Weekly market commentary

We nudge down risk on a worsening macro outlook: the commodities price shock and a growth slowdown in China. We also see little chance of a perfect economic scenario of low inflation and growth humming along. Last week’s market rout shows investors are adjusting to this reality. We upgrade investment grade (IG) credit and European government bonds to neutral as we see opportunities there. We downgrade Chinese assets and Asia fixed income as we consider them riskier now.

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Yield on offer

Global investment grade corporate yield, 2002-2022

Bonds are generally not attractive in inflationary times, and we remain overall underweight the asset class. Yet this year’s dramatic sell-off has restored some value in pockets of the market, in our view. First, we have warmed up to European government bonds because we believe market expectations of rate hikes by the European Central Bank (ECB) are too hawkish. We see the energy shock hitting Europe hard - and causing the ECB to move very slowly in normalizing policy. We also see the asset class as a buffer against the growth shock, after downgrading European equities in March. Second, we are seeing some value in IG credit as annual coupon income is nearing 4%. That’s the highest in a decade, as the red line in the chart shows, driven by a rise in Treasury yields (the pink area in the chart) and a widening of spreads (yellow). Crucially, we remain underweight U.S. Treasuries. We see the yield curve steepening on further rises in long-term yields as investors want more compensation for holding long-term bonds amid inflation.

The big picture

The Ukraine war, a global energy shock and the risk the Fed tries to fight the supply-driven inflation have sparked a reassessment of macro scenarios among market participants. The root cause is inflation in a world shaped by supply. It started with the supply shock from the restart of economic activity. Russia’s invasion of Ukraine added a broad commodities price shock on top of that. The Fed and other central banks are facing a tough choice now: suppressing supply-driven inflation means raising rates so high that they destroy growth and jobs. We believe the Fed ultimately won’t raise rates beyond neutral - a level that neither stimulates nor decreases economic activity – to avoid such a scenario. This means it will have to live with inflation that we see settling at a higher level than pre-Covid. We believe the eventual sum total of rate hikes will be historically low, given the level of inflation. This means we still favor equities over fixed income.

At the same time, we recognize risks have risen. The commodities price shock is set to hit growth, especially in Europe and emerging markets that are commodities importers. The Fed rightly is fast normalizing policy but could slam the brakes on the economy if it chooses to fight inflation. It’s tough to see a perfect outcome. Getting inflation down to pre-Covid levels likely means recession, as the Bank of England warned last week. And the growth outlook for China, the world’s second-largest economy, is quickly deteriorating amid widespread lockdowns in an attempt to halt the spread of Covid.

We are downgrading Chinese stocks and bonds to neutral on the deteriorating macro outlook. We see a growing geopolitical concern over Beijing’s ties to Russia. This means foreign investors could face more pressure to avoid Chinese assets for regulatory or other reasons. We previously kept our modest overweight on Chinese assets because we saw improved valuations making up for the risks. The rapidly worsening outlook for China’s growth on widespread lockdowns to curtail a COVID spike has changed this. Lockdowns are set to curtail economic activity. China’s policymakers have heralded easing to prevent a growth slowdown – but have yet to fully act. And yields on Chinese government bonds have fallen below those on U.S. Treasuries amid policy divergence, eroding their previous appeal as a source of potential coupon income.

Bottom line

We are nudging down risk amid the commodities price shock, deteriorating growth in China and tough trade-offs for central banks. We upgrade European government bonds and IG credit to neutral as we see tactical opportunities there. We downgrade Chinese assets to neutral due to geopolitical concerns and a worsening macro outlook. Overall, we remain overweight equities, with a preference for U.S. and Japanese stocks, and underweight U.S. Treasuries.

Market backdrop

The Fed raised its policy rate by 0.5% last week and said it would start winding down its balance sheet by not re-investing the proceeds from maturing bonds. Chair Jerome Powell signaled 0.5% hikes at the next two meetings in an effort to rein in inflation, and dismissed larger increments for now. We believe the sum total of hikes will be historically low, but see long-term yields rising further as investors demand higher compensation for holding long-term bonds amid persistent inflation.

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Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, May 2022

Our granular views indicate how we think individual assets will perform against broad asset classes. We indicate different levels of conviction.

Tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, May 2022