By Anik Sen, Global Head of Equities at PineBridge Investments

Since early this year, equity markets have labored under three major dislocations that have masked several positive underlying secular trends. Repeated Covid-related lockdowns in China since 2020, Russia’s invasion of Ukraine, and persistently high headline inflation in the US are masking several underlying secular trends that are set to reassert themselves when these short-term dislocations resolve. These longer-term trends include the $60 trillion of investments needed to achieve the Paris Agreement’s net-zero carbon emissions target by 2050 (with interim targets set for 2030), along with the push for significant reductions of concentration risk that the pandemic and geopolitics have exposed, including diversifying global supply chains and reshoring manufacturing closer to end-consumers. Lastly, the inexorable trend toward digitalization across all industries has taken on greater urgency as input cost inflation creates the need for productivity gains.

Each of the “big three” short-term dislocations – China’s lockdowns, the war in Ukraine, and red-hot US inflation – are powerful enough on their own to hurt investor confidence and dim analysts’ visibility into future corporate earnings. And when all three are present simultaneously, they pose considerable headwinds for equities. The market’s fear, in our view, is that a global recession could be around the corner – caused in part by potential policy missteps as the major central banks, particularly the Federal Reserve, try to thread the needle between robust consumer demand in the US and fragility elsewhere amid these dislocations. This fear is evidenced by a 21% drop in the MSCI ACWI global equity index this year through 23 June 2022 (according to Bloomberg).

Companies and macro investors are seeing things differently – but who is right?

Curiously, we see a big disconnect between the bottom-up view of the world from companies and the top-down view from investors – especially macro investors and momentum strategies, which, in our view, have been behind much of the liquidity moves dragging on equity markets this year. For example, over the past month alone, commodity trading advisors (CTAs), specifically trend-following systematic strategies, have sold $77.7 billion across major equity indices.1 Yet in the first-quarter results season, senior management of companies have generally reported that order books remain strong, with few or no cancellations – and this notwithstanding the market narrative earlier in the year that companies were double- and triple-ordering due to supply chain bottlenecks. Companies are now reporting greater certainty in deliveries from their suppliers, an indication that supply shortages are starting to ease.

While we have seen such disconnects before, our sense is that the gap between top-down macro and bottom-up company views are unusually wide this time around. Despite our bias to favor the bottom-up view – both because it is consistent with our stock-selection-focused investment process and has proven timely and accurate in prior episodes of market turmoil – our investment experience also tells us that if today’s dislocations were to deteriorate further, the bottom-up view could rapidly converge with the top-down. Thus, we think the near-term outlook – for the rest of the year, at least – is unusually unpredictable. But if our hypothesis is correct that all of the “big three” current disruptive forces will abate in time, the positive underlying secular trends should regain their ascendency in investor sentiment.

The current dislocations are persistent, but not new

It’s also important to note that these dislocations are no longer in early days. Equities have already suffered a sharp derating, with valuations for stocks and equity indices at or close to the lows seen at the onset of pandemic-driven lockdowns in early 2020, when the specter of a global depression loomed large ahead of unprecedented monetary stimulus. In the case of Asia, equities are trading near the lows of 2018, when investors were gripped by the fear of a hard landing in China, which the country avoided largely by opening the supply of credit to small and mid-sized companies.

Our equity investment philosophy focuses on a specific market inefficiency as our targeted alpha source: namely, the mispricing of changes in a company over a medium-term horizon, typically three to five years, recognizing that the market is generally efficient for most stocks within a one-year period given the prevalence of earnings guidance from the companies themselves. This is best seen through the increase in the standard deviation of sell-side analysts’ estimates from the current year to future years.2

This alpha target sets up three key pillars of our investment philosophy. First is that the alpha opportunity from the mispriced change in companies is always present, regardless of market conditions, which in turn drives us to seek to neutralize all other risks relative to the benchmark through portfolio construction. Second is that teamwork and collaboration across our global equities platform is critical for driving idea generation. And third is that precision in risk management results in the long holding periods necessary to realize our targeted alpha, as the mispriced change becomes visible to the market over this longer horizon. As an equities manager, our mandate is to be fully invested in equities at all times and to deliver alpha over the relevant benchmark. We approach near-term uncertainty by remaining neutral to the benchmark with respect to style risks, such as growth and value, and to seek to maximize the return from our chosen risk, which is from stock selection.

What has been an eye-opener for asset owners recently is that many of the large active funds that had been faring so well have seriously underperformed their benchmarks this year, in many cases wiping out the past three years of excess returns. Standard Brinson-based performance attribution analysis may not reveal the true reason for the underperformance, which, we suspect, has to do in most cases with poor risk control and an unintentional tilt toward growth style due to the popularity of technology-oriented names in virtually all sectors in most of the large funds. This happens when portfolios are constructed in nearly all cases to be dollar-neutral to benchmark sectors, which are heterogenous groupings of many kinds of stocks and many different factors. Being dollar-neutral to sectors for a concentrated, active portfolio means very little in terms of risk controls, since the portfolio’s factor composition is likely to be different from the benchmark’s.

Taking a leaf from our investment philosophy, we think it’s prudent to stay close to the core in terms of style allocations, since we are in an extended period where volatility and style rotation are likely to be high across all markets. This was also our expectation coming into this year, as we saw a decades-long decline in interest rates coming to an end. But little did anyone expect a war to erupt in Europe, or for China to grapple with extended difficulties in reopening its economy sustainably.

China’s path could reset investor sentiment

Indeed, China has been in a lengthy cycle of lockdowns and reopenings since the onset of Covid-19 in 2020. We have found daily flight data to be a good proxy for the state of reopenings around the world, and the number of flights in China, which was again close to Covid-era lows, started climbing back up in the second half of June 2022. Flight data are steadily moving toward pre-pandemic levels in the US, Canada, Mexico, India, Australia, and Europe, while Asian countries, with the exception of the Philippines, are somewhere in the middle, with about half having nearly fully reopened.3

Given China’s difficulties, it is no wonder that the supply chain bottlenecks around the world have persisted for so long – well beyond most expectations last year of a return to normal by now. And though it is often said that hindsight is 20-20 while foresight is myopic, it does appear that China is edging closer to a sustainable reopening. China’s “dynamic” zero-Covid policy has a sound basis, in our view, given that a large percentage of its 1.4 billion population is elderly and either will not take the vaccine or remains under-protected, since the number of booster shots administered is still relatively low. In addition, the population at large has not been exposed to the virus in the same way as, say, India’s, which is similarly large but skews much younger than China’s, and also experienced an enormous wave and countless tragic deaths from the delta variant last year. While the daily vaccination data from China show that the numbers of fully vaccinated are creeping up, the availability of antiviral medications will be key, given the enormous number of people little or no protection.

We expect the stockpiling of antivirals in China, together with higher vaccination rates, to help boost market sentiment in the second half of this year. Pfizer’s Paxlovid antiviral has already proven sufficiently effective against Covid-19 and is widely available in the West, so stockpiling of similar locally produced drugs in China appears to be one way out of the problem. China’s Junshi Biosciences is already in Phase III trials for its antiviral medication.

We expect China to continue its zero-Covid policy until the stockpiling of antivirals is deemed adequate and the rate of booster shots in the population is significantly higher. We therefore think the sustainable reopening of China’s economy is only a matter of time, and that “closed loop” workforce arrangements, whereby workers do not leave their factory premises and work in shifts in return for bonus payments, are only a short-term solution. It is also unsurprising to us that the Fed clearly called out China’s challenges in the press release on its latest rate-hike decision.

Focusing on the rate of change and central bank moves

Within our global equities team, we often say that the key difference between equities and fixed income is that the former focuses on the rate of change for any variable, or on the first derivative, while the latter focuses on the change in the variable. This is logical given where the two asset classes sit in the liability stack of company balance sheets. In equities we are intensely focused on the rate of change, and we see that for core inflation, for one, the rate of change is not worsening. Recent company surveys of wage growth expectations over the next 12 months in the US indicate wage growth expectations have peaked, with the percent of companies expecting an increase declining from approximately 80% to 70% as of 12 April 20224). The largest employers in the US are saying that they may have over-invested in labor and warehousing, incorrectly assuming that lockdown-style consumer buying behavior would continue, catching the largest retailers in the country flatfooted with the wrong inventory and overinvestment in online deliveries.

There is little that central banks can do about cost-push inflation, from supply-chain disruptions due to Covid in China, to disruptions in wheat exports from Ukraine, or to energy price disruptions due to Russia. However, there is much that the Fed can do to tame the very hot US housing market, with the Case-Schiller index rising by about 21% year over year5 – an unhealthy level given our experience of housing busts around the world and their impact on economies. There is a housing shortage in the US, as evidenced by a rise in the household formation rate paired with a static volume of new construction. The Fed has seemingly restricted household affordability mainly through the powerful effect of its words, moving the mortgage rate almost in a straight line this year, from about 3% to approximately 6%.

Household home equity in the US has reached a new record of $27.8 trillion, an increase of 13% per annum over the past 10 years.6 With household affordability in decline, and since home equity and the stock market are the key drivers of net consumer wealth in the US, we can assume that consumer spending growth is likely to slow from the high single-digits in the coming months – a prediction supported by the slowdown we’re already seeing in credit card spending data. From our bottom-up viewpoint, it is entirely right for the Fed to raise the federal funds rate to neutral and for the European Central Bank (ECB) to abandon negative interest rates and their damaging impact on the banking system, which inhibits the supply of credit. From an equities viewpoint, the impact on demand of moving from ultra-low or negative interest rates to more “neutral” levels is low, since companies have generally locked in low rates for a long period.

Equities are a “long-duration” asset class, which means the 10-year bond yield is key, and hence the pace of quantitative tightening globally is more our focus. Given the fragilities globally, it is no surprise that the major central banks are taking a gradual and data-dependent approach to reducing their balance sheets. Just as quantitative easing was a powerful force supporting markets and the economy following the 2008 financial crisis and the 2020 pandemic-driven lockdowns, we believe its reversal, or quantitative tightening, will be executed in line with the prevailing economic conditions and as the incoming data warrants. That is why there are strong arguments that the market is wrong in thinking that the Fed is “behind the curve” when it has the capability to speed up or even to slow down the reduction of its balance sheet as conditions dictate, that it has already achieved its objective of dampening consumer demand by curtailing the rate of growth in home equity, and has accelerated the pace of normalizing the fed funds rate to neutral.

Taking advantage of valuations as underlying trends remain strong

For longer-term investors, the current conditions provide fertile ground for buying not just good companies, but great companies that were too expensive before now – with strong visibility and valuations we view as modest, on the premise that the big-three dislocations are not likely to deteriorate significantly from here. That said, the war in Ukraine is clearly more difficult to predict.

Every cloud has a silver lining, and we believe the generalized sell-off provides an opportunity for investors to buy companies set to benefit from the powerful longer-term trends shaping the world, including digitalization, investments in carbon neutrality, and diversification of supply chains – none of which are likely to be derailed by the short-term disruptions we’re now facing. We think now is the time to take a hard look at one’s portfolio and to selectively upgrade its holdings, since these opportunities do not come by every day.

For more investment insights, visit our 2022 Midyear Investment Outlook.


1 CTA Scenario Analysis, Goldman Sachs Global Markets Division, as of 18 May 2022.
2 Bloomberg, Standard Deviation of stock level estimates, 24 June 2022.
3 FlightAware and Barclays Research as of 23 June 2022.
4 Evercore ISI Company Survey Report, 31 March 2022.
5 S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index YOY%, Bloomberg, data as of 31 March 2022.
6 US Federal Reserve, Bloomberg, data as of 31 March 2022.


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