In the past quarter, equity and bond markets have been airing two different stories. The equity markets have, after an initial correction, recovered most of the lost territory – the S&P500 is still down by around 5% while the Nasdaq, after having gone into a bear-market case, is down by about 10%. On the other hand, the bonds market continues to suffer from the inverting of the yield curve.
An inverted yield curve means that a short-term U.S. treasury is paying a higher interest rate than long-term U.S. treasuries. The inverted yield curve was first coined as a recession indicator by financial economist Campbell Harvey of Duke University in 1986. An inverted yield curve does not create recessions; rather it is a representation of how we the people view the future of the economy. If the general premonition is that a recession is near, investors will flock to the safest financial asset, the U.S. bond
It is a given fact that the market assumes the FED will successfully guide the economy toward a “saft landing.” Furthermore, the majority of investors consider rising inflation-adjusted interest rates as temporary; yet we believe that the Russia–Ukraine conflict will have much deeper ramifications that will result in some macroeconomic headwinds.
Here are few points of concern:
- FED tightening process: While some six months ago, the future market expected only three interest rate increases, it is now anticipating nine. In absolute terms, this would mean that interest rate will peak not at 2.5% but rather at 3.5%. In addition, the FED announced that it will decrease its asset holding to about $95 billion a month. This aggressive tightening process makes the exit process relatively complex to maneuver, and the market may feel the heat stronger and for longer.
- How long will the interest rate cycle last? The majority of investors still believe that the interest rate cycle may be short-lived, and if so, it is supportive for the equity market. This could be elusive thinking as higher interest rates will be impacting real rates and in consequence valuations.
- Macroeconomic headwinds: The new macroeconomic picture is dominated by:
- Rising costs (labor, logistics, distribution, energy, and other procurements)
- The shift from products to services to normalize
- Europe most likely facing a recession on the back of the Ukraine-Russia conflict
- Lockdowns in major industrial areas in China as a complementary strain to a stretched global supply chain
How to navigate in this environment?
While we defend a pro-equity approach, we would recommend investors to neutralize over and underweights in the asset allocation. Given this, investors are recommended to move towards market neutral assets. Finally, equity allocations should be considered on a true conviction approach that emphasizes an active selection focusing on quality and earnings factor attributes.