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The virtues of uncertainty

Market Insights 18.02.2022




Laurent Denize

Laurent Denize,

All in all, the sudden change in course by central banks in developed economies requires a marginal adjustment to positions and slightly more cautious positioning

The shock wave unleashed by the latest euro zone inflation figures has forced the ECB to tweak its monetary policy and, most importantly, the sequencing of its asset purchases. We’ll let the economists draw up new rate-hike scenarios. We are more concerned here with which assets to overweight in this new environment.

What inflation are we talking about?

So far, the wave of inflation in Europe has unfurled mainly through the channels of commodities and supply chains. Little of it has shown up on a national level in second-round effects, as the output gap remains in negative territory.

Hence, for the time being, it makes sense to overweight companies that are situated at an earlier stage of the supply chain, as they theoretically have the greatest capacity to raise prices. Accordingly, B2B (business-to-business) and B2G (business-to-government) companies should be overweighted vs. B2C (business-to-consumer) ones.

As we stated in our investment strategy, we are overweighting industrial companies, as most of them are situated at an early stage of the supply chain. These sectors will benefit from the heavier capital expenditure that is being driven by government stimulus plans. Keep in mind that these companies are willing to raise their capex because their returns on equity are rising. A positive spiral is therefore taking hold, boosted by the operating leverage of these “cyclical” companies.

At the other end of the supply chain, B2C companies will have the greatest difficulties in passing on higher input prices. In the event of significant wage hikes, the impact on their margins, which are already under pressure, will be even greater.

What about the banking sector?

While this is one of our favourite sectors and the first beneficiary of higher interest rates, keep in mind that financial conditions are worsening with widening credit spreads and declining equity prices. But the parameter that is of greatest short-term concern is the 10-year Italy/Germany spread.

It has widened considerably over the past weeks and is a perfect illustration of investor nervousness, given the ECB’s plans to phase out purchase programmes earlier than expected. So, some short-term caution is in order. At the very least, avoid adding risk to this segment.

Fixed income

We reiterate the message we have hammered home for six months now: reduce your government bond exposure as much as possible, and overweight short-dated highly rated bonds. Meanwhile, we are tactically downgrading high yield from overweight to neutral, as many short-dated investment grade bonds investors have taken on too much exposure to High Yield in a quest for returns. This crowding out effect, which allowed portfolios to offer additional remuneration, has backfired now that spreads are widening. Best to let this wave of selling and changes of hands pass before repositioning. Here again, patience is key, even though the cycle is still structurally favourable to high-yield bonds. Yes, growth is decelerating, but remains far above its potential. We are not worried for the medium term.

Asset allocation

All in all, the sudden change in course by central banks in developed economies requires a marginal adjustment to positions and slightly more cautious positioning (neutral or slightly underweight). But be careful to correctly identify the risks in portfolios. To start with, bonds that are meant to safeguard portfolios (government bonds and medium-/long-term AA and AAA ratings) are no doubt those that will do the most damage, given how sudden and unexpected the shift has been.

As for equities, keep an eye on changes in real rates, which have risen sharply from their October 2021 lows, particularly in the US. This is a trend that, if it continues, would not be good news for tech stocks.

The asymmetry between the probability of a limited rally and a more marked correction is keeping us from returning to a risk-on stance. Even so, growth is still strong, albeit decelerating, and suggests you can hold onto the most cyclical and undervalued stocks in portfolios if you are willing to accept a little more volatility. In fact, volatility is something we will all have to get used to. In short, uncertainty is back and this is not such bad news…

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