It has been a couple of months since we sent out our last Top Down and it has been a pretty pleasing period. World equites have retuned almost 6% in euro terms since the middle of June and the broad euro area fixed income market has given us almost 2%. For the equity investor we had a strong reporting season across the globe leading to further profit upgrades. Earnings for 2022 are now expected to be 16% higher than forecast at the start of the year. The bond market got a boost from the new policy framework adopted by the ECB. It has now moved towards needing actual inflation to move above target and not just forecasts. Latterly the spreading of the Delta variant of Covid 19 has caused some concerns over the economic recovery and this has led to some jitters in equity markets and driven a slight flight to safety into government bonds.
And have we been on holidays?
Well actually we have made some changes over the last month. The move in equity markets this year had increased the equity exposure in our multi-asset funds by between 3% and 5% leaving us with very high equity exposure. Since the second quarter we have felt that the economic momentum would peak sometime in the third quarter and our investment strategy would have to change to reflect that. We started by altering our equity mix, reducing deep cyclical exposure and moving towards sectors and companies with more dependable growth but left our asset distribution unchanged.
Over the last couple of months economic data has been more mixed and the sector leadership in equity markets has moved to the dependable and structural growth sectors (IT and Healthcare). The commodity sectors (Materials and Energy) declined during the period. We do seem to be transitioning from the recovery phase of the cycle to the expansion phase. As we move into that stage of the cycle returns from equity markets start to decline. With that change in potential returns it seemed prudent to bring our allocation to equities back to where we had it at the start of the year.
The other factor that was weighing on us was the recovery in the bond market. 10 Year yields across the world had almost fallen to the level that they were at the beginning of the year. But economies are operating at a much higher level than we expected back then. We have seen the resultant inflationary pressure and the supply chain problems which, in the short-term at least, are compounding those inflationary pressures. We felt that we were nearing the end of the emergency support from central banks. From the last set of FOMC minutes the Fed does seem to be getting ready to start tapering. Lastly the disruption to the economy from the spread of the Delta variant is likely to be transient and confidence in the recovery will be restored. For these reasons we thought that this was as good as it was going to get for the bond market and there could be some turbulence there which could pass over to the equity market as well.
Do not get us wrong, we remain positive on the outlook
What we have been doing in recent months is positioning portfolios for the transition of the global economy from the recovery phase, where you have above trend growth and the growth rate is accelerating, to the expansion phase, where the rate of economic growth decelerates but it remains above trend. But this is still a good period for equity investment. The ISM Manufacturing Index is one of the indicators that is closely followed as an indicator of the health of the US. It does appear to have peaked. Looking at data for the past 30 years, in periods when the ISM has recovered from below 50 and then peaks but still remains above 50 (i.e. the economy remains in expansion) the S&P 500 was up in all of them. The average return in these ‘past the peak but still in expansion’ phases was over 30% (worth pointing out the average period here lasted 3 years). So, we are still in a good environment for equity investment.
One could not issue a Top Down now without some mention of developments in China. At the moment we are in observation mode on the region. The government has brought in policies that curtail the profitability of some industries and wants to see highly profitable companies and industries give back something to society which would mean lower earnings growth going forward. This has impacted on the region; Asia Pacific ex Japan is down almost 10% since the middle of June. The region is also being impacted by the switch over from goods consumption to services consumption as the Western economies opened but that does not justify the extent of the falls we have seen. There could be opportunities but in authoritarian countries you need to be on the right side of government policy so we will tread carefully.
Just carrying on the same transition
Since the end of the first quarter, we have been transitioning our portfolios for a maturing in the economic and investment cycle. We started with our sectoral mix in equity markets and we will be doing more here going forward, now we have adjusted our asset mix. Good market performance had produced a high equity content for us. We felt it prudent to reduce this given we are transitioning into a period of more subdued equity returns but we still remain well overweight equities.
