Markets turn defensive

Uncertainty now surrounds financial markets at every turn. Whether from the prolonged crisis in Ukraine, the slowdown in China or more aggressive central bank policy. And as inflation soars and growth slows, the risk of contagion is rising. It's little wonder that markets have taken a defensive turn. We look at how these uncertainties are playing out across different asset classes and how our tactical asset allocation has been adjusted to take advantage of recent market moves.

As a scene setter, could you start by giving an idea of exactly how volatile markets have been at the start of this second quarter.

Markets have been under a lot of pressure in recent weeks, and we've seen a lot of volatility. Not just equity markets, but bond markets as well. For Q2 so far, since the beginning of April, we've seen some big negative returns. The S&P 500 in the US is down 13%. Europe and Japan are down a little bit less, 6% to 7% in their local currency terms. And the euro has really underperformed against other currencies such as the dollar. So if you're looking at things in dollar terms, you could add another 4 to 5% to those losses.

Emerging markets had a difficult year last year and a difficult start to this year. For the quarter so far it's down another 13%. And if you look on a year-to-date basis, it's down now almost 20% and most of that's coming from China, which is having another difficult year down 26%. US markets are down 17% on a year-to-date basis. Very negative returns out there. And other markets like the Nasdaq, a big darling for investors in recent years, down almost 20% in the quarter, 27% on a year-to-date basis, more even because the Nasdaq correction began in November last year. You're seeing it in deep correction territory as we speak, so growth stocks under a lot of pressure. A very difficult recent period in equity markets.

It is indeed, but have the traditional safe haven assets come to the fore?

Yes and no.

Normally you would expect government bonds to provide some form of support or protection in these kinds of difficult markets, but they haven't, so we've seen bond yields rising, and as a result their prices have been falling too, and it's the same worries that are impacting both the bond and equity markets.

We are seeing rampant inflation, and this is requiring monetary tightening from the central banks and as a result, both bond investors and equity investors are worried. You're not seeing bonds do as well and be the safe haven asset they normally would be.

But there have been other areas which have done well. The US dollar is at a 20-year high right now and there's increasing talk that we might see parity with the euro. This is something we haven't seen since shortly after the creation of the euro back in 2002. Gold is having a great year so far and commodities as well, they've generally been doing ok, although we have seen volatility in certain parts of commodity markets. But generally they've had a good year thus far as well. It's a bit of a mixed picture.

The oil price reacted very sharply to the crisis in Ukraine, but that has in fact become less volatile in recent weeks. It's trading within a range between $100 and $110 and the price there is clearly being restrained by developments in China. Can you update us on the current Covid lockdown situation in China?

We currently see a mixed picture. On the one hand, we see the nationwide daily cases falling from over 30,000 around mid-April to currently below 5,000. Also, while in mid-April cities which account for around 40% of China's GDP, were in some type of lockdown. This number decreased to below 20%.

On the other hand, there is still a strict lockdown in most districts of Shanghai, China’s main financial and port city. Shanghai currently has the strictest form of lockdown in China. Besides Shanghai, there are four other cities, in total 8% of GDP, which are imposing the strictest form of lockdown with a significant impact on the local economic activity. Also in the capital Beijing, there is still uncertainty around potential stricter lockdowns.

And the impact on China's economy has already been significant. How long can this zero-Covid policy now be maintained?

It's a difficult question. I In a recent statement the Chinese government reaffirmed that both economic growth goals and Covid containment need to be achieved and that they will stick to their zero-Covid policy.

To be more precise, recently China aims, in the strict lockdown cities like Shanghai, to have zero-community spread. Which means no positive cases of people outside of quarantine. The current goal in Shanghai is to reach several days of zero-community spread before a loosening of the restrictions in the specific districts, if possible. To put it in perspective, this Tuesday Shanghai had the first day without any community cases.

Yesterday Shanghai had around 2,000 cases, four of them were not quarantined. It's also unclear what a gradual loosening of the restriction would look like, should the goal of zero-community spread be achieved. For China's current policy to work, they need frequent mass testing and early and rapid quarantine of infected people and their close contacts. This has already worked in the past in some cities, like for example in the tech hub Shenzhen. Given we have no experience with this kind of approach in other parts of the world, it's hard to say for how long this policy can be maintained.

China is now facing forecasts of a negative quarter for Q2, is the government’s 5.5% growth target still achievable for this year?

Yes, the government set the target at 5.5% for this year. The Bloomberg Consensus is currently around 4.8%, with the lowest at 3.6%. And this forecast has been revised down especially recently.

At the current stage, it's hard to imagine that the growth target will be reached without strong monetary and especially fiscal stimulus.

Given the important Party Congress meeting in October this year, and the renewed statements that economic growth goals need to be achieved, the market and Architas expect further stimulus. Whether this will be enough depends on how effective the stimulus measures and how sustainable the current Covid policy could be.

Could you give us some indications from China of renewed supply chain disruption with, of course, the broader implications that would have for Asia, and indeed elsewhere in the world?

Yes, we still see supply chain disruptions in China, especially due to the lockdown in an important port city like Shanghai. China’s April PMI data was, not surprisingly, very weak. The April Markit Manufacturing PMI dropped from around 48 in March to 46. And the Services PMI dropped from 42 to 36, levels we have not seen since the Covid outbreak in February 2020.

And the drop in the China PMIs recently contributed to weaker global PMIs. This weakening of PMI data around the world is perhaps not surprising given the uncertainties we described earlier.

The US Fed recently spoke of aiming for a ‘softish’ landing for the US economy. How much of a challenge is the Fed facing now?

The challenge was described by one member of the Fed as ‘difficult but not insurmountable’. But history shows that this is not an easy task.

There are almost more examples of recessions following rate rising cycles as there are not. The Fed has indicated that there are likely to be 50 basis point increases at its next two meetings, and then afterwards 25 basis point rises at all other meetings this year. Markets are now expecting rates to get to 3.25%, maybe 3.50%. Whether this is enough will depend on the path of inflation from here.

US CPI inflation is running at over 8%, a 40-year high, so we need to start seeing signs of peaking or easing in price rises. The longer inflation stays elevated, the more difficult the task is for the Fed. But one positive is that corporates are in fairly good shape at the moment; they’ve got strong balance sheets and ample cash. At least they are better positioned to weather some tightening of financial conditions and manage any potential slowdown that might come.

But the US Treasury bond market seems to be indicating that the Fed wouldn't have to tighten too much before growth starts to stall?

Yes, what we've seen in recent months is a flattening of the yield curve, so a bear flattening with the short end rising more than the long end. This indicates that markets believe the Fed would not need to raise rates too aggressively given economic growth is likely to slow on the back of these tighter financial conditions. In fact, rates might even need to come down again, in a year or two, to provide support for what would probably be a weaker economy at that time.

And in the equity markets, we've recently seen a decided preference for the traditional defensive sectors?

Indeed, so while equity markets have been taking a bit of a hit, in particular growth-oriented stocks, there have been some areas which are holding up better. Namely traditional defensive companies and companies with good dividends. They've seen some good outperformance, for example, from food stocks. Campbells, known for their soups, and Kellogg's, these have been outperforming.

These kinds of companies are facing rising costs and their margins are being squeezed, but at the same time investors are looking for these defensive sectors to preserve their capital for better times ahead.

What potential bright spots do you see on the horizon?

Valuations for one thing, there's a lot of bad news already priced into markets. And given the move that we've seen in bond yields, it's hard to say now that the Fed is still behind the curve, because this is something they've been accused of a lot in recent months.

Valuations are definitely more attractive. And the rate rising cycle has begun now in many key regions, so this should begin to have some effect, and help tame inflation in the weeks and months ahead.

And recent inflation figures are not showing significant signs of easing, but equally they are not showing signs of further increases either. We should see some of the key drivers of inflation, like supply constraint issues, ease and demand is likely to fall further from here as well, as growth slows in many key economies. And so, a lot of markets and asset classes are beginning to look a bit more interesting once again.

Those lower valuations are particularly striking in China?

Exactly! The current forward P/E ratio of the MSCI China is at 9.8, which is almost 50% lower than at the latest peak in February 2021, especially compared to global equities. We see almost record high valuation discounts between the MSCI China and the MSCI All World. Besides that, the PBOC (People’s Bank of China) has indicated that they will be more supportive, with potentially further rate cuts.

And as mentioned earlier, this will likely be combined with further fiscal stimulus, probably through more infrastructure investments, and at least some temporary easing of the property market policies. The picture is certainly not exclusively one of doom and gloom.

In the light of this, could you outline the recent changes we have made to Architas’ tactical asset allocation?

In the near term, we don't see the outlook improving too much for many of the current factors that are weighing on market sentiment.

Inflation is likely to remain well above the central bank targets far into next year, and this presents an issue for equities. And it creates a bit of an uncertain path for them in the foreseeable future.

With this in mind, we continue to prefer US or Asia Pacific equities, compared to European or eurozone equities. Europe is the region most impacted by what's going on in Ukraine and most exposed to inflation-induced slowdown, so we're not very positive on the European region. We are more positive on China now; we believe we're nearing the point of maximum pain and the risk reward now is becoming more attractive again on the back of this.

On the bond side, given the large moves that we've seen in yields, we are less negative here. So we've been very negative on bonds for a long period of time. But we have seen some big moves in yields, and so they are more attractive from a valuation perspective.

And in the corporate bond market we've seen credit spreads widen quite a bit recently and on a year-to-date basis as well. We think they're a lot more attractive, so as a result we've moved from an underweight in investment grade credit back to neutral stance.

In high yield, we've moved to an overweight. In the high yield asset class bond yields are over 7%, closer to almost 7.5% in dollar terms. It's the most attractive level it has traded at in a long time. These are the key changes that we've been focusing on.