The recent weakness in China, ‘stagflation risk’, and an earnings reporting season dominated by ‘margins squeeze’ concerns could sap confidence in the short term. Further out, we continue to favour equities over government bonds as growth strengthens again, inflation pressures fade, and central bank stimulus falls away only slowly.
It has become clear that supply chain bottlenecks and inflation will last longer than thought. To deal with the higher prices, households in the US and elsewhere will likely draw down some of the savings they accumulated during the pandemic.
Europe is more vulnerable to the disruptions from the post-lockdown reopening — higher energy costs, supply chain disruptions — than the US. The increase in natural gas prices is more damaging as it is a much more important energy source for the region, and the car industry is a larger part of the economy, particularly in Germany.
However, the outlook is still positive. Supply and energy issues should abate, the EU support funds will be disbursed, excess savings are high, and eased travel rules should boost tourism further.
China has been facing numerous challenges recently: debt-laden property developers, Covid infection outbreaks, flooding, and now power shortages. As Chinese growth slows, many observers expect government action to spur a rebound by increasing credit.
Since equity markets have now absorbed the news on inflation, and concerns over property developers in China have waned, earnings are in focus. Reported results have been surprisingly strong. It appears many firms have been able to pass along price increases, maintaining margins.
Inflation expectations have risen. Accordingly, market expectations of what central banks will deliver have changed. The US Federal Reserve is now expected to raise interest rates twice by the end of 2022. We expect the ECB to stress that it expects rates to remain at present or lower levels until at least the end of 2022.
- We are long equities, more specifically long US and Japanese equities. We are upbeat on US and EMU small caps and on European banks.
- We rotated our overweight position in emerging market equities to US equities.
- Being underweight duration is a strategic position given the favourable economic outlook, the currently low yields and the prospects of a normalisation of monetary policies. We closed our short position in EMU sovereign debt.