduce our overweight in European equities earlier this month. We prefer U.S. and Japanese equities instead.
What are the risks? First, central banks could trigger a recession by raising rates too high in an effort to contain inflation. Second, inflation expectations could become de-anchored from central bank targets and cause them to slam the brakes. Third, companies could see margins shrink amid escalating input costs and upward wage pressures.
The bottom line: We prefer DM equities in the inflationary backdrop of the restart’s momentum and a historically low sum total of rate hikes. We could see long-term yields rising further as investors demand a higher term premium, or extra compensation for holding them amid high inflation and debt levels.
Yields of 10-year U.S. Treasuries hit new three-year highs last week, and stocks fell. We believe long-term yields can rise further and could see short-term bonds outperforming because market expectations for rate increases have become overly hawkish. The European Central Bank confirmed our view it will normalize slowly and gradually. It’s set to end asset purchases in the third quarter and raise its policy rate “some time” thereafter.
Private sector wages grew by 5% in the U.S. in 2021. This marked the fastest pace of gains since the 1980s, as the chart shows. Employers could fund higher wages by increasing prices, in turn causing workers to demand further pay rises – and so the loop goes on. In other words, is this the start of a wage-price spiral? We don’t think so.
It has proven difficult to entice workers back to work as pandemic restrictions lifted, especially to services jobs that require a lot of contact with people. Wages have gone up to persuade them. This is unusual, given that many people have not yet returned to the workforce. These are not wage pressures typical of a normal business cycle: they’re helping the economy adjust to a labor shortage.
Moreover, research shows that workers are 4.5% more productive now than before the pandemic. Greater productivity negates the need for price increases. And when you consider currently high inflation, there is still more room for individual wages to rise before they catch up with existing price increases. See our macro insights hub.
1.Living with inflation
• expect central banks to quickly normalize policy. We see a higher risk of the Federal Reserve slamming the brakes on the economy to deal with supply-driven inflation after raising rates for the first time since the pandemic.
• The Fed has projected a large and rapid increase in rates over the next two years. We see the Fed delivering on its projected rate path this year but then pausing to evaluate the effects on growth.
• Normalization means that central banks are unlikely to come to the rescue to halt a growth slowdown by cutting rates. The risk of inflation expectations becoming unanchored has increased as inflation becomes more persistent.
• We believe the eventual sum total of rate hikes will be historically low, given the level of inflation. DM central banks have already demonstrated they are more tolerant of inflation.
• The Bank of England hiked rates for a third time but signaled that it may pause policy normalization on concerns about the growth outlook from spiraling energy costs. This is the bind other central banks will likely face this year.
• The European Central Bank confirmed plans to wind down asset purchases in the third quarter and raise rates some time afterward. We expect it to go slowly given the material hit to growth we see from higher energy prices.
• Investment implication: We prefer equities over fixed income and overweight inflation-linked bonds.
2.Cutting through confusion
• We had thought the unique mix of events – the restart of economic activity, virus strains, supply-driven inflation and new central bank frameworks – could cause markets and policymakers to misread the current surge in inflation.
• We saw the confusion play out with the aggressively hawkish repricing in markets this year – and central banks have sometimes been inconsistent in their messages and economic projections, in our view.
• The Russia-Ukraine conflict has aggravated inflation pressures and has put central banks in a bind. Trying to contain inflation will be more costly to growth and employment, and they can’t cushion the growth shock.
• The sum total of expected rate hikes hasn’t changed much even with the Fed’s hawkish shift.
• Investment implication: We have tweaked our risk exposure to favor equities at the expense of credit.
3.Navigating net zero
• Climate risk is investment risk, and the narrowing window for governments to reach net-zero goals means that investors need to start adapting their portfolios today. The net-zero journey is not just a 2050 story; it’s a now story.
• The West’s decision to reduce reliance on Russian fossil fuels will encourage fossil fuel producers elsewhere to increase output, but we don’t expect an overall increase in global supply and demand. We see the drive for greater energy security accelerating the transition in the medium term, especially in Europe.
• The green transition comes with costs and higher inflation, yet the economic outlook is unambiguously brighter than a scenario of no climate action or a disorderly transition. Both would generate lower growth and higher inflation, in our view. Risks around a disorderly transition are high – particularly if execution fails to match governments’ ambitions to cut emissions.
• We favor sectors with clear transition plans. Over a strategic horizon, we like sectors that stand to benefit more from the transition, such as tech and healthcare, because of their relatively low carbon emissions.
• Investment implication: We favor DM equities over EM as we see them as better positioned in the green transition.
Strategic (long-term) and tactical (6-12 month) views on broad asset classes, April 2022
Six- to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, April 2022