Portfolio Perspectives, February 2024

A desynchronisation in global growth

Equity markets have had a respectable start to the year with the world index returning almost 5.5% in euro terms year-to-date. Economic momentum remains strong in the US, which is helpful, but the earnings season has been the primary driver of the move in equity indices. However, the move in equity markets has become narrow again. If we look at an equal weighted world index it is just about in positive territory in euro terms.

Thus far this year the performance of the global economy has been desynchronised. The US continues to defy the forecasters and is accelerating again. The euro area is stalling and China, while growing at close to 5.0%, is skirting with deflation and a depressed property market. Inflation data is more mixed and interest rate expectations in the developed world have deteriorated. This has flown through equity markets. Of the 11 sector groupings, four are down year-to-date. The interest rate-sensitive sectors (Property and Utilities) and the sectors sensitive to Chinese growth (Materials and Energy).

The top performing sectors are IT and Communication Services, and it is the earnings outcome that is delivering their strength. The large caps in these sectors have delivered better results than expected as sales momentum was maintained in the fourth quarter. The only other sector to out-perform this year is Healthcare. Some of this is due to recovery from relatively poor performance in Q4 2023 but results from the sector have also given a boost.

We are still travelling through the fourth quarter results season, and we are seeing desynchronisation here as well. In the US, profits for the quarter are 7% higher than forecast. In the euro area, earnings performance is not as good, results are just in line with forecasts. Some of this is due to sectoral mix (higher weight in Commodity sectors and small exposure to the ‘new economy’) but a moribund local economy and struggling China is also weighing on the region. The worrying feature we see is that in the US, more companies are cutting guidance than raising it. We generally do not see this outside of recession periods which casts doubts over the current forecasts. This is why we are cautious on equity markets; profit expectations need to come down.

Bernard Swords,
Chief Investment Officer

Increasing portfolio duration 

We are more constructive on duration following the moves in fixed income markets in January. Longer duration bonds may not be overly cheap, but they are a lot more attractive today. Three factors which we consider when looking at bond markets today are:

1. Yields: yield moves became quite over-extended at the end of last year as markets became more excited about the prospect of rate cuts. Since then, yields have increased again, led by what you could call a sobering of expectations. As at the time of writing, the bund is yield is around 2.35%,and the primary driver of this increase has been the moves in real yields. The real yield is the yield that you receive after inflation adjustments and is largely considered a reflection of how tight or loose monetary policy is. This real yield is also a key measure of value when looking at bond valuations. So, to be able to buy bonds with a better real yield, one in line with early December, is a lot more attractive relative to what we saw at the end of the year or in early January.
2. Central bank messaging has softened: we had two central bank meetings in January that we paid particular attention to, the ECB meeting and the FOMC meeting. In Europe, Lagarde stated that rate hikes were likely to happen in summer of this year but failed to push back explicitly on early cuts. Whilst, in the US, the FOMC dropped their reference to a tightening bias in their statement. Both events were considered by the markets as a shift in tone in a more dovish direction.
3. Inflation data and expectations continue to fall: there have been some pockets of concern, such as supply chain delays in the Red Sea, but when Lagarde was asked about this at the ECB meeting she stated, that they were watching this closely and not overly concerned. In addition to this, a key focus within inflation markets for the ECB is wage inflation and we also saw some softening of language here too from the ECB as Lagarde seemed to emphasise the progress showing up in forward-looking wage data.
   

As we cover in more detail below, we have increased portfolio duration – and the moves to do so bring us to a neutral duration stance from a strategy perspective. Within our portfolios, we have a higher allocation to high-quality investment grade corporate bonds relative to the Bloomberg Euro Aggregate Index. Corporate bonds as we know offer a higher yield relative to government bonds to compensate investors for that additional corporate risk. Corporate bonds also typically have a lower duration profile relative to government bonds. Hence, as we have a higher allocation to corporate bonds that provide higher yield, but have lower duration, our natural neutral duration stance will be slightly lower than an index with less corporate bond exposures such as the Bloomberg Euro Aggregate Index.

Elizabeth Geoghegan,
Head of Fixed Income Strategy

Equity and fixed income allocation changes

This month, we made a number of modifications to our flagship portfolios within both the equity and fixed income allocations in response to evolving market conditions. 

The most significant change to our portfolio construction comes from our fixed income allocation. We have been incrementally increasing the duration of the portfolios since Q4 of last year, moving away from the shorter maturity profile which we successfully employed through 2022 and early 2023. At our latest Asset Allocation meeting, we made the decision to increase duration once more moving to a more neutral duration standpoint from a strategic point of view.

We increased the weighted maturity profile of our fixed income portfolios, using longer duration European government bonds. From a strategy perspective, we consider the portfolios neutral duration. However, relative to the Barclays Euro Aggregate Index, we retain a slightly lower weighted duration. This is because our government bond maturity profile is balanced by an overweight or higher allocation to corporate bonds which have a higher yield and lower maturity profile relative to the overall investment grade fixed income universe.

Within equities, we continue to favour a defensive bias with overweight positions in sectors such as Healthcare and Industrials. The only change within the positioning is a rotation within the mix of our Healthcare exposure – increasing our exposure to the Medtech sector and reducing the allocation to pharmaceuticals with deteriorating pipelines.

There are three key drivers of this rotation: 

• The drivers of structural growth for the sector remain a positive, with ageing populations, low emerging market exposure and high barriers to entry.
• Earnings expectations for MedTech are depressed despite volumes recovering to pre-COVID levels. These lower expectations are due to the inflationary outlook, supply-side bottlenecks, and unquantified GLP-1 (Ozempic) drug impacts. If supply chains can continue to normalise and we see further disinflationary effects without causing a major slowdown, then there is potential for upside surprises to margins set against the current low expectations.  
• Going into an election year, Medical Devices typically offer a hedge against political rhetoric. US MedTech has outperformed US Healthcare in the 30 months leading into the last two US Presidential elections. This outperformance is especially pronounced as we get closer to the election.
  

Sarah Quirke,
Head of Investment Solutions