War and rate shocks argue for simplified asset allocation - Dorval's Macro Corner (March 2022)

Since Russia and Ukraine do not account for a significant share of the world economy, the Ukraine crisis is transmitted mainly via the price and availability of raw materials. In the short term, the energy shock means less growth and more inflation. Europe is on the front line with its dependence on Russian gas, while energy independence better protects the American economy. With a large part of the world not applying sanctions, Russian oil should be able to find buyers, which would limit the price per barrel below $120/130. The Ukraine shock would then be manageable, particularly given Europe enters this phase with a favorable economic momentum, and financing resilience plans. Disruptions in the production chains will however worsen, with China partially reconfiguring its economy.


One of the major changes is that central banks no longer intend to absorb all shocks. They have gone to war against inflation, and only concrete risks of recession could deflect them. The European Central Bank has begun to scale back its asset purchases despite Ukraine, and the US Federal Reserve is no longer hiding its firm intention to slow an overheated economy. The relationships between growth, inflation and interest rates have therefore become unstable. The conclusion we draw is that global bond markets have become uninvestable. Bonds are indeed overpriced, with negative real (i.e. excluding inflation) yields even for corporate bonds.


In this tougher world, global stock markets have bent but they have not collapsed. In our view, the main cause of this resistance is the consolidation of valuations and equity market positioning over the past year. The euphoria at the start of 2021 was followed by a very sharp drop in Covid-19 flagship stocks (biotech, etc.), an Asian bear market (including -50% on the MSCI China since February 2021!), then a correction in the valuation of large cap growth stocks from November 2021. All in all, global P/Es have normalized, making equities even more attractive relative to bonds. Stocks are also "real" assets since corporate profits broadly follow inflation.


In this context, international asset managers have, we believe, an interest in simplifying asset allocation solely around the equity-cash pair. Peripheral bets on the bond or foreign exchange markets seem too dangerous to us in the current context. Also, we focus our equity exposure on developed countries only. Our method of equally weighting equities allows broad sector and regional diversification, with, for example, significant exposure to Japan (hedged against currency risk), a low-valued market where rates are not rising. We continue to favor the theme of energy transition, a theme that has emerged strengthened from the Ukraine crisis.


Download Dorval’s Macro Corner of March 2022 in PDF version here

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