- The value segment in European equites has fallen behind growth in the recent weeks because of rising inflation and demand destruction
- Idiosyncratic fixed income opportunities are developing amid the market volatility
The US Federal Reserve and the Bank of England (BoE) both raised rates this week in a bid to tame inflation despite the uncertainty caused by Russia’s invasion of Ukraine.
The Fed raised its benchmark interest rate by a quarter of a percentage point on Wednesday in the first of what is expected to be a series of hikes this year, while the BoE’s quarter-point rise on Thursday was the third back-to-back increase since December.
Surging in inflation in much of the developed world underpins central bank concerns. The US consumer price index reached 7.9% in February hitting new 40-year high, fuelled by higher food and energy costs1. UK inflation stood at 5.5% in January2.
The European Central Bank is winding down its quantitative easing programme ahead of a potential increase in interest rates before the end of the year3.
“The challenge facing many central banks is how to tackle the fastest-growing inflation in decades without triggering a global recession,” says Lewis Grant, Senior Portfolio Manager – Global Equities, at the international business of Federated Hermes.
The US S&P 500 Index rallied on Wednesday to close up 2.2%, while on Thursday the UK FTSE 100 Index closed up 1.25%.
“Higher commodity prices will lead to weaker consumer demand and lower economic growth. As a result, we believe the global earnings growth for stocks in 2022 will be less than 5%, or approximately half of the current market expectation. With increasing geopolitical tensions and recession risk the market will struggle in returning positive returns to investors,” Grant adds.
The yield on the US 10-year treasuries rose to its highest level in almost three years shortly after the Fed’s announcement before falling back to 2.15% on Thursday at 16:30 GMT. The yield on the 10-year UK gilt fell as much as 11bp on Thursday afternoon and stood at 1.55%4.
“Market pricing of rates has risen across the maturity spectrum and more so at the front end, flattening the yield curve. Credit spreads have also widened, particularly in Europe,” says Fraser Lundie, Head of Fixed Income – Public Markets, at the international business of Federated Hermes.
As economies re-open in the aftermath of the pandemic, market focus has shifted away from Covid-19 and onto geopolitics and central bank activity, Lundie adds.
“The array of outcomes from here are broad, but increasingly idiosyncratic opportunities are developing in the market volatility, and we are actively participating in the relative value shifts taking place across sectors and regions within the global credit spectrum.”
The conflict in Ukraine has sent energy and commodity prices surging this year. Brent crude oil futures stood at $106 a barrel at 16:30 GMT on Thursday, a rise of 37% year to date. The price of corn futures has risen more than 27% this year on the Chicago Board of Trade; Nickel is up more than 119% year to date on the London Metals Exchange5.
“The energy and commodities space has become overcrowded, which is unsurprising given that investors rushed in to reap the short term gains and ignore the fact that this cost push inflation is ultimately demand destructive,” says James Rutherford, Head of European Equities at the international business of Federated Hermes.
“We have also seen the value part of the market falling behind growth in the recent weeks, which is being driven by a combination of rising inflation and demand destruction; in some industries factory output has come to a halt as the cost of production has become uneconomic and supply issues remain. Earnings growth will become increasingly scarce,” Rutherford says.
“Despite a gloomy picture for European stocks, we are still finding pockets of value in the market, particularly in corporates that are structural growing with cash on their balance sheet. But we remain cautious of earnings risk and the threat of the market backdrop continuing to deteriorate.”