Risk appetite has deteriorated while global growth is expected to fall.

Looking at global market sentiment reveals a more cautious investor landscape. Government bonds have done well and outperformed equity markets as a reaction to higher credit costs, a potential upcoming recession, and the threat of further banking failures. The banking failures remind us that monetary policy impacts the economy with a lag and rate rises impact is just starting to make its mark on the economy. The tightening of credit conditions can be seen as being equivalent or a substitute to a rate rise.

Markets expect the Fed to now pause its rate rising while the ECB will likely continue to hike. This will have the impact of weakening the US$. Inflation is expected to decline but we are in a contraction phase so therefore should be more cautious.

Global growth is expected to remain low and the chances of a fall in GDP growth are rising. For this reason, fixed income is favoured over equities and that value sectors and regions are preferred for equity such as Europe and Japan. The GDP growth figures for China, emerging markets and South East Asia are relatively strong but the stock returns are not reflecting that yet.

One sector of the equity market that has deteriorated is the real estate sector. There have been obvious declines due to work from home policies and on-line shopping due to the pandemic. However, due to interest rate rises and borrowing costs increases along with defaults, voids and financing problems in the real estate sector has meant the fall off in property fund values. This has not been helped by the rise in bond yields. We are therefore planning to reduce our holdings in property.

We do feel that the banking sector can withstand the recent failures but the Fed and US treasury will need to act decisively when needed. The recent failure was a result of loose monetary policy that encouraged risk using cheap money and that the rapid reversal of policy exposed this. It is quite possible that there will be more minor banking failures particularly in the USA.

The outlook for GDP growth is likely to fall except for China. Global inflation will fall as will interest rates but with a lag. Government bond yields will strengthen as the year progresses but commodities will struggle as demand slows. We will reduce our natural resources holdings. The US$ should weaken against other major currencies which will aid non-US markets.

Given the rise in bond yields and the recent strength of the US$, gold has done well as an asset. One might have expected an easing in the gold price, but with elevated inflation and the threat of recession has helped sustain gold prices.

With recession expectations in the global markets, it is likely that longer dated government bonds will become more attractive. We have been used to cash rates and bond yields at or close to historical lows over recent years. The rise of bond yields will help valuations of other assets and that yields are now equal to or above equity dividend yields. Bonds are now back in fashion and again a diversifier in a blended portfolio.

Having been underweight in government bonds we have shifted our preferences back to US Treasuries and UK Gilts. The feeling that the global economy is at risk of recession due to monetary tightening and banking stress may increase the possibility of a fall in long term yields and a corresponding rise in prices. We will underweight high yield and favour investment grade and government bonds.

Despite the feeling that risk appetite has deteriorated and global growth expected to fall due to lending conditions tightening, economic data has been stronger than expected in Q1. It is the strength in labour markets and consumer spending that has strengthened the position of central banks to continue to raise rates further despite the potential banking crisis and recession.

Without doubt inflation will remain the critical driver of financial markets. While inflation appears to be falling, some data is suggesting that it may not fall as rapidly as expected. US CPI is currently 4.9% and expected to fall to 4.5% in June. This may be a little optimistic. The momentum is in the right direction but may not satisfy the Fed sufficiently that inflation is beaten.

The picture of inflation in the Eurozone is less clear as headline CPI is 7% while core CPI is 5.6% and both may not have yet peaked. The Eurozone has a wide range of inflation ranges within its member countries. Spain has a CPI of 4.1% while Italy’s is 8.3%. The ECB current rate of interest is 3.75%. Markets are expecting another increase at the ECB’s meeting in June and there is certainly the possibility one more thereafter resulting in a peak rate of 4.25%. This stands in contrast to the Federal Reserve, for whom the long-awaited ‘pause’ looks to have arrived. This transatlantic differential in the direction of monetary policy should prove supportive to the Euro relative to the US$. A falling dollar provides a liquidity boost to markets.

Some global forces should ease inflation over the months ahead. Commodity prices have started to fall. This is happening at a time when supply chain pressures are easing and the opening of the Chinese economy will help. For these reasons analysts are feeling that global inflation has passed its peak. The US is further ahead than Europe, while China is likely to see a rise in inflation. Despite the easing of inflationary pressure, central banks are not letting their focus diminish in reducing rates just yet. They want clear evidence that inflation is beaten.

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