In March, energy supply concerns even overshadowed AI in the headlines. Financial markets priced in stagflation amid a 50% surge in oil prices – an unwarranted narrative reminiscent of 2022. For political reasons, either a swift de-escalation in the Middle East or, conversely, military escalation to end the oil supply blockade seems most likely.
What we initially assumed, like most observers, to be a brief US military intervention in a geopolitically sensitive region has escalated into a bottleneck in oil and gas supplies to Asia and Europe. Amid a 50% surge in oil prices, financial markets priced in a stagflation scenario: higher inflation forcing central banks to raise interest rates, thereby slowing the economy to the point of stagnation. This narrative is reminiscent of 2022, when wages rose post-Covid due to labour shortages, and goods and services prices climbed as a result of supply chain issues. In the current situation, however, we consider a stagflation scenario unjustified, as rising prices are primarily driven by higher energy costs. We therefore expect financial markets to soon refocus on AI and private credit themes. The most significant market distortions, in our view, are in the bond market.
The loss of purchasing power among US consumers due to higher petrol prices negatively impacts Republicans ahead of the upcoming November midterm elections. Our base scenario assumes a swift de-escalation in the Middle East. Where have usable distortions emerged in the financial markets? Interest rate expectations have reversed: while rate cuts, such as by the US Fed, were expected in February, the market is now pricing in rate hikes. We consider this excessive. We are taking advantage of this by increasing the duration of global government bonds, which should benefit from a decline in inflation fears and rate cuts (see chart). A mere return of US yields to early March levels would generate a 5% gain on a 20-year bond. Conversely, we are closing our position in AUD government bonds, which were boosted by the 10% rise in the commodity currency. Except during inflationary phases, we continue to attribute an important diversifying role to the duration of government bonds in a mixed portfolio.
The global equity market has lost around 8% in USD since its late February peak. The noticeable euphoria from late February has thus subsided, which, combined with the continued growth in corporate earnings, supports our overweight in equities. Targeted regional adjustments are warranted:
US: The US market has been less impacted by the Iran crisis, but headwinds are emerging from the labour market (partly AI-driven) and the struggling private credit sector.
EM: Emerging markets are less favoured than in recent quarters, as investors are pricing overly ambitious expectations into major AI firms.
CH: The Swiss equity market, on the other hand, appears to have overly pessimistic expectations priced in.
We are making no changes to alternative investments and remain overweight in gold following the price correction. Alternative investments, such as insurance-linked bonds, contributed successfully to diversification during the turbulent March.
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