Good News, Bad News
May 2022
Global equity markets are off to a rough start in 2022 and tough sledding may still lie ahead into the summer months as hurdles in the form of monetary policy uncertainty, the Russia/Ukraine conflict, and China’s “zero COVID” policy remain, dampening sentiment and equity returns over the near-term. While uncertainty generated by monetary policy normalization and the war in Ukraine may be with us for some time to come, China could relax lockdown restrictions relatively soon, easing fears surrounding the inflationary impacts of global supply chain bottlenecks. However, optimism surrounding the reopening of China’s economy and global supply chains would likely be at least partially offset by additional upward pressure on commodity prices as the country reopens. This scenario underscores the predicament investors find themselves in as good economic news could negatively impact asset prices as upward pressure on commodity prices contributes to persistent inflationary pressures, forcing policymakers to look beyond economic uncertainty and focus on price stability. Central banks appear set to remain ‘hawkish’ until demand is sufficiently lowered or until something breaks in the economy, an approach that will pose challenges for equities for months to come.
While painful, the U.S. economy could withstand a further rise in commodity prices, but higher commodity costs on the heels of the war in Ukraine are already weighing heavily on Europe, and additional upward pressure on food and energy prices would be particularly damaging. Crude oil and natural gas prices rose sharply as the European Union (EU) proposed a phased in ban on Russian oil and refined products (gasoline) in early May, and a spike in commodity prices as China’s economy reopens could be the straw that breaks the camel’s back and forces the European Central Bank (ECB) to raise short-term rates. When the ECB begins normalizing policy, Euro Area economic growth expectations will likely trend lower still and, depending on the pace of rate hikes, calls of an imminent recession will grow louder, making it more difficult to maintain a positive stance on European stocks.
Domestic large-cap stocks appear best positioned to withstand inflationary and geopolitical challenges, but they aren’t immune to volatility. As such, the S&P 500 may just be the best house in a rough neighborhood for a time. Higher yielding equities could continue to garner inflows as investors favor ‘defensive’ characteristics, which ties in with our theme of allocating toward ‘quality’ throughout the balance of this year. The S&P 500 is the highest ‘quality’ index there is, but near-term upside may be limited given the index’s outsized exposure to the information technology, communication services, and consumer discretionary sectors, sectors facing headwinds from higher interest rates. Domestic SMid indices are likely to remain challenged by rising labor and commodity costs, both variables that could weigh on margins for quarters to come. We like the U.S.-centric revenue streams these companies boast, but a neutral allocation remains prudent given significant cost pressures likely to persist.
Emerging markets face headwinds from higher commodity prices and a stronger U.S. dollar, but many emerging market central banks began raising short-term rates in 2021 and are ahead of the FOMC and central banks in Europe, which could lead to improved relative returns out of emerging market equities and bonds. China, specifically, and emerging markets broadly are worth monitoring for signs of deterioration but, as of now, we remain comfortable with a neutral position relative to our strategic benchmark. Europe is likely to bear the brunt of rising commodity prices, and shortly after the ECB begins raising short-term rates, the Euro Area economy is increasingly likely to enter recession. We expect developed market stocks abroad to lag and are closely scrutinizing our exposure and allocations.
Source: Bloomberg, Factset
