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A New Year with Familiar Problems
Every month, our Asset Allocation Committee meets to discuss and debate our market outlook.
How has our asset allocation changed month-on-month?
Chief Investment Officer, Bernard Swords, presents our views.
Markets ended on a weak note in December. With both bonds and equities down double digits for the year, there’s no doubt it has been a difficult year for investors. The upward trend of inflation and the moves to fight it, were big topics in December, but the economic growth outlook began to feature a bit more than prior quarters. The new year has brought some cheer. Fixed income markets are almost back to where they were in September and world equities have recouped half the losses from December.
Be wary of central banks
The European Central Bank was explicit in their rhetoric about having to raise rates aggressively at a faster pace to get inflation under control: "interest rates will still have to rise significantly at a steady pace”. In the US, members of FOMC (Federal Open Market Committee) were unhappy with the unintentional easing of financial conditions driven by the markets’ expectations of interest rates into 2024. As a result, the expected peak level of interest rates in the euro area and the US increased by 0.5% to 3.5% and 5.0% respectively.
Inflation picture is improving
For the last three months in the US, inflation readings have been at or below expectations at both headline and core level. Core goods prices fell on a month-on-month basis in all three reports. In the euro area, it is only at headline level that we have seen deceleration, as the core rate reached a new high at the last reading.
Weak growth outlook
Data released during the quarter showed developed economies are proving to be more resilient than expected and the out-turn for 2022 is likely to be better than thought. The euro area has avoided the worst impacts feared from the energy crisis, and natural gas prices have fallen significantly. However, we are still seeing downgrades to the outlook for 2023. The US was losing momentum and the non-Manufacturing ISM dropping below 50 is a worrying sign. China is facing its own challenges as it removes most of its Covid-19 restrictions. A sharp downturn is expected there in the short-term followed by an equally strong rebound towards the end of the first quarter, similar to what Europe and the US experienced in 2020. China will be a drag on the global economy in the coming months but is likely to augment global growth from the end of Q1.
Better sentiment in markets
Both bonds and equities have started the year on a strong note. Some of this is due to a rebound in sentiment after a very weak end to 2022. However, there have been some positive developments. For fixed income markets, while the Federal Reserve remains aggressive, there could be enough easing in the inflation data to change their rhetoric towards the middle of the year. While fixed income markets have improved, having short duration has been the best strategy. This has helped investment grade instruments out-perform. We expect this to continue, maintain low duration and pick up the additional spread from corporate credit until it is clear where policy interest rates peak.
Equity markets have started the year well. In Europe, the energy fundamentals were better than expected. Natural gas supply appears plentiful for this winter, meaning no production outages and rapidly declining natural gas prices improved the input price outlook for manufacturers. In China, the focus has been the authorities’ move to immediately remove the vast bulk of Covid-19 restrictions. The hope is that the economy will follow a similar path to that of Europe and the US in 2020/2021, and with it the equity market.
The fourth quarter results season is now starting. Over the last three months there have been only modest adjustments to 2022 forecasts, but more significant cuts to 2023. Profits are now expected to grow by 9.2% in 2022 and 2.7% in 2023. With global economic growth slipping towards 2% in 2023 and pricing power weakening, it will be a very challenging year to deliver earnings growth.
Raising fixed income exposure again
In December, we altered our asset mix, bringing our fixed income allocation to a neutral level for the first time in many years. Yields had risen to levels that the income return from fixed income looks attractive relative to a deposit rate. Inflation is showing signs of falling, which should mean the risk to fixed income markets will be lower. In times of growth concerns, which we think will take centre stage this year, fixed income assets should be able to give some stability to portfolios. Central banks may not react quickly to declining inflation statistics, so we increased our exposure to short, dated bonds. We also grew our protection against a growth scare by increasing our holdings in sovereign bonds. We remain well over-weight in investment grade corporate debt.
We reduced equities to underweight. They rallied strongly into early December as sentiment recovered from extremely low levels, bringing valuations back towards neutral. There was no improvement in the earnings outlook and the downgrades were starting to accelerate, a process we expect to continue. In cutting our equity exposure, we did reduce our over-weight in the defensive Healthcare sector as our weighting had become large and its strong recent performance has pushed the valuation into the top quartile of its historical range. We remain over-weight in defensives but with a slightly reduced position.
Asset allocation: A reset to neutral
A slowdown on the horizon, but not a stop
2022 was a very difficult one for investors as there were significant corrections in both bonds and equities. The new year should be better. There has been a significant resetting in bond yields, and we expect positive returns from fixed income markets. Equity markets remain hostage to the performance of the global economy, and it is still deteriorating. But valuations have declined, and an attempt has been made to price in near recession conditions. Employment levels are very high so that if a recession does arrive it will likely be a shallow one and thus the downside to equity markets does not appear large and hence our moderate underweighting to the asset class.
Bernard Swords,
Chief Investment Officer
Bernard joined Goodbody in 2002 and is Chief Investment Officer. As CIO, he formulates and implements the global investment strategy and chairs the asset allocation committee. Bernard also leads the investment research team.
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