Markets continue to trade volatilely and without a driver that can pull them out of their recent weakness, at least in the short term. On the one hand, there is pressure from geopolitical risks in Ukraine, which, of course, generates uncertainty due to the disruptive effects that a military escalation would have (which is not our base case), and on the other hand, concerns persist about the monetary normalization process by the U.S. Federal Reserve, where the market (and we) have been leaning toward faster and more aggressive rate hikes given the higher inflationary risks.

In a way, both events feed into each other. Increased geopolitical tensions are causing investors to be more cautious about the prospects of aggressive action by the Fed to tackle inflation. Immediately after last week's very strong US CPI report (+7.5% year-on-year), federal funds futures were basically pricing in a full 50 bp move in March. But since the situation in Ukraine escalated last Friday, that has been retreating almost continuously, with futures now only seeing a 38% chance of a 50 bp move next month. Now, if geopolitical risks diminish, those odds will rise again, leaving the market essentially "stuck" and likely to remain so until at least mid-March when the Fed will finally have to "transparentize" its forward rate and inflation scenario.

But let's get to the point... Lastweek, we argued that we believe we are at a turning point for some important structural changes. The post-pandemic cycle is driving higher inflation and interest rates. (Embracing the new reality: Strategies for a world with positive interest rates).

And as we move forward at this turning point, the drivers of returns and market leadership should be very different from the last cycle and should result in a different approach to investment strategy. Namely:

1. Aggregate equity returns are likely to be lower.
2. Relative returns are likely to be higher (compared to bonds).
3. Market value areas should be re-rated and recover.
4. Returns across sectors and countries should be less divergent

In particular, we believe that the last two points are key in terms of positioning ourselves for the future.

Citi Research recently published an interesting study that addresses these trends from the perspective of investment flows, whose conclusions support our main convictions regarding asset allocation for 2022, namely: overweight equities, underweight fixed income, and overweight commodities and markets outside the US.

Basically, the study concludes that there are three rotations underway.

Rotation #1: Bonds to stocks: Global bond funds are on track for two consecutive months of outflows (-$32 billion YTD), while stock funds have recorded inflows of $153 billion. These are significant moves, but they remain small in historical context. Looking at cumulative flows since 2007, there is still a US$3 trillion gap between bonds and equities. Perhaps more of that money could be reinvested in equities if prices fall further. We are favoring a very conservative strategy in terms of duration and credit risk.

Source: Citi Research

 

Rotation #2: From the US to the rest of the world: Equity inflows have been solid across all geographies this year. However, investors are beginning to show a preference for cheaper markets outside the US. For example, flows into global funds outside the US have outperformed funds that include the US for seven of the last eight months, as a percentage of AUM. For those looking to diversify outside the US, we are overweighting Emerging Markets, Europe (primarily the UK), and Japan.

Source: Citi Research

 

Rotation #3: Value growth: In line with this year's price action, value funds have seen strong inflows relative to growth. However, this still seems small compared to the value rotation in Q1 2021. Looking at value-style funds, inflows peaked at around US$70 billion last year, but have only seen US$20 billion in inflows to date. Although the rotation in Q1 2021 quickly faded, we suspect that its counterpart in Q1 2022 could extend further. We are overweighting the financial sector, energy, and commodities in general.

Source: Citi Research

 

Finally, the positioning and fund flow context appears negative for inflation-protected bond funds, investment-grade corporate bonds, and certain equity sectors, particularly growth (technology) sectors: these market segments are overpositioned (relative to history) and losing flows. The cash flow outlook may be more positive for European and emerging market equities, as well as energy equities: these market segments are under-positioned (relative to history) and accumulating flows.

Source: Goldman Sachs

 

Humberto Mora

Strategy and Investments