Principal Monthly Viewpoints (March 2022)

Q: Principal Asset Management (Asia) Investment Management Team

A: Crystal Chan, Principal Asset Management (Asia) Senior Investment Specialist

 

Q:How will the global economy and investment markets be affected by the uncertain geopolitical landscape in the context of Russia and Ukraine?

A:Fears over the conflict between the two countries escalating was one of the primary drivers of recent stock market correction. Economic impact can be analyzed from two perspectives. First, this event may affect short-term energy supply, pushing prices of energy and food even higher, leading to rising inflation and less clarity on the outlook for monetary policy. Second, aside from the economies of Russia and Ukraine, Europe also faces greater downside risk, which may further impede the pace of global economic expansion.

The S&P 500 Index has once retreated nearly 15% from its peak YTD, with market volatility trending upwards. As has been the case with many past geopolitical incidents, market corrections are not triggered by political events alone. Behind the current market corrections, there are more market fears induced by the uncertain outlook of US monetary policy.

Looking back at the impact of past geopolitical events, we found that despite broad corrections across investment markets, the duration was relatively short. If we consider the 12 geopolitical events which have led to market corrections over the past 30 years, including the invasion of Kuwait by Iraq in 1990, the invasion of Afghanistan by the US in 2001 and the invasion of Iraq by the US in 2003, the S&P 500 index on average fell 5.9% from its highest point, while markets took 16 days on average to recover lost ground. One year after such events occurred, the average return of US stocks was positive. As markets refocus on fundamentals and if the economy has not slipped into recession, stocks have a greater chance of returning to their previous upward trajectory.

In the short run, geopolitical factors and the Fed’s impending first rate hike may result in sustained volatility in global stocks and capital flowing towards safe haven assets. Stocks may continue to fall in tandem with yields of sovereign bonds until uncertainties dissipate. Nonetheless, we generally recommend against adjusting risk allocations based on short-term geopolitical factors, especially when stocks have already undergone some corrections. Focus should be on fundamentals instead.

From a mid-to-long term perspective, growth rates of global and US economies now remain above long-term average and market liquidity is still relatively abundant. Equity fundamentals are relatively positive with current valuations after the recent correction more reasonable. Capital is more likely to extend an 18-month trend and continue to flow towards assets with higher mid-term potential returns. These factors may support a market rebound after uncertainties are digested. Investors may therefore consider remain a holding of more stocks than bonds, and diversify investment risks with alternative asset allocations.

 

Q:How should stocks and bonds be allocated amid such uncertainties?

A: Considering that growth of the economy and corporate earnings is set to normalize this year, coupled with a slew of uncertainties, both the economy and corporate earnings face greater downside risks. Equity returns may not be able to replicate the rally in 2021. However, with bond yields trending upwards slowly, stocks are still likely to generate greater returns than bonds by the end of the year. Among equities, we continue to be slightly optimistic on the US, neutral on Europe, Asia, Japan, China and Hong Kong, and are slightly pessimistic on emerging markets.

In the US, despite expectations of five rate hikes by the Fed this year, we believe economic growth will remain above long-term trends. The probability of an economic recession occurring within these two years is still low, implying a tailwind for earnings. Looking at fundamentals, S&P 500 corporate earnings grew more than 30% yoy in 4Q. Corporate earnings growth generally beats market expectations. Forward P/E based on earnings of the next 12 months falls below the five-year average. Fundamentals are improving. Besides, US is an energy exporter, which means a rise in energy prices may not has a large impact on it.

We’ve recently revised down our stance on Europe to neutral. A higher vaccination rate of booster shots within the region has encouraged countries to relax pandemic-related restrictive measures, allowing the economy to recover. At the same time, inflation expectations are relatively contained, which gives room to the European Central Bank to maintain relatively accommodative monetary policies, boosting local financial conditions. However, as a large proportion of Europe’s oil and natural gas is supplied by Russia, it faces the risk of energy supply disruption. These factors may cause inflation to shoot up and harm industrial production. The risks of stagflation in the European economy are rising.

As for bonds, with continuously rising yields and flattening yield curves, investors may consider reducing the proportion of traditional bonds and reallocate to other bond assets. High yield bonds can generally benefit from rising inflation because of the spread advantage and higher correlation with economic development. Positive corporate earnings outlook also helps keep default rate of high yield bonds low, while short duration bonds are especially effective in lowering potential interest rate risks. In addition, with market volatility on the rise, mixed positioning in Asian investment grade and high yield bonds may benefit as these bonds are supported by yield advantage and relatively shorter duration.

 

Q: Do tightening spreads between long- and short-term US Treasuries point to economic recession?

A: Yields of global sovereign bonds have risen steadily this year. Prior to the emergence of geopolitical concerns, yield of 10-year US Treasuries surpassed 2%, gaining 50 bps year-to-date. However, expectations of Fed rate hikes drove up yields of two-year Treasuries to close to 1.7%, with spread between two- and ten-year Treasuries narrowing to below 0.3%.

Short-term rates may rise further due to greater expectations of rate hikes by the Fed, while slower economic growth and the large scale of balance sheets will somewhat limit the rise of long-term yields, causing continuous flattening of the yield curve. This may trigger market concern as inverted yield curve can be an indicator of a forthcoming economic recession.

From the 1950s onwards, the US Treasury yield curve was inverted every time before the US economy went into recession. In the previous rate hike cycles of the Fed, spreads generally contracted by 80 bps in the first year of policy tightening. As markets have already aggressively factored in the extent of policy tightening by the Fed this year, current spreads may already have partially reflected policy factors. Our current baseline scenario is that yield of 10-year US Treasuries may rise to 2.3% by the end of the year, and yield of 2-year US Treasuries may end up at a similar level, leaving a very small difference between the two. The yield curve may even become slightly inverted during the year.

The lead time between the yield curve’s first inversion and economic recession has varied, ranging between 12 to 18 months on average, but it can be up to four years. During previous rate hike cycles, economies have stood greater chances of continuing growth in the first year of tightening, until the close of the end of the rate hike cycle. The US economy is unlikely to slip into recession in the short run. At least risk signals are yet to emerge in terms of corporate activities. The recent setback in stocks and wider spread of corporate bonds are yet insufficient to point to recession.

This development will obviously depend on several crucial factors, most importantly, the interrelated factors of high oil prices, supply chain issues, inflation trends and the possibility of major policy mistakes by the Fed. Assuming that geopolitical tensions shall subside, oil prices shall retreat to around USD 80 by the end of the year, supply chain issues will be gradually resolved in the second half, and inflation figures shall start to fall, the Fed may be able to hike rates at a slower pace after substantial hikes this year, until the end of the rate hike cycle in 2024. The US economy is set to maintain an expansionary status for the next two to three years.

(Written on 10th March 2022)

Crystal Chan
Senior Investment Specialist
Principal Asset Management (Asia)

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