Top Down
Bonds look attractive again
Every month, our Asset Allocation Committee meets to discuss and debate our market outlook.
How has our asset allocation changed month-on-month?
Here Bernard Swords, Chief Investment Officer, presents our views.
Since we published the last edition of Top Down, it has been a turbulent time for financial markets – and a particularly difficult time for investors. Equites and bonds tumbled: world equities fell 6% in euro terms, while the euro area bond market returned -4.3%.
There was nowhere to hide. There was a resurgence in inflation in the US and, in the euro area, inflation did not ease. And the consequent increase in interest rate expectations was the primary factor in the weakness of asset markets. Dislocation in the UK gilt market since the end of September added further tensions to already stressed financial markets.
The risks of a global recession have risen further over the last month, but this has not eased interest rate fears. In the past when global growth was slowing, inflation fears and interest rate expectations would be declining. However, we have not seen this come to pass on this occasion. The global economy has been decelerating but the inflation readings keep going up. This has un-nerved investors.
Growth outlook down again…
The outlook for economic growth deteriorated again during the quarter, with forecasts for the developed world reduced again. Global growth is expected to be below 3% for both this year and next which is below trend. Higher energy prices weighing on consumption and the impact of the tighter financial conditions have been the primary drivers of the downgrades.
There are fears of a global recession, and the probability is now about 50% and rising. However, labour market statistics are still well off recessionary levels and have been improving of late which keeps us guessing.
… but this has not changed central banks’ response
Central banks remain in an aggressive mode with comments that inflation must be brought under control, and this could entail ‘some pain’. As a result, interest rate expectations went up again. One month ago, the European Central Bank was forecast to move the policy rate up to 2.75% in 2023 – that has now been increased to 3.0%.
In the US, the Federal Reserve was expected to move rates up to 4.5% in 2023 – that has been raised to 5.0%. The persistence in inflation remains the cause of these changes to the interest rate outlook. In the euro area, we have yet to see either core or headline inflation decline on a year-on-year basis. In the US, core and headline inflation were on a downward trend but that got disrupted with September’s data.
Do not fight the bond market
We are in the middle of a policy fiasco in the UK. A “mini” budget announced at the end of September sent the UK gilt market into a ‘tailspin’ which forced the Bank of England to intervene to restore some order. It has cost the Chancellor of the Exchequer his job and who knows who else may have to resign.
The new Chancellor, Jeremy Hunt, has reversed practically all of the measures outlined in the “mini” budget and is stressing stability rather than stimulation. There is a fiscal gap which he will have to address at the end of the month when he outlines his medium-term plan, so this is still an evolving story. We now need to see what the Bank of England makes of this policy. Sterling assets have recovered somewhat but have not returned to the pre-mini-budget levels. Given that uncertainty is going to remain about policy and politics in the UK that seems sensible.
The fixed income markets bore the brunt of this interest rate outlook change. The broad euro area bond index delivered -4.3% since the last Top Down as higher interest rates got priced into the market. Corporate debt did hold up a little bit better, returning -3.7% during the quarter due to its shorter duration.
The increase in peripheral spreads in the sovereign market following the Italian election undermined the returns from the sovereign market. Keeping duration short remains the key strategy in fixed income.
Asset allocation: what’s changed?
Equity markets took their lead from bond markets
Equity markets followed bond markets declining 6.0%. By region, emerging markets were the weakest, with a strong US dollar and a big upward shift in US interest rates being the major drivers. The ranking of sector performances was also driven by movements in the bond market.
Bond yield sensitive sectors, Utilities and Communication Services, were the worst performing during the period. Energy was the best performer owing to OPEC’s decision to cut production; this was followed by the defensive sectors, Healthcare and Consumer Staples. These remain our favoured sectors at the moment.
The third-quarter results season is starting, but expectations are low. There have been some adjustments to earnings growth forecasts both from company preannouncements and from analysts reviewing their figures. Profits are now expected to grow by 9.8% in 2022 and 6% in 2023. The main downward revisions have been to sectors that had very strong profit growth during the pandemic, namely Communication Services and IT.
The only sectors seeing upgrades are the Commodity sectors, namely Energy and Materials. There are fears of profit misses this quarter, so if the outcome is close to forecast that will probably be a positive for equity markets.
Using the weakness in bond markets to lock-in some positive returns
We are increasing our exposure to fixed income assets as the correction in the bond markets has pushed yields to attractive levels.
In Germany, the five-year yield has gone above 2% – well above what one can earn on deposit, and it is a safe haven asset. Volatility levels in bond markets have only been higher at the peak of the great financial crisis. Buying when volatility is high is generally a good strategy.
We do not know whether all of the interest rate fears are behind us and that is why we still target relatively short duration. Interest rate expectations have moved a lot this year, so we have ‘baked in’ quite high levels of interest rates.
If the forecasters are right about the growth trajectory of the global economy, then we will have to start seeing weak figures – this should ease inflation fears and with them interest rate expectations.
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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