Caught in crosswinds
There are a number of crosswinds buffeting financial markets and impeding further recovery and growth. These factors include rising inflation, tightening central banks and increased geopolitical risk due to Russia’s invasion of Ukraine. Stock markets have been surprisingly resilient in the past few weeks, while in the face of rising inflation and the intention of central banks to hike rates, European government bond yields are entering more firmly into positive-return territory after a long absence.
Uncertainties abound in the financial landscape. Inflation, and energy prices in particular, have been rising, inducing central banks to tighten monetary policies and bringing a halt to the expected post-lockdown recovery. Russia’s invasion of Ukraine further increased uncertainty and contributed to already snarled supply chains and inflation.
In the face of these negative factors, risky assets, such as stocks, have been volatile and show negative returns year-to-date, but have been fairly resilient in the past few weeks. The impact of Putin’s war has, so far, had a milder-than-expected effect on financial markets. Economic data has even been surprisingly positive lately, while Bunds and other core European government bonds are, after a long time, again posting positive yields.
The return of government bonds as an investable asset class with above-cash returns can offer some comfort to investors. Bonds are on their way to once again being able to act as a buffer and a source of portfolio diversification when riskier assets run into trouble.
At the latest meeting of the ABN AMRO Investment Committee, the decision was made to use cash and modestly reduced holdings in corporate bonds to invest in core European government bonds. The allocation to stocks was maintained at neutral, and the overall allocation to bonds remains underweight but to a much lesser degree.
Equity outlook remains uncertain
We continue to take a balanced stance toward equities. The overall allocation remains neutral, with a preference for US markets (overweight) over European (underweight); and a neutral stance toward emerging markets. Growth in the US is expected to improve in the second half of the year; and the US is also somewhat more insulated from the war in Ukraine, both geographically and due to its greater energy independence.
Earnings momentum is expected to slow as the year progresses, with inflation raising input prices and putting corporate margins under pressure. Already, the overall number of downward earnings revisions by analysts is larger than the number of upward revisions. There are some sectors, however, that are doing better than others, namely energy, materials, health care and utilities. Energy and materials are benefiting from the rise in commodity prices, while health care and utilities are seen by investors as being more immune to margin pressures than other sectors.
Rising bond yields
Rising bond yields offer the possibility to adjust long-held underweights in “safe” bond segments, such as core government bonds and to return to a more balanced investment strategy. The percentage of negative yielding bonds in the bond universe has for a long time been larger than the percentage of positive yielding bonds. This metric is now reversing, as bond yields (which move in the opposite direction of prices) respond to central bank tightening. This also means that core European government bonds, such as from France and Germany, have become more attractive, with returns solidly better than cash investments.
In addition to adding to the holding in European government bonds from cash, the decision was also made to reduce some holdings in corporate bonds and to also direct these proceeds to government bonds. In the future, these investment-grade corporate bonds are likely to no longer be underpinned by the European Central Bank’s asset purchases, as the central bank begins to cut back on measures instituted to support markets during the pandemic.
Conclusion
The number of consequential financial market ‘’unknowns” increased in 2022 and interrupted the expected recovery as the global economy emerged from lockdowns. But despite inflation, tightening central banks and a slowdown in economic growth, recession continues to appear unlikely. While the US Federal Reserve is implementing an increasingly aggressive approach to rate hikes, it is also a guardian of growth. And even though high inflation is weighing on US consumers, they have ample cash on hand. We believe these crosscurrents call for a balanced and defensive approach to investing, where risks are carefully weighed and opportunities to improve returns are assessed. We expect markets to continue to be volatile and welcome the stabilising influence that a larger allocation to bonds can offer in this environment.
Richard de Groot
Chair, ABN AMRO Investment Committee