This April/May 2022 market update is brought to you by LGT Vestra

Investors have had to contend with a number of significant headwinds so far this year. We have seen a dramatic rise in inflation, and central banks having to respond by raising interest rates.

While developed markets central banks remain hawkish, the Russian invasion of Ukraine and lockdowns imposed in China have increased inflationary pressures at the expense of short-term growth. These developments have added to supply chain difficulties, and central banks have found themselves forced to quell demand, causing a negative impact on both bond and equity markets.

The Federal Reserve (Fed) had clearly signalled its intention to raise base rates by 0.5% ahead of its last meeting. Therefore, despite first quarter US GDP data contracting, the largest and unanimously agreed increment in over 20 years had little market impact.

The Fed also mentioned that they expect to implement similar increases over the next couple of meetings and announced that it would start the process of unwinding its balance sheet holdings of Treasuries and Mortgage-Backed Securities in June. Ahead of the meeting, Fed member James Bullard had floated the idea of a 0.75% increase, but at the meeting he did not vote for it, and Fed Chair Jay Powell ruled this out.

While inflation in the US slowed from 8.5% in March to 8.3% in April, the deceleration was less than expected and primarily due to rises in housing costs and air fares. It is widely expected that inflation will continue to moderate as we go through the rest of the year, but the Fed may adjust policy depending on the speed of decline.

The Bank of England (BoE) also hiked rates as expected, this time by a further 0.25% to 1%, but it was one of the most split Monetary Committee decisions for some time.

They are clearly trying to balance a very tight labour market with the increasing cost of living crisis.

The tight labour market risks wages rising materially higher; on the other hand, given the rise in energy costs, they now forecast inflation to peak above 10% in the fourth quarter of this year.

Given the extraordinary increase in the cost of living, the BoE is now predicting that the UK economy will slow and even shrink by 0.25% next year.

Ideally, the BoE would like to support households and the economy, but it is also attempting to ease inflationary pressures while maintaining real incomes, which would constrain consumer spending. Given the overall tone of the meeting, expectations for further rate hikes were pared back.

While the US and UK push ahead with tightening, the European Central Bank (ECB) is also expected to make similar moves as soon as July. Although it is likely to act slower than the US, the European economy has been harder hit by the war in Ukraine.

However, elsewhere around the world, tightening is not universal.

So far, the Bank of Japan has made no policy move despite the sharply weaker yen. Meanwhile, China’s Politburo said they will continue to support the economy by sticking to their growth target, given continuing pandemic-related lockdowns in the country.

Although the general direction of travel for rates in the West is clearly upwards, markets have priced-in a considerable amount of tightening already.

If central banks raise rates too fast, there is a risk that they tip the economy into a recession. Should this be the case, the rate rises priced into the market may moderate.

Equity markets have seen a sizeable correction this year, particularly if you exclude the energy sector. The prospective equity earnings look attractive relative to where long-term interest rates are likely to peak. While we expect volatility to remain high, the underlying valuations of equities with quality earnings should play out in the long run.

Market View Changes

• No changes

Currencies

The US Dollar remains the reserve currency of the world and has benefited from its safe haven status. With the Fed set on an aggressive tightening path relative to other developed markets, we have seen a rise in the dollar.

The ECB is likely to move away from negative interest rates later this year, which may offer support to the Euro, having been weak given the war in Ukraine.

Sterling is caught between global pressures which have the propensity to raise the level of imported inflation and the BoE’s policy stance. The reaction to the BoE’s decision to raise rates while cutting its growth forecasts saw the pound fall.

Fixed Income

The supply-side issues that have been the key driver of higher price pressures are set to last longer given China’s continued use of lockdowns and energy market disruption. As such, central banks have responded by recalibrating their policy stance resulting in significant moves across developed market government bonds.

The US and UK bond markets are reflecting most of the expected policy tightening and as such, may provide protection should the growth outlook deteriorate.

Inflation-linked exposure in the UK remains affected more by short-term drivers and given its long average maturity, we remain cautious on the segment. While its US and German counterparts have moved significantly, they appear to be less sensitive to these factors.

Given the tightening bias among ECB members, Eurozone bond yields have now moved into positive territory and as such, we feel a neutral stance on German government bonds is warranted.

As central banks are now looking to normalise at a brisk pace, we have seen both government bond yields and credit spreads move higher.

The announcement by the BoE to unwind its corporate bond purchases, pared with the Fed embarking on quantitative tightening is likely to weigh on markets. However, given the elevated yields on offer, this is likely to bring support to this market where we are seeing selective opportunities.

While default rates remain benign and the ratings trajectory remains positive, the combination of higher interest rates and central banks’ plans to reduce asset purchases have impacted the broader market. This may continue to weigh on high yield bonds for some time, but we are now starting to see better opportunities. We retain our neutral stance for the time being and continue to stress selectivity.

Emerging Market Debt

With developed market central banks set to tighten policy, this generally weighs on emerging markets. Though, many emerging market central banks have already raised rates substantially, which is likely to result in a much smaller impact than previous hiking cycles. Should China continue on its easing trajectory, this could provide further support to these economies.

Uncertainty around Russian hard-currency debt may continue to weigh on sentiment for some time.

Furthermore, recent upheavals in Pakistan, Sri Lanka and Peru demonstrate the political risks from rising food and energy costs. Therefore, we emphasise that selectivity remains as important as ever, and we retain our neutral stance across this diverse asset class.

Equities

That said, the UK domestic economy faces significant headwinds from higher energy costs, interest rate rises, and tax increases. While much of the index is made up of international companies, the domestic economic situation may weigh on market sentiment. Considering the mix of factors, we recommend a selective approach in this market.  The FTSE 100 index has been buoyed by its exposure to energy, materials and a weaker pound. Nevertheless, the market continues to trade at valuations that look cheap compared to markets elsewhere in the world. This has spurred takeover interest by overseas buyers, given the opportunity to pick-up companies at discounted prices.

The European equity market has been particularly vulnerable to the impact of the war in Ukraine and has seen large moves in both directions driven by the news flow.

The re-election of President Macron was a relief for markets, but this is followed by parliamentary elections in June. On the grounds of valuation, the European market looks relatively attractive, but the risk of higher energy costs to the economy are significant.

In the face of a military campaign on its doorstep, Europe has been united with its countermeasures and we are seeing fiscal responses, which may mitigate these head- winds. We retain our neutral stance on European equities.

The ongoing volatility surrounding inflation and its impact on the long-term discount rate has continued to cause gyrations between cyclical and less-cyclical companies. Furthermore, the potential for a sharp slowdown has increased causing yet another factor to weigh on equity markets.

While results were mixed, the earnings season was generally positive. Nevertheless, the market focused more on macroeconomic factors. The US market continues to be a source of attractive companies with good long-term prospects, with relatively high self-reliance in terms of energy and food supply.

While inflationary pressures have weighed on the West, Japan has thus far not seen a similar picture. However, growth has remained muted at a time when demand for goods has been buoyant.

Furthermore, rising energy costs may squeeze margins, given the country’s reliance on raw material imports. A problem that is likely to be exacerbated by a much weaker yen.

The Japanese index has significant exposure to large international companies that usually benefit when the currency weakens however this may be offset by the rise in input costs. Thus far, the Bank of Japan has maintained its loose monetary policy stance. Despite loose financial conditions and relatively low valuations, its reliance on imports of raw materials and energy may continue to weigh on the market.

While many countries are emerging from the pandemic, China continues a zero Covid-19 tolerance policy which has seen further lockdowns imposed in major economic centres. This has weighed on markets across the region, but, ultimately, is unlikely to dent long-term prospects.

While the political risks remain high, the valuations look cheap relative to other markets and the lack of sanctions mean that energy headwinds are less of an issue for some countries in the region. As such, we think the potential for long-term growth is higher than elsewhere.

While the rise in commodity prices has a natural benefit for resource rich countries like Brazil, the heavy-hitting sanctions placed on Russia have highlighted how extreme the geopolitical risks may be.

The Russian stock market has re-opened trading, and the rouble has rebounded yet remains hard for international investors to trade. Asset seizures on both sides of the conflict may continue to undermine investor confidence for some time.

Despite this, long-term growth prospects for many emerging markets remain high. Hence, we continue to stress selectivity in this diverse universe, emphasise its volatile nature and maintain our neutral stance.

Alternative Investments

Hedge Funds/Targeted Absolute Return

Given pronounced movements across interest rate expectations, this will undoubtedly weigh on financing costs which may temper some merger and acquisition (M&A) activity.

Furthermore, regulatory pressures have increased, resulting in some notable deals being pulled. This has tempered our enthusiasm for event-driven strategies. More broadly, when allocating to this space, we look for funds that could diversify returns away from the directionality of conventional bonds and equity markets.

In a relatively low yield environment and when cash returns are meagre, the diversification offered by these strategies can be attractive. Nevertheless, we continue to stress the importance of finding the right vehicle and investment manager, which requires extensive due diligence on the strategy and fund.

Property

While we acknowledge the yields on offer may look attractive relative to other sources of income, the outlook for retail and office segments remains uncertain. We continue to suggest that any exposure to property should be selective and closed-ended over open-ended vehicles are preferred, due to the liquidity mismatch.

The seizing of assets in light of Russian sanctions, may weigh on future demand as it undermines the notion of property ownership. Accordingly, it remains important to be selective and not chase the otherwise attractive yield, when investing in this asset class.