Risk-off sentiment still abounds. Equity markets are slumping and credit spreads are now wider than their post-Ukraine-invasion peak. We are positioned cautiously and see little reason to change that view yet.
Markets have been consistently weak some time now, meaning a bout of short-covering could lead to a sharp move on little or no news. However, given the longer-term headwinds still in play, including consumer weakness, high inflation, and tightening financial conditions, we do not believe it is yet time to become reacquainted with risk.
Comments from Fed board members last week reaffirmed the market’s view that a 50bps hike is coming at both the June and July meetings. Fed speakers also downplayed the risk of a recession, given the strength of the labour market. A US recession is not our base case, but the risks do appear to be higher than the Fed is admitting.
We expect the Fed’s hawkishness to be backed by policy action in the near-term. But given the risks to growth and our view that positive real rates will be unmanageable for any significant length of time, we expect the Fed to deliver less tightening in 2022 overall than it and markets currently expect. Monitoring how much recession risk is really there, and whether the Fed is evaluating that correctly, will be key to a number of asset allocation decision in the coming months.
Meanwhile, the ECB is preparing to start its own hiking cycle, largely forced by the Fed’s hawkishness. Today, Christine Lagarde confirmed the base rate would likely rise to zero from the current -0.5% by the third quarter this year. However, given our base case is for a recession in Europe, we think the pace of hikes expected by the market after that is too aggressive.
What we are watching
- Flash PMIs – The manufacturing and services PMI data from the US, Europe, the UK, and Japan released this week could have enormous significance given the weak consumer survey data and the recession risks swirling around.
- Covid in China – There are signs that Covid cases are easing in Shanghai. However there are still a large number of districts classified as ‘high risk’. At some point the lockdowns in China will ease. When they do, it should provide support not just for China but also a large number of economies closely linked to China.
Summary of Fidelity International’s tactical core view