In this article:
What has happened
Since early January, we have seen sharp pressure on momentum and real rate sensitive sectors of the equity market, coupled with some moderate gyrations in credit as risk-on sentiment has turned. The key trigger point has been the rapid shift in narrative from the central banks led by the Federal Reserve as the strong inflationary pressures which had been strengthening for most of 2021 have brought policy focus on the need for immediate and significant tightening. This is reflected in the sharp moves we are seeing - especially in real rate markets.
Our view has consistently been that the Fed faces a Catch-22 (or Catch-2022) policy dilemma (see our Fidelity Investment Outlook 2022). After initially misjudging the nature of the current inflationary impulse given the incidence of supply-side disruptions, the Fed has now clearly pivoted towards a much quicker and faster roll back of its asset purchase programme, coupled with more recent indications that it will raise rates as early as March and initiate the rundown of the $8.87 trillion balance sheet, in order to rein in inflationary expectations by using the full range of tools at its disposal.
However, this is a unique business cycle given the nature of the pandemic shock and the extraordinary support provided through unprecedented fiscal and monetary policy channels since lockdowns were put in place in March 2020. In addition, given the very heavy debt burdens, we continue to think that an overly aggressive hawkish policy creates financial stability risks (with real rates as the key proxy) and will ultimately be a limiting factor on how aggressive the tightening of policy can be going forward.
The recent market reaction we have witnessed is a direct consequence of this dilemma, whereby the strong inflationary impulse means that tightening is required but, at the same time, it raises the risks that Fed may end-up killing the business cycle and/or generate financial stability risks as it tries to move ahead of the curve. This has led to a re-assessment of risk premia across the more policy sensitive part of the risky asset complex.
Looking ahead, as we move through 2022, from a macro policy perspective, we continue to expect this Catch-22 dilemma to remain very much live as clarity on both policy trajectory and inflation/growth dynamics is not yet a reality. All in all, as we expected, macro policy volatility is now the dominant factor and is here to stay for some time with risky asset markets now starting to move sharply to price in the new regime.
Sanctions will impact Russian firms and create downside risks to growth for Europe
In addition to uncertainty around macro policy, geopolitical risks have also escalated in recent weeks. Previous moments of increased tension between Russia, Ukraine, and the West have driven risk aversion and periods of weaker stock market performance. The sell-off commenced in November 2021, however, the first few weeks of 2022 have seen the Russian equity market tumble a further 18 per cent year-to-date (in dollar terms), as Russia has amassed further troops on the Ukrainian border sparking fears of an imminent attack.
The risk of Russia invading the Ukraine and concomitant financial sanctions should not be dismissed and is risk factor we are watching closely. The Senate has drafted sanctions which would be imposed in the event of an invasion. These sanctions focus on areas such as energy and defence, and naturally target Putin’s closest allies. Beyond the US, the matter is highly complex given Europe’s dependence on Russia for its natural gas and oil needs. The Russian financial sector is also likely to feel the effects if proposed sanctions come into force, especially more controversial banks that are involved in armaments industries. Sanctions would most likely restrict new bond issuance - long and short-dated - although we do not see restrictions on ownership as a risk.
From a global perspective, renewed tensions and the possibility of war in Europe come at a time when inflation has become a major concern and led to policy shifts. Moreover, as highlighted above, European dependence on Russia (and scope for disruption there) raises the risk of a growth downturn if the situation were to deteriorate into outright conflict.
Even before the current bout of market volatility, our recent positioning moves have largely been about taking risk off the table. We continue to think that inflation pressures will persist this year and growth is slowing as the tightening of policy comes online. However, we do not expect a more serious downturn just yet, though we acknowledge that the uncertainty corridor surrounding the current business cycle has widened. Corporate earnings are strong, and consumers are in decent shape. Overall, from a total portfolio perspective, we have a neutral outlook for equities and credit. We have an underweight position in duration, a reflection of our expectation that yields will rise in response to central bank tightening to combat inflation.
Within equities, we are taking a cautious approach as the market was showing signs of fatigue before the Fed’s hawkish pivot. The ‘Covid cycle’ that has driven markets for the previous two years appears to have played out with high(er) inflation being the major legacy from a pure macro point of view. That said, dividend yields are still high, and the market is further supported by liquidity and buybacks against a backdrop of an environment with still contained outright recession risks. Nonetheless, we remain cautious on real rate sensitive parts of the market.
Within fixed income, the direct challenge posed by tightening policy in the face of inflationary pressures is now the dominant force as well. As a result, we recommend higher yielding debt, such as Europe and US high yield. We expect defaults to stay low this year and while there is little chance for spread compression, the risk-adjusted carry is acceptable. Global hybrid funds also appear to be decent value. They have low sensitivity to interest rates and offer similar yields to B-rated credit but from investment grade-rated institutions.
In addition, we expect the dynamics in private markets to stay robust this year. European loans in particular should remain resilient in the current environment given floating rate structures: they have a high margin for error and there is significant room for rates to rise before interest coverage would be stretched.
In the FX space, we have removed our overweight to the dollar (as a hedge against risk-on positions) given positioning and await clarity on differential central bank policy pathways. The medium-term outlook for the dollar remains challenged, in our view.