Market complications are piling up to start the year and weighing on equity and bond returns. It began with higher-than-expected inflation (the CPI hit 7.5% in January) and the Fed’s firm response (signaling a first rate hike in March). Then it took another turn with Russia’s invasion of Ukraine — creating a massive and distressing humanitarian crisis, while adding another layer of market complexity given Russia’s role as a global supplier of commodities.

So where to from here? To state the obvious, we have no idea how the war in Ukraine will unfold and can only assess the likelihood of various scenarios. We think markets will continue to grapple with the trade-offs between inflation and growth and the central bank response. We remain convinced that inflation will be higher and stickier than expected. The war in Ukraine and sanctions on Russia only bolster this view, given the likelihood of additional supply-chain disruptions and shortages in agricultural, metal, and energy commodities. Higher energy prices could also weigh on growth.

Given our inflation outlook, we are most bullish on commodities, including gold. We continue to favor a moderate overweight to global equities despite the somewhat worse fundamental backdrop. Why? As of this writing, we believe that consumer spending should remain resilient given the accumulation of savings and higher nominal wages, and companies should continue to benefit from relatively strong growth. In addition, COVID restrictions are being lifted and bearish sentiment is at an extreme. Finally, with geopolitical risk running high, central banks are likely to be cautious in removing liquidity and fiscal spending is likely to increase, which would benefit risk assets. The market has backed off its expectation of six Fed rate hikes this year and we suspect that even the reduced expectations may still be too high (Figure 1).

Figure 1

In fixed income, we continue to see downside for total returns in the coming months. Looking at developed market government bonds, we think Japan’s central bank is least likely to hike rates. We have turned marginally more negative on credit risk. Spreads are wider and credit returns could be vulnerable to higher government bond yields should investors shed duration. Within credit, we continue to prefer floating-rate structures like bank loans but favor an underweight to credit overall.

Equities: Favoring Japan and the US

We think Japanese equities are attractive, with more monetary and fiscal policy tailwinds than any other market and cheap valuations. What’s more, the yen could prove a safe-haven hedge in a risk-off environment. In addition, Japan has long suffered from deflation and should benefit from higher global inflation.

We made similar arguments for Europe last quarter, but now European inflation has reached higher and less helpful levels, equities are expensive across a variety of metrics, and the region stands to suffer the most from the invasion of Ukraine. Europe is heavily reliant on Russian energy, and European energy prices had already skyrocketed prior to the invasion (Figure 2).

Figure 2

US equities look moderately attractive given a still robust economic cycle and their relative safety from global concerns like weak growth in China and Russia’s invasion of Ukraine. Corporate fundamentals are quite strong and a ratcheting back of Fed tightening expectations should ease pressure on rate-sensitive growth sectors. EM equities may be a source of funding as China’s growth shows few signs of improvement and Russia reminds investors of the perils of autocratic government decision making. Within EM equities, we favor commodity exporters such as Brazil.

Commodities and inflation: Higher for longer

Our bullish view on commodities is supported by structural supply shortages across many commodities, which our firm’s experts expect to persist for several quarters if not years. Demand should remain strong and bottleneck pressures acute. The invasion of Ukraine is another, more cyclical reason to consider commodities, as Russia is a major exporter of oil, gas, and metals, and Ukraine is a large exporter of wheat. We also think gold is attractive as a hedge, given geopolitical concerns and the risk that inflation expectations de-anchor.

In terms of implementation, allocators may want to consider exposure through commodities futures, energy companies, or miners. We believe the focus should be on companies that have clear ESG plans and have begun to transition their business toward renewables and reduce their carbon footprint.

Higher rates a challenge for governments and spreads

It’s been a tough year so far for fixed income, with yields rising (the US 10-year Treasury hit 2% at one point in response to the 7.5% January CPI print) and spreads widening. With stiff headwinds from inflation and Fed policy, we have an underweight view on both defensive and growth fixed income (see “Our multi-asset views” table).

There has been some improvement in valuations. Year to date, spreads have widened 30 to 200 bps, depending on the sector. Valuations are near the median for investment-grade corporates and wider than average for emerging markets, while still on the rich side for high yield (measured from the inception of the indices). But even with more attractive valuations and low default risk, we don’t see a case for longer-duration credit given the threat of duration shedding in government bonds and credit at a time of rising rates. Figure 3 shows that correlations of US Treasury yields and high-yield spreads have turned positive recently, an atypical relationship that augurs poorly for spreads should rates rise.

Figure 3

Risks

We are optimistic that central banks can approximate a soft landing even if the growth/inflation trade-off worsens somewhat. Despite some reduction in market expectations, we think markets remain priced for substantial tightening and that central banks are unlikely to surprise on the hawkish side. However, if inflation proves stickier or higher than we expect — perhaps because supply-chain bottlenecks don’t ease as anticipated — then central banks may be forced to tighten more aggressively and risk assets may falter.

One potential driver of more persistent inflation is a drawn-out conflict in Ukraine that inflicts greater-than-expected disruptions in energy, metals, and wheat markets. If Putin’s ultimate goal is to occupy all of Ukraine, then we fear the conflict will be a bloody stalemate of urban warfare with even greater economic costs in the form of reduced business and consumer confidence, higher inflation, and lower growth for the rest of the world.

On the upside, if Russia chooses to retreat or only occupy parts of eastern and southern Ukraine, risk assets may rally strongly. Any news that suggests the potential to avoid interruptions in trade with Russia would also help markets, as would an increase in European fiscal support. Turning to China, the country’s opaque system is difficult to analyze, but an upside policy surprise is worth watching for. Finally, in terms of the pandemic, we appear to be on the cusp of a more normal summer in the northern hemisphere and a recovery in the service sector, though we must acknowledge the risk of yet another variant.

Investment implications

Stay the course with equities — Given geopolitical uncertainty, we expect a risk premium in global equity and credit markets — particularly in Europe and EM. However, given the repricing we’ve already seen, the likelihood of less hawkishness from developed market central banks, and extremely bearish sentiment, we expect equities to outperform bonds over a 12-month horizon. We prefer Japanese and US equities.

Inflation risks remain higher for longer — Shortages and supply-chain disruptions stemming from the Russian invasion of Ukraine could drive commodities prices higher. Allocators may want to consider adding broad exposure to commodities, the asset class that has historically been most sensitive to higher inflation. We think TIPS are likely to outperform US Treasuries. Higher yields and inflation should support value stocks, but weaker growth would favor growth stocks.

Stay short in fixed income — We continue to favor shortening duration in fixed income given our expectation of higher longer-term yields and wider spreads.

Consider defensive assets — US equities, unhedged Japanese equities, and gold are likely to be favored should growth weaken amid geopolitical uncertainty. High-quality government bonds may regain some of their diversification role during bouts of turmoil. We think the focus should be on quality in equities: domestically oriented companies, service companies, and companies that have growth potential and are profitable may be more insulated from geopolitics. More military spending by Europe is highly likely and may warrant a closer look at defense stocks (though ESG considerations could limit allocations).

Active management may play a role — In an environment of increased volatility, higher return dispersion, and worse liquidity, active managers have the opportunity to distinguish between winners and losers and take advantage of price dislocations that may not be justified by fundamentals at the country and company level.