Central bank tightening, the threat of energy shortages in Europe, and COVID-related mobility restrictions in China all present headwinds to global growth. (UBS)

A surge in the UK’s 30-year government bond yield, which had jumped more than a percent since the start of the week to its highest level since 2002, had been spilling over into global fixed income markets, which were already under pressure due to expectations of more aggressive central bank tightening. A commitment by the UK central bank to purchase long-dated bonds on “whatever scale is necessary” to ensure financial stability was aimed at protecting the UK economy from a harmful rise in borrowing costs. But the move also helped reverse a sharp rise in yields in the US and Eurozone.

Signs of easing risk aversion were also apparent in foreign exchange markets. The DXY dollar index, which has been pushed to 20-year highs by safe-haven inflows, edged 1.2% lower, though it is still up 18% since the start of 2022. The price of Brent crude, which fell to its lowest level since January on recession worries earlier on Wednesday, rose 3.5% to near USD 89 a barrel.

Equity markets in Asia were mixed on Thursday. The Nikkei 225 rose 0.95% while the Hang Seng fell 0.5%. In Europe, equity markets declined in early trade, with the Euro Stoxx 50 down 1.1%. S&P 500 futures for Thursday's session were down 0.6% at the time of writing.

The improvement in sentiment on Wednesday came despite further worries that geopolitical tensions could lead to further disruptions in energy supplies to Europe. The governments of Germany, Denmark, Sweden, and Poland all said that sabotage was likely to blame for major leaks in the Nord Stream pipelines supplying gas to Europe. The reliability of gas supplies to Europe from Russia, which are already running at less than 20%of capacity, was also called into question by indications from Russia’s state-controlled Gazprom that Moscow would impose sanctions on Ukraine’s Naftogaz. Gazprom stated this could prevent it from paying transit fees, further imperiling the flow of gas to Europe.

What do we expect?

After a period of relentless declines, a modest rebound in equity markets was to be expected at some point. Equally, the sell-off in government bonds had gone too far in our view. The move, which took the 10-year Treasury yield to an intraday peak of over 4% on Wednesday before ending the day at 3.74%, is not sufficiently pricing the risks to US growth. Our year-end forecast is for 3.5%.

But we remain skeptical that the calmer mood in markets on Wednesday marks an end to the recent period of elevated volatility or risk-off sentiment. For a more sustained rally, investors will need to see convincing evidence that inflation is coming under control, allowing central banks to become less hawkish. This turn, in our view, is still some time away. The European Central Bank meets next month amid mounting expectations that it will raise rates by 75 basis points for the second meeting in a row. The rate hiking trajectory of the Bank of England will also likely become more aggressive to offset the inflationary implications of the government’s fiscal expansion. Meanwhile, the long-dated bond purchases are only temporary and are due to run until 14 October.

In addition, we do not yet see signs of an imminent cease-fire in Russia’s war against Ukraine. This week’s pipeline leaks have added to concerns that Russia remains willing to use energy as a weapon against nations that support Ukraine.

How do we invest?

Add defensive exposure. Central bank tightening, the threat of energy shortages in Europe, and COVID-related mobility restrictions in China all present headwinds to global growth. As a result, we favor tilting allocations toward parts of the market that should prove more resilient in the event of slowing economic activity. Within equities, this includes healthcare and consumer staples. In currencies, we like the Swiss franc and the US dollar. In fixed income, we favor high-quality bonds and resilient credits. Capital protection strategies can also help make overall portfolios more defensive.

Seek income opportunities. At a time of heightened market volatility, the opportunity to earn more predictable returns is more highly valued. We see opportunities for investors to add income to their portfolios across stocks (e.g., quality income—high dividend stocks with solid fundamentals), fixed income, volatility-selling strategies in FX and commodities, and real estate.

Invest in value. Periods of elevated inflation have historically been associated with outperformance by value stocks relative to growth. We favor global value and the UK equity market, which has a high exposure to value sectors. In addition, we expect energy stocks—a value sector with attractive cash returns—to benefit from higher oil prices in the months ahead.

Seek uncorrelated hedge fund strategies. It has been difficult for investors to earn positive returns in 2022. But one bright spot has been hedge funds, where some strategies, like discretionary macro, have done particularly well. With inflation and central bank policy continuing to drive both equities and bonds, we recommend investors diversify into hedge funds to navigate market uncertainty.

Position for the era of security. While we retain a least preferred stance on growth stocks, we expect the era of security and the global transition toward stability and sustainability to continue to generate attractive long term opportunities. Plans to improve energy security, environmental security, food security, and technological security are likely to be among the key long-term drivers in the years to come, supporting investments in areas ranging from greentech to agricultural yield solutions.

Main contributors - Mark Haefele, Christopher Swann, Vincent Heaney, Patricia Lui

Content is a product of the Chief Investment Office (CIO).

Original report - Market pessimism abates for now, 29 September 2022.