Risk assets sell off
Originally published as a CIO Alert by Mark Haefele, Chief Investment Officer for UBS Global Wealth Management
What happened?
The S&P 500 fell 2.8% on Tuesday, amid anxiety over high-profile US earnings results, escalation in the Ukraine war, and worries over the impact of China’s pandemic lockdowns.
The tech-heavy Nasdaq was particularly hard hit, falling 4.0%, reflecting investor nerves ahead of first quarter earnings releases by Alphabet and Microsoft. With sentiment fragile, some investors were worried that markets would be less able to cope with any disappointments. In the S&P 500, 10 of 11 sectors moved lower, with consumer discretionary, IT, and communication services leading the way.
Such concerns came alongside indications of increased confrontation between Russia and western nations over the war in Ukraine. At a meeting on Tuesday, the US and its allies promised new packages of heavier weapons for Ukraine. In a notable reversal, Germany, which had previously rejected calls to provide such armaments, agreed to do so. Russian rhetoric has been intensifying, with foreign minister Sergei Lavrov saying that “we must not underestimate” the threat of nuclear war. News reports on Tuesday that Russia intends to shut off gas supplies to Poland on Wednesday also raised escalation fears, although Poland has long intended to stop Russian gas imports by the end of 2022. The price of Brent crude rose 3.4% to USD 105.78 a barrel.
China’s CSI 300 fell 0.8% on Tuesday, after its largest one-day fall (5%) in two years on Monday. This follows signs that China is doubling down on its zero-tolerance COVID-19 policy, which investors fear will drag on growth and complicate global supply chain problems. Beijing started mass testing of millions of residents, adding to concerns that China’s capital city could face the kind of lockdown that has impacted Shanghai in recent weeks.
In the background, worries linger that rapid tightening by the Federal Reserve will slow growth. Along with a flight to safety from geopolitical risks, this appeared to contribute to a swift decline in US yields. The yield on the US 10-year Treasury fell 8 basis points to 2.74%, down from last week’s intraday high of 2.98%. The US dollar (DXY) appreciated by 0.6% to trade at a two-year high.
What do we expect?
Facing geopolitical risks, threats to growth from China’s lockdowns, and uncertainty over the prospect of overtightening by the Fed, equity markets are likely to remain volatile. The VIX index of implied US stock option volatility traded back above 33 on Tuesday, consistent with daily moves up or down in the S&P 500 of around 2%. With the Fed talking tough about persistent inflation, investors are in a “show me” mindset, and until the data offers clear support for our projections for moderating inflation, fears about a Fed or geopolitically induced recession will remain elevated.
Today’s news out of Europe is a reminder that the potential for an escalation of the war in Ukraine that drives energy prices higher looms over this market in the near term. We continue to recommend exposure to commodities and energy equities because they can do well in our base and bear case scenarios. However, Europe still has many diplomatic and fiscal policy responses available to prevent an energy induced recession and based on current information, a European recession is not our base case.
Fixed income markets are also volatile. Last week, expectations for the year-end level of the fed funds rate rose from 2.47% to 2.83%.?Our view of this rise in yields was that the market may have priced in too great an extent of Fed tightening this year.
So far this week, year-end fed fund futures contracts have priced back out 12bps of hikes, and contracts for mid-2023 have priced out 15bps.?Volatility in bond markets is a reminder that?market expectations for the pace of Fed rate hikes can decrease as well as increase.?The level of expectations for Fed tightening has increased to such an extent that it could provide a catalyst for market sentiment to improve if inflation starts to fall and the Fed is perceived to have more flexibility around moving rates higher.
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In China, we do expect lockdowns to slow the economy. We now expect China's GDP growth to be 4.2% this year, and we have lowered our full-year 2022 earnings growth forecasts for MSCI China by two percentage points to 11%.
But while market sentiment will be fragile in the near term, with earnings downgrades capping the performance of Chinese equities, current valuations have priced in much of the negatives. The current near-trough valuation of 10x forward price-to-earnings ratio has already reflected the lowered earnings growth for the next 12 months, in our view. We continue to believe Beijing will step up fiscal and monetary support to shore up the economy. We retain our most preferred rating for China within our Asia portfolios and continue to see areas of value.
On US earnings, there is a risk of high-profile idiosyncratic disappointments—most likely among beneficiaries of the COVID-19 pandemic, such as Netflix’s results last week. But overall, the 1Q earnings season is off to a solid start: 25% of S&P 500 companies have reported at the time of writing, with 80% beating expectations and by 6% in aggregate. Cost pressures have been in focus, but consistent with recent quarters, corporate America has been successful at passing on higher expenses to its customers in 1Q. As a result, profit margins are holding up and beating expectations. Our full year 2022 and 2023 S&P 500 EPS estimates are at USD 230 (10% growth) and USD 245 (7% growth).
How do we invest?
Looking ahead, over our tactical investment horizon, we think inflation is likely to fall from current levels but remain above pre-pandemic ranges. In an environment of moderating growth and inflation, we think equity markets will finish the year higher.
Aggressive Fed expectations have been priced into the market and we acknowledge the risks to earnings have risen. Therefore, we tilt our positioning toward areas of the market that can perform well in an environment of high inflation, rising rates, and elevated volatility.
Commodities.?Year-to-date the Broad Bloomberg Commodity Index is up 29% compared with an 11% loss for the MSCI All Country World index and the 52-week correlation between the two indexes has dropped to zero. Commodities are offering diversification benefits and have performed well historically during inflation regimes. We see room for another 10% move up in total return for broad commodity indexes over the next six months and prefer active commodity exposure.
Value vs. growth.?Value sectors—like energy—suffer less of a drag in a rising rate and higher inflation environment than growth sectors, such as technology, where valuations tend to be more reliant on future profits. Energy stocks remain cheap, and we think they are only discounting an oil price in the mid-USD 70s per barrel.
Defensives.?We have become more balanced between cyclicals and defensives in our equity positioning, with energy and healthcare our most preferred sectors. The pharmaceutical segment is traditionally relatively resilient to periods of slower growth or risk-off moves, and valuations look undemanding, in our view.
Fixed income.?In fixed income, rising yields mean areas of value are emerging. We see value in European credit default swaps as well as a select basket of emerging market short-duration bonds. We also see an opportunity in environmental, social, and governance (ESG) engagement high yield bonds. Finally, for investors willing and able to lock up capital and accept the additional risk this entails, direct lending can provide enhanced income opportunities in excess of public market returns.