• Slowdown in growth not as bad as feared, inflation more stubborn than expected
• Investors now share the outlook of central banks
• Cautious investment policy unchanged

After an upbeat start to the year, markets declined again in February amid concerns that stubbornly high inflation and resilient economic activity would force central banks to raise rates higher than expected and keep monetary policy restrictive for longer. The MSCI All Country World delivered a negative total return of 2.9% in February. The S&P 500 lost 2.4% on the month and Chinese equities consolidated, delivering a negative total return of almost 10% after having rallied 40% in the last 3 months. Intensifying geopolitical tensions led to some profit taking. European equities returned +1.6% in February, extending their strong year-to-date gains, supported by signs that Europe’s economy is in better shape than feared. The global aggregate bond index registered a 3.3% sell-off, giving back a large part of the positive performance recorded in January.  

 February started with a solid set of economic data. In particular, the stunning US employment report was a wake-up call for investors betting on rate cuts in the second half of the year. Subsequent US (strong retail sales growth, hotter-than-anticipated CPI, PCE inflation prints, a surge in service sector activity) vindicated these worries, that the job is not done for the Fed. During his Congressional testimony on March 7th, Fed Chair J. Powell stated that policymakers are “prepared to increase the pace of rated hikes” if warranted by the “totality” of the data, which reveals that a return to larger rate hikes is not a distant possibility anymore. The US treasury curve flattened sharply as markets moved to price in additional tightening (2-year treasuries: 5.07%), with the peak fed funds rate now expected to reach 5.5% in September. The 10-year treasury rate was largely unchanged (at 4%) on concerns that more aggressive tightening will push the US economy into recession. Meanwhile, the 4th quarter earnings season in the US showed a contraction in profit growth vs. last year, with much of the effect of tighter financial conditions still to be felt. The earnings guidance was generally very conservative. 

February core inflation in Europe (energy and food excluded) did not find a ceiling and increased to a record high of 5.6%. ECB president Lagarde expressed explicitly the intention to increase interest rates by another 50 bps in March. While the year-over-year decline in M1 money supply – as well as the slowdown in credit flows to households and businesses and tighter credit standards – indicate that ECB policy is already restrictive, market participants are betting that the ECB will raise interest rates to a peak rate of close to 4% until the end of 2023 - 150 bps higher than today. While soft indicators (IFO, ZEW) point to an improvement in sentiment among economists, analysts and businesses about the economic outlook, businesses have yet to experience an improvement in hard data. The manufacturing sector in particular reports receiving fewer orders. Weak demand for durable goods remains a headwind to the manufacturing cycle. In this context, a key risk to the more positive outlook for the Eurozone economy and stock market is if the ECB maintains its hawkish stance. 

Uncertainty about the inflation trajectory and concerns about an overtightening are likely to dominate market sentiment. Economic momentum in Europe and China is picking up sooner than expected and the US economy has remained more robust than expected, so far this year. The question investors are now asking is whether this represents good or bad news. While some resilience against higher rates could suggest a higher chance of a achieving a soft landing, it may increase the Fed’s and ECB’s conviction to continue hiking rates too. Further stock market advances will be dependent upon clearer signs that central banks are close to the end of the tightening cycle. With all that in mind, a vigilant disposition seems appropriate at the current juncture. We are maintaining our underweight in equities and high yield bonds. 

Please find attached our last Asset Allocation Update for March.