Tactical Asset Allocation

In a nutshell:

• The two key areas of market focus are the prospect of rising interest rates as the recovery progresses further, and rising geopolitical risk as the Russia/Ukraine crisis intensifies
   
• With the Russian military moving further into Ukraine, we expect more expansive sanctions to be imposed on Russia. The economic impact will be acute in Europe, through higher energy prices, trade disruptions, and a broader hit to confidence, and more limited in the US.
   
• Solid activity and employment data point to a favourable macro picture as Omicron concerns continue to recede. But the persistence of high inflation means that a significant adjustment is upcoming on the monetary policy front – most crucially from the Federal Reserve
   
• Asset allocation: the flight to safety could have further to go in the short term as worst case geopolitical scenarios get priced in. We adjust our fixed income positioning, and maintain equity exposures unchanged despite current volatility. In EUR portfolios, we reduce our euro underweight.

 

Lombard Odier views by asset class

Following the Investment Committee meeting on 23 February 2022, please find below a summary of our global views and asset allocation recommendations.

Cash

• We had retained a moderately overweight cash position for the last few months, giving us the flexibility to seize investment opportunities after bouts of volatility and market corrections. We reduce this now by adding to fixed income.

Fixed income

• Amidst more enduring inflationary pressures, rates should continue to rise, but the recent repricing has been sharp. As a result, we have tactically reduced the size of our underweight to sovereign bonds and investment grade credit. We still favour carry and diversification strategies. In the former, we prefer high yield and emerging market debt, where we have initiated a position in Brazilian sovereign bonds denominated in reais. In the latter, we reduced our overweight position in RMB-denominated bonds. 

Equities

• We remain constructive on equities and expect positive but lower returns as earnings growth, rates and valuations normalise. Robust earnings still support the asset class and elevated valuations are improving, but risk appetite is waning as monetary policy tightening expectations accelerate. We favour sectors and regions with more cyclical and value-exposed assets with catch-up potential and quality companies that can retain pricing power. We recommend more risk-averse investors implement hedging strategies in the context of high geopolitical risk.

Alternatives

• We remain underweight gold, amid a stronger environment for the US dollar, rising real rates, and our expectation that the geopolitical risk premium supporting the metal will wane in the medium-term. We keep our overweight in European real estate, as we believe the sector’s recovery can continue on improving fundamentals.

FX

• We believe the USD should remain supported by tighter global liquidity and expect EURUSD to remain under pressure. In EUR profiles, we have reduced our EUR underweight positioning by buying EURJPY, in line with USD and GBP profiles. We retain a small long RMB exposure, which we see as well supported.

 

Global macro outlook

Market focus has centred on two key issues: high inflation and rising interest rates, and geopolitical risks as Russia moves troops into Ukraine. Meanwhile, the world economy continues to perform well, with recent data pointing to a healthy recovery.

The most recent developments on the Russia/Ukraine crisis have made clear the fact that Russia’s intervention will not be limited to the Donbas region. It is extending deeper into Ukrainian territory, with large-scale military operations underway. The prospect of diplomatic resolution has now been practically eliminated, and the scenario of a localised conflict limited to Eastern Ukraine no longer looks likely. 

As a result, we now expect materially more expansive sanctions to be imposed on Russia. The first round of sanctions announced by the US, UK, and EU in the aftermath of President Putin’s recognition of Donetsk and Luhansk regions as independent entities were fairly limited, with more serious measures kept as options for a possible full-scale invasion. Now that a broader invasion is materialising, Western sanctions look set to tighten significantly. We would expect Russian financial and trade sectors to be targeted first, while even energy exports (and possibly the removal of Russian banks’ SWIFT access) may now be considered. 

Such a scenario would have wider macroeconomic implications – through higher energy prices, trade disruptions, and a broader hit to confidence. We would expect this impact to be particularly acute in Europe. An energy price shock would push inflation higher and growth lower, hurting real incomes. We see more limited impact in the US’s relatively closed economy, which benefits from strong domestic demand and energy independence.

The potential impact increases further as the shock takes place at a time when central banks are already concerned about high inflation, and therefore do not have the luxury of easing policy to cushion the blow, as they would in a typical supply shock. However, monetary policymakers may now delay some tightening; thus, the risk of overtightening, which was significant up to last week, has dropped considerably.
Looking beyond geopolitics, the broader context is of a favourable global macroeconomic picture, with high-frequency indicators pointing to a strong recovery as Omicron concerns recede (see chart 1). This was also evident in February’s Purchasing Manager Index (PMI) surveys. PMIs rose by over three points in developed markets, with notable gains in services sectors, as several countries are now shifting to a strategy of living with Covid, reopening economic activity further with few restrictions. 

With the recovery well advanced and labour markets tightening particularly rapidly, persistent high inflation has become a key concern for policymakers. The Federal Reserve (Fed) looks set to hike interest rates for the first time in March, and start balance sheet reduction this summer, at a relatively rapid pace. We still forecast it will implement four to five hikes in 2022. Starting to adjust policy with the economic cycle much more advanced and inflation much higher will make this hiking cycle different from previous ones. While we acknowledge the challenge of achieving a “soft landing”, we still expect this to prove manageable, particularly as inflation should moderate in H2 2022. 

Monetary policy is also shifting in other developed economies. The Bank of England has already delivered its first two hikes and started to reduce its balance sheet; the ECB is pointing to an earlier rates lift-off. Although demand looks less excessive in the euro area and wages are growing more slowly than in the US or the UK, we now expect the first rate hike in late 2022, given the ECB’s growing concern about inflation.
 

Portfolio positioning

Market action so far this year has been driven by the Fed, earnings and geopolitics, with the latter taking centre stage in recent days. More fundamentally, stubbornly high inflation means central banks are pivoting towards tighter monetary policies. Fed funds futures are now pricing in six US rate hikes this year, along with an expected balance sheet reduction. The repricing in nominal and real yields has been sharp, with the 10-year US Treasury yield up 50bps since early December. The move in rates proved too much, too fast, for equities to absorb, even before the deepening of the Russia-Ukraine crisis. Mixed corporate guidance during the Q4 earnings season did not help, despite solid results. 

Still, the economic recovery is incomplete and cyclical sectors have held up well so far, outperforming defensives. The move in rates has seen value stocks rally strongly across regions. We think it is too early to call an end to this trend, as a large relative valuation advantage over growth stocks remains, and earnings trends favour value sectors given strong commodity prices and expected higher rates. However, recent developments add some downside risk to growth and rates , and could tame these trends in the short term.

Following the sell-off, the S&P500’s forward price/earnings ratio is now back to pre-pandemic levels, when rates were more restrictive and fundamentals less supportive, although still above longer-term average multiples. Q4 earnings have been solid, and margins remain above pre-pandemic levels despite cost pressures. Markets outside of the US still score more attractively in this regard.  While we are still in an overall positive environment for growth, it is nonetheless an environment of normalisation, not only in growth but also in earnings, policy rates and valuations. Visibility for corporates has fallen, amid inflation concerns, which will likely be exacerbated by the current spike in oil prices. Still, profit margins have been solid across regions.

History also shows us that equity corrections are fairly common (14.5% average intra-year drawdown since 1980) and rarely turn into bear markets unless the economy is headed into recession. Two further qualifications are in order in the current environment. Our analysis of previous Fed tightening cycles also suggests that, despite early volatility, US and global equities tend to outperform bonds in the months after the first rate hike. Periods when the Fed increased rates faster, by over 200bps over a year (1994 and 2004), still saw markets gain ground. More advanced tightening and balance sheet reduction could eventually turn more problematic, but healthy balance sheets and strong cash flow generation should continue to stimulate investment, buybacks and dividend increases. This should also support credit. 

Turning to history again, we find that prior equity sell-offs due to geopolitical events and military conflicts have been typically short-lived, with equities down as the conflict erupted but mostly up in the subsequent three and six months. Short-term dynamics point to a deterioration in investor sentiment and reduction in positioning. We believe the flight to safety could have further to go in the short term, before we reach a capitulation, as worst-case geopolitical scenarios get priced in. Central banks will probably face an increased challenge but fiscal measures could be implemented to contain the impact of price pressures on consumption. 

We retain our overall constructive positioning, while expecting market volatility to stay elevated. In equities, we continue to prefer cyclical and value sectors, beneficiaries of reopening and higher rates, and quality companies with pricing power. Energy scores well amongst the former, and healthcare amongst the latter. We recommend more risk-averse investors implement strategies to cushion downside equity risk, including put spreads and short calls, but tactical consideration will be important given elevated volatility levels.

This month, we are also making a number of changes to portfolio positioning. Firstly, we are reducing our underweight in high quality fixed income. Amidst more enduring inflationary pressures, rates should continue to rise in the medium term, but the recent repricing has been sharp. As a result, we tactically add to sovereign bonds and investment grade credit. Secondly, we are reducing our China sovereign debt overweight by 2% on narrowing interest rate differentials, policy easing, slower inflows, and limited currency appreciation potential. Thirdly, we are buying 1.5% of Brazilian sovereign debt denominated in reais across all portfolios, given Brazil’s commodity exposure, a policy cycle close to peaking at double-digit interest rates and its lower comparative exposure to geopolitical risk. Finally, we are allowing our renminbi hedge to roll off and are reducing our euro underweight in EUR portfolios by buying euros against the Japanese yen.

 

The Investment Committee meets on a monthly basis to reassess investment views and portfolio positioning. The meeting also discusses how best to take advantage of trends and opportunities in the market. Additionally, the meeting will convene on an ad-hoc basis in response to market developments. The committee is led by Chief Investment Officer Stéphane Monier.