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Equities fall as rate rise worries add to market uncertainty

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What happened?

On a month-over-month basis, headline inflation was 0.8%, with core prices up 0.5%. The release comes ahead of the policy-setting FOMC meeting next week, when the Fed is expected to announce the first increase in rates since 2018.

The US data came alongside news that the European Central Bank will wind down its bond purchase program faster than previously planned, setting the stage for rate increases. The Governing Council described the Russian invasion of Ukraine as a “watershed for Europe” and added that it would “take whatever action is needed…to pursue price stability and safeguard financial stability.”

Talks between the Russian and Ukrainian foreign ministers on Thursday failed to advance toward a cease-fire. This was despite optimism earlier in the week over the potential for diplomatic progress after Russia signaled limits to its territorial demands and Ukraine indicated it was open to discussing neutrality.

How do we interpret this?

The latest news undermines hopes that central banks will meaningfully slow the pace of tightening in response to the economic damage from the Ukraine conflict.

The US inflation data, which reflect a period prior to the latest price spike in commodity prices, will make it harder for the Fed to moderate the trajectory of rate increases, with the market now priced for around six hikes this year. Relatively hawkish rhetoric from the ECB is also consistent with an increase in rates before the end of 2022.

Overall, central banks now have less flexibility to cushion shocks to equity markets, as they have succeeded in doing over recent years.

Our base case for the war in Ukraine remains for a cease-fire and a reduction in hostile rhetoric between Russia and NATO by the summer, although this outcome still looks some way off. We continue to see considerable uncertainty about a range of factors relating to the conflict, including over Russian President Vladimir Putin’s intentions, the extent of future sanctions, military outcomes, and the policies of non-NATO states. The war is also adding to a lack of clarity over commodity prices, global growth, inflation, and central bank policy.

Investment recommendations

Our view remains that simply selling risk assets is not the best response to the war in Ukraine. But in this environment of heightened uncertainty, we advise investors to reduce excess equity exposure above long-term strategic benchmark allocations and add to hedges. Specifically, we advise investors to:

1. Manage risks from inflation and higher rates. We will receive further guidance next week on how the Fed will respond to the Ukraine conflict, whether by focusing on higher prices as a further inflation threat or as a risk to demand. But while uncertainty related to the war means the pace of interest rate increases may change, the longer-term need for higher rates is clear. So, after years of low rates and low inflation, investors need to prepare portfolios for a new normal. Exiting markets in favor of cash would be counterproductive against a backdrop of higher inflation and negative real yields. Instead, we favor investments that should outperform in this environment. Investors can consider for example US senior loans, which offer an attractive yield and a floating-rate structure that provides some protection against Fed rate rises. In equity markets, financials typically benefit from rising yields, and value stocks tend to outperform growth sectors. Click here for more.

2. Build up portfolio hedges. In addition to bringing stock holdings back to neutral, we see other ways to make portfolios more defensive in the current environment. Given the war in Ukraine, we think broad commodities remain an effective portfolio hedge. Energy equities, still a preferred sector, are also likely to benefit in the event of further increases in commodity prices. We also see the global healthcare sector, the use of dynamic asset allocation strategies, and structured solutions as potential means of reducing portfolio volatility. In the short term, we also believe the US dollar can act as an effective portfolio hedge. Click here for more.

3. Position for the energy transition. The recent ban on Russian oil imports by the US—along with the EU goal of reducing reliance on Russian natural gas imports—points to an increased focus on energy security and independence. We see this trend gathering pace due to the Ukraine conflict. The desire for energy independence chimes with the longer-term focus on reducing carbon emissions. We believe this is likely to favor investment in greentech, and clean air and carbon reduction solutions. Click here to read more.

Main contributors– Mark Haefele, Vincent Heaney, Jon Gordon, Patricia Lui

Content is a product of the Chief Investment Office (CIO).

Original report- Equities fall as rate rise worries add to market uncertainty, 11 March 2022.

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