UIC confirms neutral positioning
Things will get tougher before they get better
- Macroeconomic environment becoming less dynamic, risks to growth are mounting
- Inflation starting to level off – slow decline expected to set in over the second half of the year
- Central banks prioritise curbing inflation: more and bigger interest-rate hikes seem likely
- Equity pair trade: emerging markets overweighted at the expense of industrial economies
RoRo meter reaffirmed at level 3: risk positioning remains neutral
At its final scheduled meeting in the first half of 2022, on 28 June, the Union Investment Committee (UIC) reaffirmed its neutral risk positioning (RoRo meter at level 3). No further changes were made to the model portfolio, as a number of minor adjustments had already been made over the course of the month.
More specifically, the UIC had established a relative position on the equity side at the start of the month, increasing the exposure to stocks from the emerging markets (EM) at the expense of stocks from industrialised countries. The overall weighting of equities remained neutral. At the same time, the UIC expanded the existing long position in the Japanese yen (against the US dollar). In addition, it neutralised the existing underweight in periphery bonds in mid-June, taking profits in the process, and scaled back the overweight exposure to US government bonds. The latter position was subsequently reduced again over the further course of the month. In this context, the long position in the Japanese yen was also scaled back to an extent.
The UIC continues to regard the current market conditions as fragile. Global economic growth is slowing, while inflationary pressure remains high for now and market participants are becoming increasingly concerned that the central banks’ measures to rein in inflation could bring the economic upturn to an end. In the opinion of the UIC, the outlook for opportunity-oriented assets is unlikely to improve until the trajectory of key parameters such as growth, inflation and monetary policy becomes clearer.
Active management and intelligent use of relative positions remain key elements of a successful investment strategy in this environment. As described, the UIC has already been pursuing this course of action in June and will continue to use an agile, tactical approach in the coming months.
Economy, growth, inflation
At present, the market is predominantly influenced by fears of a recession. And these fears are not unfounded, as threats to growth have recently intensified significantly. Efforts to catch up on order backlogs that had built up in 2021 due to supply shortages are being hampered by the war in Ukraine. Persistently rising prices – driven primarily by soaring commodity prices – are dampening consumers’ inclination to spend. As a result, the pace of global growth is currently slowing and the combination of high inflation and the war in Ukraine is subjecting the economy to a ‘stress test’. This is reflected, for example, in the fact that the ifo Business Climate Index for Germany declined by 0.7 points to 92.3 points in June. Union Investment’s economists have therefore once again adjusted their growth forecasts for the current year and for 2023 slightly. They now predict US GDP to grow by 2.2 per cent in 2022 (down from 2.4 per cent) and 1.3 per cent in 2023 (down from 1.9 per cent). For the eurozone, they now anticipate GDP growth of 2.3 per cent on average for 2022 (up from 2.1 per cent) and 1.1 per cent for 2023 (down from 1.5 per cent) – provided that Russia does not cut off its supply of gas altogether. Forecasts for other regions such as China and Japan were also revised down a notch for 2022.
Growth in the eurozone and the US, in particular, is thus dropping to the trend growth rate or even lower. But even though the risk of a recession has recently increased, Union Investment’s economists do not anticipate a fall in economic output. This is because consumer spending in the US remains robust and the Chinese government is expected to bring in fiscal stimulus measures. Both of these factors should provide support for the global economy.
In terms of inflation, weaker economic growth should help to alleviate inflationary pressure. Moreover, certain tensions in the real economy (e.g. supply chain disruption) should ease to some extent over the course of the year, which would improve the situation on the supply side. The UIC also expects conditions to normalise on the demand side, for example in the form of a shift from goods towards services. Although prices of services may rise as a result, this should be more than offset by the reduction in upward pressure on the prices of goods, meaning that the overall impact on inflation should be dampening.
However, these effects will take time to materialise and will not drive inflation down in the near term. In the coming months, it is therefore likely that inflation will plateau at a persistently high level. Over the further course of the year, inflation should then come down gradually from its current high, first in the US and then also in Europe. Union Investment’s economists expect average year-on-year consumer price growth for 2022 to come to 7.6 per cent in the eurozone and 8.0 per cent in the US.
Plan for monetary policy to return quickly to neutral interest rates
With inflationary pressure remaining high, the main central banks continue to focus firmly on tackling inflation. In fact, the latest data points – whether producer prices in the eurozone or US inflation expectations recorded by the University of Michigan – may have further strengthened the central banks’ resolve to fight inflation. This determination is being met with mixed feelings in the capital markets. After all, the combination of stubbornly high inflation, lingering supply issues and an over-tightening of monetary policy actually presents the biggest macroeconomic risk. It is therefore important that the central banks do not end up in a situation in which they have to tighten their monetary policy excessively.
The central banks can manage this balancing act, not least because of the aforementioned prospects for the easing of inflation. In its baseline scenario, the UIC therefore assumes that the central banks will bring inflation under control and achieve a soft landing for the economy at the same time. The chance of this scenario materialising is particularly good in the US. However, it is by no means guaranteed and risks have actually increased of late, especially for the eurozone.
In light of this, Union Investment’s economists recently adjusted their expectations with regard to monetary policy action once again. They now anticipate that the US Federal Reserve (Fed) will hike interest rates by 75 basis points in July, followed by a rise of 50 basis points in September and rises of 25 basis points in both November and December. By the end of the year, the target range for the federal funds rate should thus be 3.25 per cent to 3.5 per cent. Union Investment’s economists do not expect any further increases in 2023. For the European Central Bank (ECB), meanwhile, they forecast that interest rates will go up by 150 basis points in 2022, followed by further rises of 100 basis points next year.
The ECB has also announced a successor, or rather an addition, to its current bond-buying programmes. The new instrument is designed to tackle the ‘fragmentation’ of the eurozone against the backdrop of wider spreads on government bonds from eurozone periphery countries. It appears that the ECB wants to focus on counteracting market movements that it believes are not justified by the fundamentals. The details of the programme are not yet known. However, simply announcing it has helped to calm the market situation.
Significant correction for long-term valuations
At 4%, the US is still above the long-term average
Europe already 13% below the median p/e ratio
Fixed income: US yield curve is expected to flatten completely
Following a phase of consolidation in May, yields returned to their upward trajectory in the first half of June. Ten-year German government bonds briefly exceeded the 1.85 per cent mark, while their US counterparts reached almost 3.5 per cent. The markets settled down in the second half of the month. Union Investment’s experts slightly raised their twelve-month yield forecasts for US Treasuries once again and now expect a level of 3.4 per cent for both two-year and ten-year paper. In the case of Bunds, yields on short-dated bonds are likely to move closer to those at the long end again. The forecast for the end of June 2023 is 1.7 per cent for two-year paper and 1.9 per cent for ten-year paper. However, Union Investment’s experts do not expect the German yield curve to flatten completely. The latest discussion by the ECB halted the widening of spreads on bonds from periphery countries, although there was no let-up in any of the other spread segments. With the economic leading indicators weakening, corporate bonds are likely to remain under pressure.
Equities: preference for shares from emerging markets over those from industrialised countries
The war in Ukraine, increasing inflation, the softening of growth and rising interest rates continue to weigh on equity markets. However, the stock markets have already largely priced in these adverse effects. As the UIC had expected, greater stability in terms of interest-rate and inflation expectations has recently helped to alleviate some of the downward pressure on valuations and the equity markets have stabilised. Another contributing factor was that investors were limiting their exposures. This provided a countercyclical purchase signal, thereby enabling sectors that had come under a lot of pressure (such as tech) to stage a disproportionately strong recovery in recent days. Although profit expectations remain stable for now, the environment for equities from industrialised countries – especially in Europe – remains fragile. At the same time, China’s coronavirus situation is gradually improving, which prompted the UIC to overweight shares from emerging markets in comparison with stocks from industrialised countries at the end of May.
Commodities: supply remains tight in the European energy market
There are continuing shortages in a number of commodity segments. The situation in the North Atlantic energy market, in particular, has not seen any improvement. Bottlenecks for various oil-based products (e.g. diesel and kerosene) are resulting in higher margins for refineries and are also being reflected in implicit roll yields of 25 per cent on an annualised basis in the forward curves. Europe’s gas inventories had recovered well in recent weeks, but Russia then significantly reduced supplies through the Nord Stream 1 pipeline due (allegedly) to technical problems. This prompted Robert Habeck, Germany’s economics minister, to announce the alert level of the gas emergency plan. According to data from the German Federal Network Agency, demand for gas has already fallen sharply year on year, at least in Germany. The crude oil output of countries in the OPEC oil cartel is still below the agreed production quotas, whereas oil production in the US continues to rise. The global oil market is therefore likely to move back into equilibrium over the course of the year or possibly even see a supply surplus, regardless of the current discussions at the G7 summit about possible price caps. There have been significant adjustments to the positioning in respect of metals in the last few weeks. Inventories have not seen any weakening of demand so far, and the relative change in prices actually points to a recovery of the Chinese market. Due to low levels of investment in new mining projects, the primary supply of industrial metals will remain tight in the medium term although there is likely to be a steady increase in the supply of recycled material. Over the medium term, the market will also experience rising demand in connection with the transition to clean energy and decarbonisation megatrend.
Currencies: uptrend continues for the US dollar
The US dollar’s wobble at the end of May was only short-lived. With inflation still advancing in the US and confirmation that the Fed would raise interest rates by 75 basis points as expected, the greenback began to climb again. What was remarkable in this context was the noticeable weakness of the Japanese yen. The Bank of Japan is looking increasingly isolated with its still expansionary monetary policy, because more and more central banks are tightening the reins or, as in the case of the ECB, are preparing the capital markets for imminent interest-rate rises. This means that a key driver for any appreciation of the yen is absent, as monetary policy is currently a crucial anchor point for the currency markets. Other influencing factors that tended to support the yen’s role as a safe haven in the past – such as investor positioning and sentiment or concerns about growth – are being largely ignored by the markets. The UIC continues to believe that this situation will change.
Convertibles: market environment remains weak
Rising interest rates and fears about a recession have a negative impact both on equity markets and on convertible bond markets. A significant countermovement only emerged in recent weeks, pushing up prices for US convertible bonds in particular. Japanese convertibles held steady in this volatile environment. Thanks to the countermovement, equity market sensitivity also remained relatively stable at around 47 per cent, while valuations remained attractive to fair. There was only a small number of new issues given the weak market environment.
Unless otherwise noted, all information and illustrations are as at 28 June 2022.