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In search for inflation and volatility protection

The pattern across stock markets suggests investors remain uncertain whether high inflation has peaked.

Since their March rebound, equities (MSCI World All-Countries index) have erased all their gains and are now down 11% (in euro) since the beginning of the year, as price pressures are being fanned by supply-chain snarls from China’s Covid restrictions and disruptions to commodity flows due to the war in Ukraine.

 

Concern is also growing that the economy faces a downturn as central banks pivot toward aggressive policy tightening to contain the cost of living.

  • After two years of holding borrowing costs near zero to insulate the economy from the pandemic, the Federal Reserve (Fed) signaled seven rate increases this year, finishing this year close to 2% and then to about 2.8% by the end of 2023. Such a set of hikes would represent the sharpest tightening in 40 years! In the Euro-Area, consensus is building among European Central Bank Governing Council members to raise ECB’s deposit rate, which has been negative since 2014 and currently stands at -0.5%, by at least 0.25% this year. Meanwhile, the central bank has guided that new bond purchases will end at some point in the third quarter.
  • History suggests the Fed will face a difficult task cooling inflation without causing a U.S. recession as 11 out of 14 tightening cycles in the U.S. since World War II were followed by a recession within two years. Global growth optimism sunk to an all-time low, according to last month’s Bank of America fund manager survey. Stagflation expectations jumped to 66%, the highest since 2008, while U.S. price pressures rose in March by the most since late 1981 (+8.5%)! Money managers are increasingly prepping for bad economic news - and nowhere more so than in Europe, belying hopes coming into this year that the region will outperform the U.S.


Global growth optimism at all-time lows


The positive effects from inflation on earnings growth for firms could have peaked as rising costs trim their margins and price pressures caused by the Ukraine war and China’s worsening Covid situation hit consumers.

  • China’s stringent rules to curb Covid-19 are about to unleash another wave of summer chaos on supply chains between Asia, the U.S. and Europe. Beijing’s zero-tolerance approach amid an escalating virus outbreak brings the pandemic full circle, more than two years after its emergence in Wuhan upended the global economy. Shipping congestion at Chinese ports - China accounts for about 12% of global trade -, combined with Russia’s war in Ukraine, risks a one-two punch that threatens to derail the recovery, already buffeted by inflation pressures and headwinds to growth.
  • The combination of weaker demand and higher input costs starts to weigh on earnings estimates. Even as the war in Ukraine is seen having a bigger impact on Europe than elsewhere – the euro bloc has the most to lose from the conflict because of its dependence on Russian energy and closer trade tie with that nation –, a Citigroup index of profit forecast revisions for world companies is turning negative for the first time since September 2020. Analyst downgrades are now outweighing the number of earnings-per-share upgrades! This is an important evolution because improving profit margins accounted for almost three quarters of the return-on-capital (ROE) expansion during the past two years.

 

Furthermore, the rise in bond yields is beginning to bite, even for the safest global companies, in a sign financing conditions are becoming more challenging. A gauge of the cost of borrowing to refinance maturing corporate debt has climbed to the highest since 2009 (0.8%), around the time of the global credit crisis. The spread between the average yield and current coupon on the Bloomberg Global Aggregate Corporate index - a measure of investment-grade debt in both developed and emerging markets - jumped into positive territory this year for the first time in well over a decade, bar a brief spike at the beginning of the pandemic. 

 

In a context where volatility remains relatively high and worries abound, investors are looking at companies, sectors, and styles that can still do well.

  • If inflation continues to be one of those worries, commodities and commodity companies should continue their run higher.
  • As the signs of a flight to quality due to growth concerns are clearly visible in a strengthening dollar, that may push money managers to adopt a more defensive stance. They are expected to favor companies with more stability and more predictability in earnings. Those include low duration stocks, such as value stocks (mainly Energy and Financials) which perform better than growth stocks (+19% year-to-date, in euro) during rising inflation expectations and higher interest rates. And also more “defensive” companies (such as Utilities or Healthcare) which, thanks to their lower sensitivity to economic conditions, pricing power, high dividend income or low volatility, have outperformed more cyclical stocks by almost 17% (in euro) since the beginning of the year.


performance of the main investment factors