Fog of War Grips MarketsFogofWarGripsMarkets

Equities should recover lost ground

In an environment of rising interest rates, stocks have experienced multiple compression from 2020’s highs. The forward P/E ratio on the MSCI World Index, for example, has fallen from 20.3 at the end of 2020 to 18.0 (as of March 25), a decline of roughly 11%.1 Most major equity markets, with the exception of the U.S. and EMEA, now trade at a discounted value to their 10-year average on forward earnings. Latin America and U.K. equities appear to exhibit very attractive value, with forward multiples significantly below their 10-year averages. Multiples could continue to be under pressure going forward as inflation runs hot and central banks hike rates, but a continued rise in corporate earnings should put a floor under stock market performance. 

Assuming the war with Russia does not extend beyond Ukraine’s borders, we think the global economy will avoid recession, and U.S. and global earnings should still grow at a high-single-digit pace in 2022. While we expect equity markets to recover lost ground under this scenario, calendar-year returns are likely to be weak, though positive, in 2022, with higher interest rates continuing to weigh on valuation multiples.  

Fixed income risk assets look better than government bonds

Global bond markets have suffered steep losses since peaking last year. The Bloomberg Global Aggregate Index has fallen 11% from a high in January 2021. That’s the biggest drawdown since 1990, surpassing a 10.8% drawdown during the Global Financial Crisis.2 Rates could move higher from here given growth and inflation dynamics, but a lot of damage has been done to start the year. The yield rally may need to consolidate, similar to what we saw last year after a yield spike in Q1, before moving higher again. Still, we are bearish on sovereign debt on a longer-term horizon, and we think yields are likely to rise over the next few years.  

We see a better risk-reward profile in fixed income risk assets than in government bonds. Emerging market (EM) debt has seen a sharper drawdown this year than U.S. stocks, falling 15% from last year’s peak. Spreads in EM hard currency debt have hit levels last seen during the depths of the COVID lockdowns, and the current yield of 6.5% looks attractive. Russian bonds currently make up less than 1% of the JP Morgan Emerging Markets Bond Index (down from 3.2% at the end of 2021) and will be removed from the index on March 31, 2022. In contrast, U.S. corporate high yield bonds have seen a shallower drawdown of about 5%, as U.S. companies are more insulated from the crisis in Ukraine. Spreads on high yield debt have also risen but are still below their historical average. However, overall yields still look enticing at 6.2%.¹ 

Commodities still have more upside potential

We remain bullish on commodities. In prior commentaries, we’ve made the case for a structural bull market in commodity prices based on supply-demand imbalances that will not be easily remedied in the near term. Russia’s invasion of Ukraine strengthens the commodity bull case, adding both additional supply constraints and a demand boost. Russia, the second-largest commodity producer in the world, is a major supplier of energy, metals, and grain. Government sanctions and self-sanctioning among private actors have created a significant negative supply shock.  

On the demand side, Russian aggression has reinvigorated NATO and strengthened the bonds between the U.S. and its allies. Germany has committed to military enlargement and energy diversification and is even considering shifting its stance on nuclear energy. These goals will take years to implement and will require significant commodity inputs. Higher military spending among NATO members increases the demand for oil, natural gas, steel, and other base metals. This will stress already tight inventories. 

Commodities remain a stellar hedge against both inflation and a worse-than-expected outcome in the Russia/Ukraine conflict. We believe the bottom of the commodity cycle coincided with the beginning of the COVID pandemic, when oil hit negative $38 per barrel on April 20, 2020. In our view, a multi-year uptrend has begun. Commodities are up 109% since then but are still 56% below their 2008 high.² If commodity prices eventually rise to their 2008 levels, we would see 77% appreciation from here, which is likely to occur over several years. Financial flows into commodities also have the potential to exacerbate any upward moves caused by deficits in physical demand. 

¹ FactSet, Bloomberg as of 3/25/2022. Past performance does not guarantee future results. 

² Global Bond Index Loses $2.6 Trillion in Record Slide from Peak, Bloomberg News, Ritchie/Flynn, 3/23/2022.