Towards a new paradigm: Adapting to volatile markets
- The current rising rate environment marks the end of a market era – and the beginning of a new one
- This year has seen a re-correlation phase between equity and fixed income that calls for a strengthening of diversification strategies
- While approaching this new environment with caution, we remain vigilant to market signals which could indicate the right time to re-engage with riskier assets
2022 has been a tough year so far, which is reflected by the performance of global bond markets which have in turn, been a disaster. Going forward, we are likely to see increased inflation and less growth. In this article, we take a look at some of the events that have marked the year and how they may have an impact on the coming months.
The beginning of the trouble.
The Russia-Ukraine war has caused a lot of turmoil in 2022. European markets hit highs at the start of the year despite ignoring warning signs of a conflict which then triggered a sharp drop in stock markets around the world, further accentuating the crash in technology stocks. Although Russia is an economic minnow, Europe - with its 450 million inhabitants - uses Russian gas for heating, among other things, so the impact has been hard.
Inflation is at its highest since the 1950s in Germany, and since the 1980s in the US.1 The majority of economists underestimated the historical levels of inflation we are experiencing today, after years of near-zero figures. Several cyclical factors are behind this including excess demand due to a strong fiscal policy and a highly accommodative monetary policy, supply problems linked to constraints on production chains (logistics, semiconductors, etc.), employment levels and an energy shock spurred on by the war in Ukraine. Structural factors such as the energy transition, excess demand for commodities and an ageing population have also played a part. The result? Real household disposable income is collapsing.
The end of magic money
We saw it coming and we've been talking about it for a long time. After more than ten years of low rates, central banks have started to normalise their monetary policies and reduce the size of their balance sheets (even if the ECB refuses to talk about "tapering") in order to combat record levels of inflation by slowing demand through tighter financial conditions. Rate hikes by the Fed, the ECB and almost all central banks were rather poorly received by markets. In the US, this cycle of rate hikes is expected to be the most severe (the largest increase in key rates in one year) since the Volcker era in the early 1980s, and the second largest since the end of World War II. What does this mean? Central banks will have to go through a recession to bring inflation back into line.
Recession: a necessary evil
Growth is already decelerating sharply in the US, due to the fall in real household disposable income, constraints on supply chains, the sharp reduction in fiscal stimulus and the tightening of financial conditions. This is also the case in Europe, where the situation is not particularly encouraging at first glance. Central banks will have to continue to normalise their monetary policy in such a way as to significantly cool the labour market and thus wage growth, which is likely to happen only through a recession. There is also the energy crisis, which makes the ECB's work even more difficult, since it has to bring down inflation that is linked to external factors. Any gradual decline will depend on growth.
We expected a slowdown in activity after a record 2021. So, did the financial sphere faithfully reflect the economic sphere? Companies’ results over the year were excellent, with rates still close to zero, and have continued to hold up very well since the beginning of the year thanks to their pricing power. But this is not going to last. Record margins are unlikely to hold up due to the decline in demand.
Taiwan, should we worry?
Geopolitical tensions between China and the US over Taiwan should not be underestimated. China may be tempted to invade Taiwan in the next few years and without Taiwan, a significant part of the world's factories could shut down in a matter of weeks. Taiwan Semiconductor Manufacturing Company (TSMC) manufactures 65% of semiconductors worldwide.2 In the short term, the risk is very real. In the longer term however, the European Union is planning a huge investment plan of €42 billion3 into the sector to reduce its dependence on semiconductors manufactured in Asia, which could represent investment opportunities in Europe.
Against this backdrop, we are approaching the autumn with increased caution by being underweight equities at a historically low level in our portfolios. However, we remain vigilant to the various market signals - movements, valuations, sentiment and technical factors - in order to reposition ourselves on risky assets when we consider the timing to be appropriate. On rates, our position is neutral and non-directional.
The end of persistently low interest rates marks the end of an era that proved favourable for equity markets. In concrete terms, we can no longer count on the stability of an inflation-free economy, dominated by hyper-accommodative central banks and the absence of returns on fixed income assets. We are coming to the end of an era…and the beginning of a new one.
We therefore need to evolve in more volatile markets and, to do so, strengthen our diversification strategies in order to seek to preserve capital in asset re-correlation phases, such as the one we have seen since the start of this year.
Companies are mentioned for information purposes only and this does not constitute a recommendation to buy or sell.
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