7 APR, 2022
By Kenneth J. Taubes
Over a month has passed since the start of the conflict in Ukraine and, following the initial volatility swings across all segments, markets have been more constructive in the past few weeks. Rates have drifted higher, reaching 2.5% for US 10 year Treasuries, amid expectations of more aggressive monetary action. Equities are returning to pre-conflict levels, while commodities are still volatile but running cooler overall.
While negotiations between the parties involved in the conflict may have reached a stalemate, market attention has shifted toward issues concerning the current inflationary environment and how central banks are expected to react. The Euro area annual inflation rate in March reached 7.5%, up from 5.1% in January. Likewise US inflation almost skimmed 8% in February, its highest level in 40 years, albeit within a sturdier economic environment than in Europe.
Market assessment: After an initial negative reaction to the Russia-Ukrainian conflict, US equities markets are now above their pre-war levels. US equity volatility has proven much lower compared to Europe, which is more exposed to the crisis and to the economic downturn. On government bonds, the repricing has been very fast across the US yield curve. Its inversion in the 2-10 year segment shouldn’t be taken as a recessionary signal, in our view, and the 3 month-10 year interest rate differential, that we consider a more reliable indicator, remains broadly positive.
Economic outlook: The US has exhibited exceptional resilience to the crisis, and a strong labour market continues to drive economic growth this year, despite building inflationary pressures. Europe on the other hand has been fully impacted by the conflict and faces a significant growth deceleration in 2022. Likewise in China, where the pandemic continues to proliferate despite a ‘Zero Covid’ policy, our growth forecast for 2022 has been revisited downwards.
Monetary policy: Both the European Central Bank (ECB) and the Federal Reserve (Fed) were late to react to mounting inflation, the former more so than the latter, and the war has complicated the path toward policy normalisation. We expect rate hikes and quantitative tightening to continue, although at a slower pace in Europe compared to the US.
Main convictions: Inflation continues to be the key theme driving portfolio construction. Equities remain in favour, particularly in the US where earnings growth should stay positive amid a more resilient economy. Here, investors should however avoid the names most exposed to higher rates, and look at value and quality segments in the search for opportunities. The ability to preserve margins will be critical especially in H2 and 2023, and company pricing power will be key in this respect. Strong and fast movements in the bond market calls for a tactical approach to duration, now not as short as a few weeks ago. The short part of the curve now seems particularly appealing as it has already priced in most of the Fed hiking cycle, while the long end will likely reprice further. US housing related securitised markets may be particularly attractive in light of a strong housing market.
Source: Amundi Institute forecasts as of 24 March 2022 vs 14 February 2022 forecasts.
Turning to Europe, the outlook is not as bright. We have revised our growth forecast for the Eurozone to 2.3% for 2022, down almost 1.5% from a month ago, as we anticipate faster growth deceleration than before the war. In parallel we are witnessing inflationary pressures driven by commodity shortages as well as supply chain disruptions. Our CPI expectations for the Eurozone this year have been revisited upwards to 6.3% YoY, compared to 6.9% in the US. The big question that remains is whether Europe is entering a stagflationary phase, and whether this would be a transitory phenomenon or the beginning of a new regime.
Ultimately this will steer the ECB’s behaviour. Another question relates to whether there will be increased fiscal spending, particularly concerning the energy transition and defence, and at what rate the latter can be financed. We must wait and see what rate environment will prevail and how much room will be left for government spending. Overall, Europe is in a much more fragile position compared to the US. We have also revised growth in China down to 4% for the year, mainly due to the evolution of the Covid pandemic in this region. Until a new and efficient vaccination campaign is implemented, China will continue to adopt a ‘Zero Covid’ policy, which will impact on growth and the supply of goods and commodities.