Top Down

Growth indicators were reasonable during the month. Retail sales and industrial production surprised on the upside in the euro area and there was even broader strength in the US. But the consensus forecast growth rates are still declining with the focus now on 2023. Forecasts for 2022 in both the euro area and the US were nudged up slightly as the incoming data has been more resilient than expected. However, it does appear at this stage that if a global recession is avoided in 2023 it is likely to be by a small margin. The one part of the globe that has been struggling over the last month is China. Its zero-tolerance approach to the Covid virus is yielding a stop-go pattern to economic activity and this does not seem likely to change. 

The minutes from central bank meetings showed some slight change. In the ECB meeting there was some discussion of the impact of the monetary tightening on the growth rate of the economy for the first time. It will continue to hike but we have the first signs it may be more responsive to activity levels. In the US the Federal Reserve has not changed its line of thinking. The ‘dot plot’ will be moving up but looks like it will lie below current market projections so there has been no new ‘bad news’.

UK back to normal?

The saga of fiscal policy in the UK is coming to an end. After a brief flurry with fiscal reflation the UK is now set on a course of fiscal rectitude. As a result, gilts yields and the Sterling exchange rate are now back to where they were prior to the ill-fated mini-budget of the Truss administration. While one could say everything is back to normal now the UK has been left committed to a tighter fiscal stance over the next several years than was the case before the whole episode began.

The recovery in bond markets was more about improved sentiment rather than any great change in expectations. In the euro area interest rates are forecast to peak at 3% and in the US at 5%, the same as a month ago. It is a good outcome that those forecasts have not increased, as for the past number of months we had a steady increase in them, so stability has been a relief. 

We have been increasing our fixed income exposure and we are not yet up to our target levels. The bond market has rebounded recently and hence we are holding our current position. There is a large gap again between 10-year yields in the euro area and US and where interest rates are expected to peak. We would like a more reasonable gap between them before increasing our exposure any further.

Equity markets have had a good run since the last Top Down, up over 7% in local currency terms. However, improved sentiment across financial markets led to a movement out of the ‘safe haven’ US Dollar bringing the euro return from world equities down to 2.8%. Better bond markets were a positive and the third quarter results season provided some relief. In the US, earnings were 3% above forecast but excluding the Energy sector this dropped to 1%. In the euro area the beat was 5% but ex-Energy this drops to 2%. This is below average but not a major surprise given the macro backdrop. There have been cuts to forecast earnings growth for 2022 (-1.2%) and 2023 (-1.8%). Earnings forecasts are coming down but are not expecting recessionary conditions overall. Valuation does lie below long-term averages so it has built in some downside to earnings but it can go lower.

There was a cyclical bias to sector performance over the last month and most of this can be put down to an increase in risk appetite. The best performing sectors were Materials, Industrials and Financials but these had been some of the weaker sectors in the previous month. Consequently, we would see these as relief rallies rather than any change in trend. We still believe that relative earnings growth will drive sector performances and that profit resilience of the defensive sectors will lead to outperformance in 2023.