Snapshot

Views at a glance – July 2022


Central banks have picked their poison

The consequences of high inflation are now clearer to see, as it starts to take its toll on both consumer spending and corporate profits. Left unchecked, it threatens to evolve into a “wage-price spiral” as employers are forced to increase pay and another round of price rises ensues. Cooling demand by raising interest rates, at the risk of triggering a global recession, is regarded as the lesser of two evils. Equity markets have been volatile as they start to price in a now inevitable slowdown. Bond yields have also retreated as the focus of investors’ anxiety shifts from inflation to recession. Against this backdrop, the second quarter delivered the worst combined quarterly performance from global equities and bonds in over 30 years.

Equity valuations not pricing in a worst case

The outlook for markets hinges on whether this engineered slowdown results in a “soft” or “hard” landing. The former would see the economy and inflation cool while unemployment and defaults remain low; the latter would come with greater collateral damage. Global equities are now down just over 20% (in local currency) from their peak at the start of the year. However, the MSCI All Countries World Index still trades at a relatively full 16x forecast earnings over the next twelve months. There could be scope for share prices to fall further if earnings estimates move lower. One relative bright spot is China. Neither its economy nor markets boomed like the US did last year, potentially paving the way for better performance as the country emerges from lockdowns.

Ukraine remains crucial

Central bankers’ efforts to curb inflation would certainly be helped by a de-escalation of the situation in Ukraine, easing supply pressures in commodity markets. Sadly, this looks unlikely any time soon. By contrast, it is still very possible that the conflict escalates – either intentionally or unintentionally. Even if this outcome is avoided, the war in Ukraine could still result in more global division, further disrupting the flow of capital and goods around the world. At the moment, Western leaders do not find themselves in a strong position to deal with this shifting geopolitical landscape. The cost-of-living crisis in many developed countries means that governments are far more focused on domestic challenges.

Portfolio positioning

A global recession is not our base case, but the risk is increasing. We therefore continue to increase the defensiveness of our portfolios. We have already tilted our equity allocation towards higher-quality companies and are now looking to trim our overall equity exposure. This year, we have benefited from our underweight position in fixed income and overweight position in alternatives. However, government bond valuations now look more attractive and we continue to believe that they represent a good hedge against recession. Over the medium term, we are likely to add back to nominal government bond positions gradually, which would further increase the defensiveness of our portfolios.

Outlook

At-A-Glance-EXPORTS-Icon-625x626.png Economics
  • The risk of “stagflation” - an environment of high inflation and low or negative growth - remains high.  
  • Weaker consumer spending could have broader economic implications.
  • Interest rates are likely to continue to rise.
At-A-Glance-VALUATION-Icon-625x626.png Valuations
  • Global equities have meaningfully de-rated this year and now look more attractively valued on a relative basis.
  • Government bond valuations also look relatively more appealing given the sizeable moves we have seen this year. However, the asset class could be vulnerable if bond yields continue to rise.  
  • Alternative assets including absolute return funds and commodities look attractive as diversifiers.
At-A-Glance-SENTIMENT-Icon-625x626.png Sentiment
  • Escalating geopolitical tensions, rising inflationary pressure and interest rate rises continue to negatively impact investor sentiment.
  • Consumer confidence is the weakest it has been since 2009.
  • Investor sentiment indicators in or approaching bearish territory.
At-A-Glance-RISKS-icon-625x626.png Risks
  • Further escalation of the situation in Ukraine.
  • Risk of a faster than anticipated rate of monetary policy normalisation.
  • Threats to global economic growth from the impacts of high inflation and a China slowdown.
  • Consumer-led recession. 

 

Asset Classes

 Asset classes Current positioning Medium term view Current views
Equities At-A-Glance-Status-Icons-NEUTRAL-50x50.png    At-A-Glance-Status-Icons-NEGATIVE-NEUTRAL-50x50.png   Russia’s invasion of Ukraine, China’s response to Covid, inflation and rising interest rates have created a less favourable economic backdrop and resulted in higher volatility. Given the greater risk of “stagflation” (high inflation and low or negative growth) we prefer higher-quality companies with the ability to pass on higher input costs to consumers. We maintain conviction in long-term, secular themes including healthcare and energy transition.
Bonds At-A-Glance-Status-Icons-NEGATIVE-NEUTRAL-50x50.png At-A-Glance-Status-Icons-NEUTRAL-50x50.png   Longer-dated government bonds offer defensive characteristics given growth concerns. We prefer USD government bonds due to their relatively higher yields and diversification benefits. We prefer inflation-linked bonds to conventional government bonds at this stage. Valuations look relatively more attractive given the sizeable moves we have seen this year, but remain vulnerable to further increases in interest rates.
Alternatives At-A-Glance-Status-Icons-POSITIVE-NEUTRAL-50x50.png At-A-Glance-Status-Icons-POSITIVE-NEUTRAL-50x50.png Attractive diversification characteristics compared with equities and bonds. We favour absolute return strategies with the ability to deliver less correlated returns as well as real assets with long-dated, visible revenue streams and commodities.
Cash At-A-Glance-Status-Icons-POSITIVE-NEUTRAL-50x50.png At-A-Glance-Status-Icons-NEUTRAL-50x50.png Cash has defensive qualities in potentially volatile markets.



Equities

 Asset Current positioning Medium term view Current view
Equities At-A-Glance-Status-Icons-NEUTRAL-50x50.png   At-A-Glance-Status-Icons-NEGATIVE-NEUTRAL-50x50.png   Russia’s invasion of Ukraine, China’s response to Covid, inflation and rising interest rates have created a less favourable economic backdrop and resulted in higher volatility. Given the greater risk of “stagflation” (high inflation and low or negative growth) we prefer higher quality companies with the ability to pass on higher input costs to consumers. We maintain conviction in long-term, secular themes including healthcare and energy transition.
UK At-A-Glance-Status-Icons-NEGATIVE-NEUTRAL-50x50.png At-A-Glance-Status-Icons-NEUTRAL-50x50.png   Valuations remain relatively attractive. Larger companies have benefited from greater exposure to cyclical sectors. The Bank of England remains under pressure to continue normalising monetary policy given elevated inflationary pressures, despite growth concerns.
Europe At-A-Glance-Status-Icons-NEGATIVE-NEUTRAL-50x50.png   At-A-Glance-Status-Icons-NEGATIVE-NEUTRAL-50x50.png   Given Europe’s greater economic exposure to Russia (particularly through energy) the inflation and growth outlook for the region looks more challenging. This could impact consumer and investor sentiment. Monetary policy is likely to remain relatively accommodative, while spending from the NextGeneration EU plan will also be supportive.
North America At-A-Glance-Status-Icons-NEUTRAL-50x50.png   At-A-Glance-Status-Icons-POSITIVE-NEUTRAL-50x50.png   The US economy has the potential to be more self-sufficient in terms of both energy and agriculture and is therefore more insulated from events in Ukraine. Inflation remains a risk and consumer sentiment is the weakest it has been for over a decade. Valuations remain elevated despite recent moves and certain parts of the market are sensitive to rate rises, although the earnings outlook remains positive.
Japan At-A-Glance-Status-Icons-NEUTRAL-50x50.png At-A-Glance-Status-Icons-NEUTRAL-50x50.png A delayed reopening, lower risk of inflation and more policy support (both fiscal and monetary) could lead to improved domestic growth, driven by consumption. Japan’s economic exposure to China could weigh on activity and sentiment in the near term, although valuations are supportive.
Asia/
Emerging markets
At-A-Glance-Status-Icons-POSITIVE-NEUTRAL-50x50.png At-A-Glance-Status-Icons-NEUTRAL-50x50.png   In the near term, China’s zero covid policy poses a notable economic headwind, despite some easing of restrictions. However, lending activity is picking up again, with greater political support for fiscal spending to support growth. The earnings outlook remains robust and valuations are now at a significant discount to their 15-year average.

 

Bonds

Asset Current positioning Medium term view Current views
Bonds At-A-Glance-Status-Icons-NEGATIVE-NEUTRAL-50x50.png At-A-Glance-Status-Icons-NEUTRAL-50x50.png   Longer-dated government bonds offer defensive characteristics given growth concerns. We prefer USD government bonds due to their relatively higher yields and diversification benefits. We prefer inflation-linked bonds to conventional government bonds at this stage. Valuations look relatively more attractive given the sizeable moves we have seen this year, but remain vulnerable to further increases in interest rates.
Government bonds At-A-Glance-Status-Icons-NEGATIVE-NEUTRAL-50x50.png At-A-Glance-Status-Icons-NEUTRAL-50x50.png   Long-dated government bonds provide some portfolio insurance characteristics, given increasing concerns over global economic growth. Valuations look relatively more attractive given the sizeable moves we have seen this year, but remain vulnerable to further increases in interest rates.
Investment grade At-A-Glance-Status-Icons-NEUTRAL-50x50.png At-A-Glance-Status-Icons-NEUTRAL-50x50.png We prefer shorter duration and higher quality credit in the near term given the potential for further spread widening. Opportunities remain within asset-backed securities which offer a relatively attractive yield and often have floating rates, which are attractive in a rising rate environment.
High-yield At-A-Glance-Status-Icons-NEUTRAL-50x50.png At-A-Glance-Status-Icons-NEUTRAL-50x50.png Default rates remain low although face headwinds from a rising cost of debt and a more challenging economic backdrop. Recent spread widening offers some valuation support.
Inflation-linked At-A-Glance-Status-Icons-POSITIVE-NEUTRAL-50x50.png At-A-Glance-Status-Icons-NEUTRAL-50x50.png   We prefer US TIPS to conventional treasuries and UK linkers given the low cost of currency hedging. Inflation expectations have the potential to remain elevated in the short term although we are conscious of the potential impact of rising real yields from very low levels.
Emerging markets At-A-Glance-Status-Icons-NEGATIVE-50x50.png   At-A-Glance-Status-Icons-NEGATIVE-NEUTRAL-50x50.png   Certain emerging markets could see near term balance sheet deterioration as a result of a more uncertain global economic backdrop and continued Covid headwinds. There is selective value across both US dollar and local currency debt.

 

Alternatives and cash

Asset Current positioning Medium term view Current views
Alternatives At-A-Glance-Status-Icons-POSITIVE-NEUTRAL-50x50.png At-A-Glance-Status-Icons-POSITIVE-NEUTRAL-50x50.png Attractive diversification characteristics compared with equities and bonds. We favour absolute return strategies with the ability to deliver less correlated returns as well as real assets with long-dated, visible revenue streams and commodities
Absolute Return At-A-Glance-Status-Icons-NEGATIVE-NEUTRAL-50x50.png At-A-Glance-Status-Icons-NEUTRAL-50x50.png Selected opportunities in market-neutral strategies given increased stock dispersion and diversification characteristics.
Liquid private real assets At-A-Glance-Status-Icons-NEUTRAL-50x50.png At-A-Glance-Status-Icons-POSITIVE-NEUTRAL-50x50.png Long-dated revenue streams and income characteristics remain attractive in select parts of the market. Within this space we see good opportunities in digital infrastructure, specialist property and exposure to private companies.
Commodities At-A-Glance-Status-Icons-POSITIVE-NEUTRAL-50x50.png At-A-Glance-Status-Icons-POSITIVE-NEUTRAL-50x50.png Gold is attractive as a diversifier and should provide portfolio insurance in the event of a meaningful equity market correction or economic growth shock. Broader commodities can hedge against further rises in inflation.
Equity-linked income strategies At-A-Glance-Status-Icons-NEUTRAL-50x50.png At-A-Glance-Status-Icons-NEUTRAL-50x50.png Offer attractive returns, especially in times of heightened volatility. However, there is a shorter-term correlation with equities.
Cash At-A-Glance-Status-Icons-POSITIVE-NEUTRAL-50x50.png At-A-Glance-Status-Icons-NEUTRAL-50x50.png Cash has defensive qualities in potentially volatile markets while higher interest rates may offer some potential for returns. 



Key

At-A-Glance-Status-Icons-POSITIVE-50x50.png Positive
At-A-Glance-Status-Icons-POSITIVE-NEUTRAL-50x50.png Positive/neutral
At-A-Glance-Status-Icons-NEUTRAL-50x50.png Neutral
At-A-Glance-Status-Icons-NEGATIVE-NEUTRAL-50x50.png Negative/neutral
At-A-Glance-Status-Icons-NEGATIVE-50x50.png Negative
At-A-Glance-Status-Icons-UP-50x50.png Up from last month
At-A-Glance-Status-Icons-DOWN-50x50.png Down from last month

 

Terms

Spread: the difference in yield between a non-government and government fixed income security.

Duration: approximate percentage change in the price of a bond for a 1% change in yield.

This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. 

Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.

This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.

All data contained within this document is sourced from Cazenove Capital unless otherwise stated.