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Market complacency in the face of growing macroeconomic risks

By Fabiana Fedeli, CIO Equities and Multi Asset at M&G Investments

Evolving market backdrop

Equity markets have staged a comeback since early March, with the MSCI AC World Index down less than 6% in US dollar terms year to date. We believe investors are being far too complacent about the risks ahead and should exercise caution in their Equities exposure.

The backdrop for markets has significantly changed since Russian troops invaded Ukraine in the final week of February. Prior to that, inflation was high, and appeared more persistent than the market had initially anticipated, but the outlook for global demand and economic growth remained positive. The case for equities was not as strong as in early 2021, but the asset class was still attractive, in our view, from a relative valuation perspective.

In early 2022, market volatility represented a buying opportunity, and it made sense to maintain dry powder to take advantage of unwarranted price dislocations. Given companies’ varying exposure to cost inflation and yield pressure on the balance sheet, selectivity was the name of the game. Since late February, the hand investors have been dealt is a different one, with the consequences of the invasion of Ukraine and subsequent Russian sanctions likely to have more lasting effects than other geopolitical events in recent years.

Importantly, as we discuss the broader implications of the war, we should not forget the extent of the human tragedy, and our thoughts are with the people of Ukraine and all of those affected by the conflict.

Binary outcomes

From a macroeconomic standpoint, the outcome from the current events is likely to be a binary one. Either the conflict persists and the related sanctions stay in place for the foreseeable future, or we have an early resolution. If the conflict persists, we may be facing an inflationary spiral, which could weigh on the global economy – with elevated raw material prices feeding through the supply chain and curbing demand.

This would add to the existing supply side woes and potentially trigger a recession that extends beyond the borders of Europe. We have seen the first signs of – if not demand destruction – at least demand erosion. On recent quarterly earnings calls, consumer-related companies in the UK, Europe and the US, have been flagging softer demand in the first quarter.

From home furnishing companies to sporting and fashion retailers, firms have cited weakening consumer sentiment as a driver of reduced sales volumes, and are predicting increased pressure on consumer spending in 2022 as we lap COVID-related stimulus payments, and inflation and higher prices begin to squeeze household budgets.

The Chairman of Taiwan Semiconductor Manufacturing Company (TSMC), the bellwether of the semiconductor industry, also commented last week that the company was seeing signs of a slowdown in consumer electronics demand (eg, smartphones, PCs and TVs) amid geopolitical uncertainties and COVID-related lockdowns in China.

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