Ukraine – Three scenarios, and a global slowdown

Quagmire the central case. The situation in Ukraine remains very fluid. Our central case assumes a protracted crisis, keeping the country in a state of instability and energy prices at an elevated level. Alternative scenarios cover a very wide spectrum that cannot all be scenarized. By and large, the optimistic scenario sees a quick shift to the diplomatic route; while hopes of a military de-escalation are rising, as we go to press, a quick agreement is still not our core scenario. On the other side of our central scenario, the pessimistic one implies an escalation such as the invasion of another country, the usage of unconventional weapons (chemical or nuclear), or some form of third-party support to Russia making the crisis more global.

Uncertainty is high, but a sharp slowdown is in the offing.

The war has made the forecasting environment far more difficult, and indeed the standard deviation of forecasts has surged. We are taking a rather downbeat view, and more so for the Euro Area (EA), with a 2022 growth forecast at just 2.2%. This is not much at all, considering the 1.9-point carry-over effect. This would prove too low in case of a quick and durable cease-fire. The ECB only cut its forecast by half a point to 3.7% at the March meeting, which is even higher than what we would expect in our optimistic scenario. In our view, the transmission channels are many. The largest one of course lies in the surge of commodity prices, which will impact both global demand (EA consumers fact the worst shock on purchasing power since the launch of the euro) and supply (global supply chain). As the charts below show, the shock is broad-based and not limited to the energy sector. The price of cereals has increased sharply, and the surge of fertilizer prices will cause second-round effects on production costs. Russia is also a large producer of selected base metals, the price of which also reached new record highs around mid-March. Other transmission channels include the negative shock on confidence – which will depend on the duration of the war and inflation itself – and financial conditions. The latter have not tightened as much as in spring 2020 but are now much stricter than at the end of 2021, let alone before the Covid crisis.

Luckily investor sentiment about the economy, especially in the euro area, has already tanked. This is very visible in the Sentix survey, where the 6-month expectation component have dropped to deep negative levels, as low as in March 2020 (Covid-19). This looks a bit extreme, given that the shock will not be as brutal. Still, expectations are likely to stay negative in the coming months, confirming that the cycle has shifted from Expansion to Slowdown, the latter being characterised by a broad flattening out of corporate profits. Mind that equity multiples often continue to expand
during the slowdown phase. In the present case, however, the bar is higher in the context of central banks’ fast tightening policy and real yields recovering from very depressed levels. Importantly, the focus has been on the EA slowdown – sanctioned by the underperformance of EA equities relative to the World MSCI – but the US economy is not immune to the Ukraine crisis. The concomitant rise in energy prices, rates and the US dollar points towards a sharp pullback of the manufacturing PMI in the coming months. Both the equity market pullback and soaring producer prices are not a good omen for manufacturing activity (see charts). This slowdown will make the life of central banks ever harder, as they are torn between that and much too high inflation rates.

Mission impossible

The growth-inflation trade-off. Forwards are pricing at least another 8 hikes from the Fed in 2022, following the first of the series in March. There are only six meetings left, so this implies at least two 50bp hikes along the way. The market also sees the Fed peak around 3.25% by end-summer 2023, more than 300bp above the starting point. This is indeed a very steep implied path by historical standards (chart below). In the post-Volcker era, the largest tightening cycle was in 2004-06, when the Fed went from 1% to 5.25%; a liquidity crisis ensued in summer 2007, followed by the GFC in 2008. The second largest hiking cycle was 1994-95 (+300bp to 6%). The other two cycles (1999-2000 and 2015-2018) were smaller, around 200bp. In this cycle, the quantitative tightening (QT), from this summer, will also add a very significant measure of policy tightening. Arguably this is the first time since the 70s that the Fed and other central banks must tighten to push inflation firmly down, rather than merely keeping it under control. Yet we question whether the Fed can deliver so much tightening without threatening financial stability and causing a hard landing. Already higher bond yields are weighing on funding conditions (including mortgage rates), High Yield spreads are exposed to the cyclical slowdown and US equities to a pullback in currently elevated multiples – hence the cost of capital is set to increase. We suspect that as economic data start to disappoint, the Fed’s stance will turn slightly less aggressive.

What is priced in risky assets?

Investors more bearish than short. As investor sentiment about the EA economy crashed, European equity funds suffered substantial outflows. But global equity funds have still recorded generous inflows this year, some $15bn per week on average. The average of the 4 weeks to mid-March was still well above water, at +$6bn per week. Cash positions are relatively large by historical standards, and sector positioning has readjusted towards defensives, but overall positions are not short equities. In other words, we have not seen a proper clean-up of positions. Even in Europe, the de-rating of equity valuation has been mild relatively to that about the economy (left chart below). Also, cyclical stocks have pulled back a bit relative to Defensives, but the move has been remarkably mild (second chart). This leaves us relatively uncomfortable with the equity market melt-up observed in the last three weeks of March.

How to invest

Short Govies and duration but less so. Our key recommendations are exposed in the right-hand chart above. As the economy faces a triple whammy – the war, tough central banks and Covid still disrupting the global supply chain – we have reduced the cyclicality of portfolios. We stay short Government bonds, but much less than before, following the sharp increase in bond yields. Likewise, we keep a short duration position, but a small one. The less aggressive position in the rates space reflects our more downbeat economic forecasts, less aggressive central bank views and expectations
of self-correcting mechanisms (a surge in yields threatens debt sustainability and financial stability). We keep a government bond underweight and a small short duration, however, given the residual space for higher long-term yields. Though the market is pricing a Fed peak around 3.25%, the longer dated forwards are much lower, e.g.
5y3m just above 2.0%. We see a slower Fed, but a potential upside repricing of the neutral rate – which should support slightly higher yields.

Likewise, our fair value models for Bund suggest there is still ample upside, should core inflation trends stay elevated. That said, we also expect the FV to ease off as core inflation falls back in H2, and the economy slows, and we assume that the rise in bond yields is set to slow sharply from here.

Overweight Credit

We find that credit spreads, especially in Europe have been hit relatively severely among other risk metrics, e.g. equity volatility. This, combined with the rise in risk-free yields, imply that EUR Credit offers a more generous carry, for a
limited risk in the IG space. In part the widening between Credit and risk-free Government bond yields (Bund) reflects a large widening of swap spreads (top-right chart above) – equally disproportionate relative to other risk measures. IG credit spreads now appears wide relative to country spreads, e.g. Germany-Portugal. IG credit also offers a substantial pick-up relative to long-dated Bund, and historically such opportunity has generated generous excess return (see chart). That said, as we discuss in the Credit section, our Overweight (OW) is executed through defensive strategies, IG
rather than HY, subordinated debt rather than pure HY, non-financial rather than financial, and defensive sectors rather than cyclicals. EM Credit also offers selected opportunities, both in hard and local currency debt (EM central banks have been front running the rate hike cycle), but this too is sensitive material at the inception of a steep Fed hike cycle.

We cut equities to small underweight

We see no rush in chasing the strong recovery from the early March lows. Equities face significant headwinds, not least from the global slowdown under way and central banks walking their tough talk for now. Our sector and style allocations are fairly balanced, reflecting opposite forces from the slowdown (bad for Cyclicals vs Defensives) and rising yields (supporting Value vs. Growth). Our barbell strategy combining Value and Defensive stocks implies an overweight in Energy, Insurance, Materials, Durables, Food, and Health Care. Underweight Diversified Financials, Media, Real Estate, Hardware, Telcos and Utilities.