CIO Views - Clouds in Spring

Supply constraints and collapse of consumer confidence

The year 2022 started on a high note, given the strong rebound in activity anticipated after the Covid-19 pandemic. However, supply chain disruptions, with multiple bottlenecks, continue to constrain output. The war in Ukraine and the new strict containment measures implemented in China further weigh on the outlook. In the service sector, which paid a heavy price during the lockdowns, the business outlook is rapidly normalizing but is still suffering from the low availability of labour, as workers turned away from these jobs. In addition, consumer confidence is collapsing around the world to levels close to the lows seen during the Covid-19 crisis or the great financial crisis of 2008. The main reason for this fall is concerns about purchasing power, exacerbated by the surge in oil prices while concerns on Security is also contributing to the decline in household confidence in Europe.  

Household confidence Index

Source: Societe Generale Private Wealth Management, Bloomberg, May 2022

Past performance is not a reliable indicator of future performance.

A sharp decline in growth forecasts

The consensus of economists' forecasts now foresees growth of 2.8% in the Eurozone and 3.1% in the US. This level, while it may seem elevated, marks a clear reduction compared to expectations at the beginning of the year, when growth forecast was as high as 4.5% and 4.2% respectively at the end of January. The consensus is now forecasting activity to stabilize on a quarter-to-quarter basis compared From the second quarter onward. As it happens, growth is now essentially explained by the carry-over from last year. In China, the zero covid policy is severely restricting activity and is putting a major strain on the outlook for production and consumption. The revision momentum is therefore clearly negative and the level of uncertainty weighs on economic forecasts.

Inflation is clearly revised upwards

Inflation is main feature of the current recovery and, symmetrically to the downward revision of the growth outlook, there has been a sharp rise in inflation forecasts since the start of the year. The consensus forecast is for inflation to hover around 6.5% in the Eurozone on an annual average. At the end of April, the consumer price index reached a 40-year high of 7.5% in the euro zone and 8.5% in the US. The inflationary environment is further reinforced by the surge in oil prices in an unstable geopolitical environment. Nevertheless, the risks of a second round of inflation are rapidlyrising. In the US in particular, wages are accelerating sharply, raising fears of a price-wage loop. There are also a growing number of sectors that are raising prices. It very much seems like we are now paying the price for the huge expansion of central bank balance sheets to counter the effects of the pandemic. Since April 2020, the US money supply has grown by over 40%. While this increase was initially offset by a fall in the velocity of money (number of transactions carried out by one unit of money), the recovery has led to very strong pressure on prices.

Consumers absorb most of the price shock

The sharp fall in consumer confidence is not reflected in the production surveys. Business prospects in industry and services remain at very high levels. Confidence measured in the business surveys is therefore in total contrast to what is observed among consumers, and for good reason: businesses retain a strong price setting capacity. The growth "felt" by companies, the sum of real growth and inflation, is still accelerating strongly since the beginning of the year. Conversely, purchasing power is falling by almost 7% in the developed countries, even though employment is rising. There is now a positive relationship between employment and inflation, an updated version of the Taylor rule, where rising prices lead to rising employment.

US CPI Urban consumers Index

Source: Societe Generale Private Wealth Management, Bloomberg, May 2022

Past performance is not a reliable indicator of future performance.

Tighter monetary policy poses risks to growth

In a move aimed at curbing inflation, the US Federal Reserve (Fed) sharply adjusted its monetary policy stance , combining rate hikes and balance sheet reductions at a high pace. Short-term rates have risen sharply as a result. Given the pace of inflation, the path to positive real interest rates (nominal interest rates adjusted for inflation) is high. The inversion of the yield curve observed during the quarter raises fears of a recession. Indeed, the slope of the curve has historically been an effective recession indicator , predicting the last recessions in the US. These investor fears were echoed by the Bank of England in the minutes of its monetary policy committee. Nevertheless, household’s debt has fallen sharply since the 2008 crisis, and excess savings were built up during the crisis in Covid-19. The effect of monetary tightening should therefore be measured on activity. The ECB (European Central Bank) is facing the similar challenges in fighting inflation but to a lesser extent with lower salary increases. On the other hand, the war in Ukraine and the risks of gas supply disruption complicate the institution's agenda. Rate hikes will therefore be more gradual in the euro zone.

Increase in volatility and valuation correction

With US 10-year yields flirting with 3% and German yields having moved out of negative territory, the relative preferences of investors are being affected. Tighter liquidity conditions also imply a higher volatility regime. Equity markets arechallenged by a valuation adjustment on the one hand and a drying up of buying flows on the other. The valuation correction affects all equity markets, but is more pronounced in market segments with high valuations. The US market and the technology sector are the most affected. Rising interest rates are making bond assets more attractive and will necessarily lead to a reallocation out of equities and into fixed income markets. The TINA ("There is no alternative") narrative, by which investors were forced to move up the risk scale, thus seems to be coming to an end. Incidentally, the US central bank's pivot to monetary policy implies that the FED's Put no longer exists.

Asset allocation: a prudent and diversified approach is required

In this cloudy environment of growth and high inflation, asset allocation choices are crucial. A diversified approach is certainly in order. Gold and commodities have historically shown their qualities in inflationary environments and occupy an important place in an asset allocation. Gold in particular retains a safe haven status that makes sense as geopolitical risks continue to dominate the news. During the period of high inflation in the 1970s, the yellow metal particularly stood out, posting the best performance of all assets. Today, although gold is still present on the balance sheet of central banks, its weight in the financial economy has largely declined and the same performance should not be expected. Industrial metals, at the heart of the energy transition, also remain an interesting diversification alternative.

Equity markets are in a correction phase in the main geographical areas with more or less advanced levels. More than geographical allocation, the key word is to adopt a strong discipline in terms of valuation and to focus on companies that generate high cash flow. The value segment of discounted stocks has performed well since the beginning of the year and should continue to make up for the colossal performance gap accumulated over the last ten years. Conversely, the technology sector, which had distinguished itself during the covid period, is facing a marked slowdown in earnings growth.

The bond market had its worst start to a year in over 40 years and some segments are beginning to offer value. This is particularly the case in the US market. Floating rate bonds, which are naturally protected in the event of a rate hike, make sense. Similarly, short maturities of less than 3 years offer relatively high yields. Conversely, while the Chinese bond market offered relative value, US Treasury yields are now higher on maturities of 5 years and above. The convertible bond segment is also regaining its appeal, as rising yields have allowed investors to find a secure bond floor.