Tighter conditions

The first five months of 2022 could hardly have been more difficult for investors. Not only were there considerable headwinds for equities, but also for bonds, the second major investment category. At the turn of the year, the focus was still on inflation, but in February, the start of the war in Ukraine added another problem for capital markets that is very difficult to assess. As a result, justified concerns emerge that global economic growth could cool off in the second half of the year. Thus, growth in China is likely to slow due to the zero-covid strategy. In addition, we expect economic momentum in the US to weaken compared to the beginning of the year, as the Federal Reserve (Fed) is currently focusing strictly on fighting inflation. Although losses in individual market segments have been enormous since the start of the year, most broad-based equity indices trade still clearly higher than before the corona pandemic, including the MSCI World, the S&P 500 and the Europe Stoxx 600.

US financing conditions are tightening

In recent weeks and months, the Fed has repeatedly emphasized that financing conditions are too loose and should rise again to acceptable long-term levels. The conditions are influenced by several factors, including central bank rates, the long end of the yield curve, the equity market, credit spreads and the currency.

Earlier this year, the corresponding index pulled away from its fifty-year low and is now moving upward (graph 1). All factors have contributed to the rise, with the equity market setback being the largest contributor. The correction in the markets has thus helped the Fed to normalize financing conditions. Despite the steep rise, we are still well below the historical average.

Inflation – we are not out of the woods yet

For investors, inflation expectations are generally more important than the realized inflation. In graph 2, it can be observed that inflation expectations in the US are starting to weaken. However, five-year expectations are still close to 3%.

Therefore, in our view, we are not out of the woods yet. Wage pressure and price pressure due to expensive rents are currently too high in the US. Both components could remain at a higher level for longer than was expected at the beginning of the year. Therefore, the probability has increased in recent weeks that high inflation is stickier than reflected in current market prices.

Macroeconomic Outlook & Investment Strategy

Capital markets continue to be characterized by an unusual mix of growth and inflation. In an environment where central banks are almost forced to address classic supply shocks – such as disrupted supply chains –, visibility is limited and volatility elevated. Economic growth will begin to weaken as financing conditions tighten. The big question remains whether central banks will be able to manage this balancing act without triggering a recession. The war in Ukraine is another hard-to-define wild card, especially for the European Central Bank (ECB).

At the investment strategy level, we are sticking to our defensive positioning across all asset classes. Alternative investments are our preferred asset class, followed by equities, liquidity and bonds. Selection remains the number one success factor in every asset class. We expect volatility, which is high by historical standards, to be a constant companion in the coming months. This is due to the limited visibility in the macroeconomic area and the associated lower predictability.

Equity strategy

We maintain our neutral positioning for equities. However, we are adjusting our sector allocation as there have been huge performance divergences this year. In the two defensive sectors non-cyclical consumer goods and utilities we realize the outperformance and reduce the rating from “attractive” to “neutral”. In addition, we raise the technology sector from “unattractive” to “neutral” due to the expected de-rating of the sector in recent months. In order to maintain a defensive bias, we increase the weighting for the healthcare sector from “neutral” to “attractive”. Valuations for this sector are cheap by historical standards and thus have upside potential.?

Fixed Income Strategy

We see further upward pressure in government bonds of developed countries based on our inflation expectations. Therefore, we maintain our “unattractive” rating and tend to be short on duration. On the other hand, we raise our rating for corporate bonds from “unattractive” to “neutral” as rising interest rates and higher credit risk premiums are creating more potential again. Within fixed income, we continue to see the best risk-return potential in hybrid investments.?

Alternative Investments

We stick to our positioning and consider alternative investments to be “attractive”. In the current environment, gold remains our favorite. Despite recent advances, we continue to see potential in the commodities sector in the medium- to long-term.