The high level of uncertainty surrounding key factors such as inflation, growth, monetary policy and market liquidity is weighing on capital market prospects in the short term. Union Investment expects a slow but steady decline in U.S. inflation in the second half of the year. In addition, the rapid normalization of monetary policy is coming to an end before it puts too much strain on the economy.
According to Andreas Koster, Head of Portfolio Management and member of the Union Investment Committee, the capital market year 2022 marks a turning point in several respects. "The Corona pandemic has accelerated existing trends, aborted others, and triggered still others. In addition, inflation is rising strongly and with it interest rates are rising", he says. In addition, Russia's invasion of Ukraine requires a reassessment of political risk.
This threefold change in direction will lead to a recalibration of the capital market environment. "The old 'pre-Corona equilibrium' with low inflation, ultra-loose monetary policy and low geopolitical risk premium no longer carries," Koster specifies. "We are currently in transition to a new post-Corona equilibrium, of which so far only outlines such as higher inflation levels or a return of great power competition to the international stage are discernible. This transition period is fraught with uncertainty and that is currently weighing on the capital markets and the economy."
High uncertainty around inflation, growth, monetary policy and market liquidity
From an investor's point of view, Koster sees four key points as decisive for the further course of the stock market year: Inflation, growth, monetary policy and market liquidity. "There is currently a great deal of uncertainty on these issues – and as long as that remains the case, prices are unlikely to rise.", he thinks. In the first few months of the year, inflation concerns were the main factor shaping the capital markets. "Inflationary pressures have become more entrenched and widespread, so we won't see a return to pre-Corona levels any time soon," Koster is convinced.
However, starting in the U.S., expects inflation to decline over the course of the year. Many real economic tensions would be released, from supply chains to oversized demand for goods. Inflation will therefore fall slowly but steadily both in the USA and later in Europe. This takes pressure off monetary policy not to overstep the mark, which unfortunately has been the case too often in the past in the end. Union Investment forecasts consumer prices to rise 7.4 percent in 2022 as a whole, compared with 7.3 percent in the euro area. Accordingly, a sweeping decline is not to be seen until 2023, when inflation in both economies is likely to be roughly halved.
Slow but steady decline in inflation expected
According to Koster, the only slow decline in inflation remains a source of uncertainty. "The decisive factor is whether the central banks get inflation under control – or have to tighten beyond the announced level," he says. Another prerequisite is a significant easing in the real economy. Otherwise, there would be a risk that the monetary guardians in the fight against inflation trigger a recession. "This concern will be with us at least through the summer," he expects. The situation in the euro zone will be tight, as we are already close to stagnation for the year as a whole. Koster is more optimistic for the U.S. This reduces the risk of a global economic downturn.
Specifically, the capital markets strategist expects key interest rates in the United States to be raised by the U.S. Federal Reserve (Fed) by a further 175 basis points by the end of the year, starting with two 50 basis point steps in June and July. "The Fed's tightening measures have been well communicated and therefore already largely processed in the market," explains Koster. He therefore expects little upward pressure on U.S. interest rates and forecasts a yield level of around 3.15 percent for U.S. ten-year Treasuries by year-end. The situation at the European Central Bank (ECB), on the other hand, is different. "The monetary policy swing of the ECB is yet to come. Especially around the July meeting, things can get turbulent on the European bond markets," he warns. He believes further yield increases in the euro area are possible, especially in the short-dated segment, while only small increases are likely for 10-year bonds.
Economy under stress test – growth loses momentum
"The combination of stubbornly high inflation, persistent supply problems and excessive monetary tightening is where the biggest risk to the economy lies," Koster notes. As a result, concerns about growth have rightly replaced inflation as the dominant market driver, as the risk of the global economy slipping into recession has risen significantly. However, he assumes that the central banks will succeed in walking the tightrope between fighting inflation and protecting the economy. He also expects positive stimulus from China through a more successful Corona crackdown with quick, tough and targeted lockdowns, as well as additional help from monetary and fiscal policy. Koster also counts U.S. consumer spending among the supports for the economy. "American households have built up large reserves during the pandemic, are benefiting from the booming labor market via rising incomes and are therefore in a very good financial situation. That protects consumption from a sharp, inflation-triggered slump."As a result, Koster expects the U.S. economy to grow 2.4 percent in 2022 despite the drag from rising prices and tighter monetary policy.
Koster is less confident about the euro zone, which is suffering more from the consequences of the war in Ukraine: "We expect the war in Ukraine to drag on for several more months."This means that he does not see any clear easing of high commodity prices or the problems with supply chains to Ukraine. In addition, there is currently the weak export demand from China. "Eurozone growth has stalled," concludes Koster. In the second half of the year, he expects a moderate recovery. Overall, he considers growth of 2.1 percent to be realistic for the year, and only 1.4 percent in Germany. If supplies of Russian natural gas were to be halted, a recession would probably be unavoidable.
More clarity on key factors, better investment outlook over the course of the year
In the coming months, the capital market environment is therefore likely to be characterized by a mixture of high inflation rates, speculation about the course of central banks and growth worries. "Opportunity-oriented investments will have a hard time in this phase," analyzes Koster. In addition, this combination could mean that temporarily weak market liquidity and risk management-driven portfolio adjustments by large investors could potentially further complicate the situation. "Caution is called for on the capital markets for the time being," he sums up. However, he expects an improvement in the course of the year: "We will have more clarity in the coming months."
Success factors: high tactical activity, relative positions and careful stock selection
Against this backdrop, Koster is focusing on high activity, relative positions and careful security selection. The volatile, fragile environment thus requires more frequent and shorter-term investment decisions than in calmer market phases. In addition, there is much to be said for playing off the differences in attractiveness of various sub-segments within individual asset classes against each other (relative positions or. "pair trades"), for example through a stronger weighting of value stocks over growth stocks on the equity side. Overall, the capital market strategist considers equities to be a burden in the short term, but still indispensable in the long term. "Trends such as the sustainable transformation of our economies are intact and continue to offer investment opportunities," he says, citing a promising investment field. He also sees the market forces currently at work as an opportunity for active stock picking. "Earnings in the corporate sector remain good – just not everywhere. Companies with high pricing power have a clear advantage," says Koster. In addition, the negative factors should lose strength in the course of the year, thus clearing the way for renewed price gains. For Germany's leading index, the DAX, Koster therefore considers a value of 15,100 points by the end of the year to be quite realistic.
The market outlook for corporate bonds has also deteriorated for the time being, especially in the euro zone. "So far, the ECB is still acting as a strong, less price-sensitive buyer of bonds. This support will run out in early summer, weighing on peripheral and corporate bonds," he analyzes. To improve the outlook, Koster believes more clarity is needed on these key issues.
Commodities have so far been one of the few asset classes to post gains since the start of the year. Koster is skeptical as to whether this development will continue at the same pace. "Oil products are likely to remain tight over the summer, but thereafter the situation should ease as new supply comes on stream", he says. The experts at Union Investment have therefore calculated a price target of 95 U.S. dollars per barrel of North Sea Brent crude oil by the end of the year. By contrast, industrial metals, which are likely to benefit from a revival of the Chinese economy, should be much more promising.
So there are difficult months ahead for the capital markets, during which turbulence is to be expected. However, with increasing clarity about future developments in inflation, monetary policy and growth, Koster also expects more room for price gains in opportunity-oriented assets again. "In the short term, one should be on guard. In the medium term, opportunities are on the rise again, and they should not be missed. And in the long term, stock markets are facing fundamental directional changes that will take us into a very different environment," he said, summing up the outlook for investors.