Top Down
A Soft Landing in the US Still Possible
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.
Macro Background
Since the last Top Down (21 June) financial markets have been relatively flat. World equities are up 0.4% in euro terms and the euro area fixed income market is down 0.1%. Better inflation data in the developed world helped bond markets but central bank commentary about keeping rates higher for longer offset this. More stable bond markets helped equity markets, as did the resilience in earnings forecasts. But the move in equity markets remain relatively concentrated with the ‘AI theme’ still pushing indices up.
The regional differences in the global economy, which we noted last month, gained further momentum. The US economy is proving to be more resilient than expected. Job creation remains strong, and this is putting a prop under consumption. The euro area and China are telling a different story. In the euro area, the manufacturing sector continues to contract and while consumption is holding up, it is not delivering enough momentum to offset the manufacturing weakness. Economic growth forecasts are under threat in the region. In China, the impact from lifting Covid-19 restrictions is fading faster than anybody expected. Not only has internal demand started weakening but external demand is also suffering, and youth unemployment is hitting its highest level on record. Without some policy action China is unlikely to hit its target of 5% growth in 2023.
The inflation news is better and there is greater confidence that we have passed the peak in core and headline readings. We have now had two reports of core inflation declining in the euro area and both were lower than expected. In the US core inflation took a reasonable step down in the last reading to 4.8% from 5.3% in June. As a result, it looks like the peak of inflation has passed.
At the moment the market is still pricing in interest rate cuts in the first half of next year. This seems optimistic to us as central banks remain in tightening mode. The European Central Bank (ECB) raised its inflation forecasts and maintained that more needs to be done to bring inflation down. In Sintra, at the ECB conference, President Lagarde highlighted the threat of persistence in the inflationary pressures. At the same conference Chair Powell from the Federal Reserve clearly stated there could be another two rate hikes before the end of the year.
Fixed Income
Fixed income performance in Europe was marginally negative. Rates rose slightly due to the more aggressive language from the ECB, but the damage was limited as economic data for the region continues to show signs of weakness. Credit markets outperformed sovereigns as spreads narrowed due to robust profitability and balance sheets. We still believe that the degree of inversion (downward slope) of the yield curve is unjustified and thus keeping duration short is the best option. A weaker economy is holding longer rates down but the gap is too large at the moment.
Equities
World equities were led again by the US and posted modest returns in euro terms. Some of this can be put down to sectoral weightings. The US has a larger exposure to IT and Communication Services and low exposure to the Commodity sectors, but the swing in economic momentum from the euro area and China to the US would also have been a factor. The idea of a ‘soft landing’ in the US is gaining traction again.
Earnings forecasts were resilient with only small moves at the global level. The main weakness that we are seeing are in the Commodity sectors (Energy and Materials) with strength coming through in the Consumer Discretionary sector. The second quarter reporting season has just started and given the reasonable economic background during the quarter, we believe there should be no shocks. Sentiment is high, so it will probably need a very strong reporting season to push us on from here.
Asset allocation: More exposure in the euro area
Positioning
The only change we made over the last month to model portfolios was altering the fixed income composition of your portfolio. We switched some of our international exposure back to the euro area. The combination of higher European yields and the significant rise in hedging costs, meant that allocations to US hedged bond holdings were no longer attractive when compared to European government bond alternatives.
We have not changed the asset mix since the last Top Down (21 June). Asset prices are little changed and the data flow at the margin have favoured a cautious outlook. Growth momentum in the global economy is slowing especially at the nominal level which is important for earnings growth. Hence, we still favour fixed income over equities. If interest rates rise further, equities have more downside than bonds. If they fall, it is likely because economies have got into trouble which would probably produce positive returns for fixed income but negative for equities.
In both asset classes we are defensively positioned. We are keeping duration short in fixed income as markets are still pricing in interest rate cuts in the first half of next year. In equities, we maintain our preference for sectors with resilient earnings growth, preferring Defensives over Cyclicals. Within Defensive sectors we look for those that can provide growth (Healthcare and Consumer Staples) and within Cyclicals we seek sectors which have some structural growth (Industrials and Consumer Discretionary).
Outlook
Equity markets have been bolstered by a belief in a ‘soft landing’ for the US economy. This may turn out to be the case, but it will leave us with a US economy that is growing at a sub-trend rate with little left to lift that growth rate. With the euro area and China decelerating this means sub-trend growth across the globe this year and next. That is not a good environment for equity markets especially when recent performance has been good and valuation is not low. For fixed income markets, we need to see the expectation of interest cuts removed. We are almost there in the US and too far away in the euro area. There is more certainty around fixed income asset into Q3 and beyond.
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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Warning: This does not constitute investment advice as it does not take into account the investment objectives, knowledge and experience or financial situation of any person. You should not act on it in any way and are advised to obtain professional advice suitable to your own individual circumstances. The value of your investment may go down as well as up. You may lose some or all of the money you invest. Past performance should not be taken as an indication or guarantee of future performance; neither should simulated performance. The value of securities may be subject to exchange rate fluctuation that may have a positive or adverse effect on the price or income of such securities.
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