Amidst the ongoing Russia’s invasion of Ukraine, the volatility associated with equities as an asset class is in its full might. Every news of the Ukraine war and Russia’s sanctions is keeping the stock market on its toes. S&P 500 and Nasdaq Composite have already fallen almost 9.18 per cent and 15.21 per cent respectively, in 2022 so far.
In about ten days time, another key event in the US market is going to happen that may also have global repercussions. The US Federal Reserve will be taking decisions on the interest rate hike mid-march. The rates are expected to be up by 0.25 per cent as against the earlier expectation of 0.5 per cent on account of rising inflation.
Markets have been hit by a double whammy this year, ever-more hawkish expectations of interest rate hikes and the escalating conflict in Ukraine. But, have the stock market analysts already priced in the rate hike and the sanctions imposed on Russia?
BlackRock, a global investment manager, in their global weekly commentary have written that they are tactically upgrading equities as they see greater clarity on the Ukraine conflict and reduced risk of central banks slamming the brakes to curb inflation. We could see the market’s focus return to inflation, growth and central bank policy.
As per the commentary, BlackRock says, “We also think it has reduced the risk of central banks slamming the brakes to contain inflation. We are tactically upgrading developed market (DM) stocks as a result. We believe market expectations of rate hikes have become excessive and have created opportunities in equities. We downgrade credit, preferring to take risk in equities.”
In the U.S., markets have pulled forward expected policy tightening. Yet the cumulative total of hikes is little changed, making for a historically muted response to inflation that is running at four-decade highs.
How does the invasion of Ukraine affect the policy landscape? BlackRock’s weekly commentary says – We see fast-rising energy prices exacerbating supply-driven inflation, both delaying and raising its peak. We think central banks will need to normalize policy to pre-Covid settings, and that they will find it tough to respond to any slowdown in growth. In other words, policy rates are headed higher. Yet central banks may face less political pressure to contain inflation as the conflict becomes an easy culprit for higher prices. We believe this will allow them to move more cautiously as they raise rates, especially the ECB.
The confusion we flagged in our 2022 outlook has indeed played out, hitting developed market equities hard amid excessive hawkishness over rate hikes. We believe this has created tactical opportunities as markets will start to realize that central banks have little choice but to live with inflation.
We prefer equities in the inflationary backdrop of the strong restart and low real, or inflation-adjusted, yields. Also, valuations are not stretched relative to history when viewed through equity risk premiums – our preferred metric that takes into account the prevailing interest rate backdrop.
On a strategic horizon, we recently added to overweight in equities to take advantage of this year’s selloff. We remain deeply underweight nominal government bonds and prefer Treasury Inflation Protected Securities instead. Bond markets are not yet pricing in higher medium-term inflation, in our view. We now see faster rate hikes, but believe the historically low sum total is what will really matter for equities. Our bottom line: The new market regime favors equities over bonds.