Market Outlook for May

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Market Outlook May 2022

May is here with flowers in bloom (... but the financial markets aren’t blossoming)

As the old Norwegian song goes: after April comes May, which turns the forests green again and lets the flowers blossom! Nature will probably take care of this again this year, but unfortunately there is little change in the financial markets since April. Last month’s important factors are definitely still in play. The inflation troll we talked about in the last market outlook is still confidently making its presence felt. Inflation levels are remaining very high, more central banks have signalled further interest rate hikes and the interest rate path is increasing. The fact that the growth rate will probably decline offers some consolation, and means that inflation is at least levelling off. In addition to high inflation, the stock markets are up against lasting after-effects of the pandemic, consequences of the invasion of Ukraine and the Chinese zero-tolerance COVID policy. On the bright side, labour markets are strong and households still have substantial savings. And most importantly, they’re still willing to spend money. We’re therefore maintaining neutral position for equities versus fixed-income securities. At the regional level, we’re taking Emerging Markets down to an underweight position. We’re making no changes to the market matrix in the fixed-income portfolio. However, we’re reducing our underweight by about one third in global long-term fixed-income securities.


Growth and company profits

When it comes to the growth scenario, the greatest problems are in Europe. High energy prices will hit Europe hard. This is most evident in consumer surveys. If Europe’s gas supply is stopped, a recession will be difficult to avoid. This is why Germany, in particular, has been reluctant to impose sanctions on Russian gas. The tables have turned a bit, and the greater risk at the moment is that the Russians cut off the supply. Russia stopping gas supplies to Poland and Bulgaria signalled that further gas price increases could be on the cards. However, at the time of writing, we haven’t aligned the portfolio for a further escalation of the situation, or for a further decline in the gas supply.

 

The latest GDP figures from the US indicate a 1.4 per cent fall in annualised quarterly growth, as opposed to an expected 1 per cent positive growth. If we look beyond the numbers, the picture is a little more nuanced and not quite as bleak as you might think at first glance. Two factors are the main causes of the growth reduction. The US trade balance has deteriorated, and corporate inventories remain low. Private consumption, which accounts for around 70 per cent of the US GDP, is still high, showing a 2.7 per cent growth. This indicates that the average American is still spending money. Some of this consumption also ends up abroad, which helps explain why the trade balance is deteriorating. The low inventory levels are temporary, and all else being equal, companies would probably like to increase them to normal levels. This will in turn contribute to more growth.

 

The reporting season is well underway and around half of US companies have reported their figures. Almost as usual, the companies are reporting figures that surpass the analysts’ expectations, and for S&P 500, the growth in profits is estimated to be 7 per cent compared with the first quarter of 2021. At the end of March, expected growth was just below 5 per cent. In other words, expectations have been raised during the reporting season. All in all, there are no major surprises so far, but we’ve seen a tendency for large variations, especially among major US tech companies. For example, Amazon fell by 14 per cent after reporting, whereas Meta rose by 18 per cent due to strong results delivered by its subsidiary Facebook.

 

Inflation and monetary policy

A year ago, no one predicted that inflation would reach 7–8 per cent on both sides of the Atlantic. Inflation creates uncertainty for a number of reasons:

High inflation often coincides with varying inflation. It becomes harder to interpret the price scenario for companies as well as consumers. Companies will try to push the price increases onto the consumers, but may not necessarily be able to do that. And if they aren’t, their margins will shrink. One reason why the stock markets have been so favourable in recent years is indeed that margins have increased. At the time of writing, we see no clear indications of them falling, but it’s important to keep an eye on developments.

Central banks also need to react. Perhaps the most important task for a central bank is to help retain stable inflation close to a targeted level, often around 2 per cent. In this context, the key policy rate is the instrument. When it’s raised, future money flows will lose value while lenders get a bigger piece of the pie.

 

It’s therefore important to understand what drove up inflation. Depending on the inflation target, year-on-year price inflation is 6–8 per cent both in the US and in the Eurozone. Looking at the core inflation, which doesn’t take food and energy costs into account, the corresponding figure is just over 5 per cent for the US and around 3 per cent for the Eurozone. The high food and energy prices, which have played a big part in the total inflation increase, can be largely attributed to effects of the war in Ukraine. These kinds of supply-side effects cannot necessarily be mitigated by key policy rate hikes and must be reversed by themselves. If the inflation is caused by a tight economy with full employment, it may take longer to regain control. The current situation has elements of both. There is no doubt that we’re still affected by the pandemic. The war in Ukraine will hopefully not last too long, and energy prices will eventually come back down. The main challenge related to inflation can be found in the US labour market, which is very tight. This could in turn increase prices and wages. However, we still believe that we are approaching the peak of the inflation growth, now it remains to be seen how resilient this troll is. This is also the reason why we aren’t as clear with regard to the underweight position in global bonds. A large part of the ‘interest rate shock’ has already been priced in. US 10-year government bonds have nearly doubled this year and are now at 2.9 per cent.

 

China and Emerging Markets

China is the world's second largest economy and has long been the main driver of global growth. Since the beginning of 2021, however, the arrows have been pointing downwards. This is partly due to political developments, including stringent regulations in the technology sector, and a savings culture that has contributed to an inflated real estate sector. Despite the fact that the returns in Emerging Markets so far in 2022 have been decent compared with the market in general, we see several challenges going forward:

China's rigid COVID-strategy, with full lockdowns of entire areas and cities. The result is tighter supply chain bottlenecks, including long queues of ships in cargo ports. It’s true that the authorities have indicated that they will implement fiscal and monetary policy measures to stimulate growth. The problem is that they’re also communicating that their battle against COVID will continue in the same way. This balancing act is extremely difficult.

Weak economic indicators for the Chinese economy. Both confidence indicators and activity indicators for the real estate sector are generally weak.• Higher prices of staple foods have made serious inroads into household budgets. This is particularly true for Emerging Markets, where food accounts for a large share of household consumption.

A potential shift towards higher risk premiums for markets in this region, as a side effect of the war in Ukraine.Based on the above, we have chosen to take an underweight position in Emerging Markets.

 

Portfolio adjustments

We’re keeping equities in a neutral position, despite the increased risk of recession. For now, however, we believe that sound labour markets and financially stable households will withstand the pressure. We’re downgrading Emerging Markets to underweight, because this region is more vulnerable to higher food prices and the Chinese economy is still not firing on all cylinders. We’re investing the funds resulting from sales in Emerging Markets in the healthcare sector, which is a distinctly defensive sector. The portfolio's cyclical orientation is therefore somewhat reduced by this implementation. 

 

On the fixed-income side, we maintain a constructive view towards Nordic High Yield bonds.