Top Down
Cautious stance still warranted despite calm markets
Every month, our Asset Allocation Committee meets to discuss and debate our market outlook.
How has our asset allocation changed month-on-month?
Senior Research Analyst, Sebastian Orsi, presents our views.
Macro Background
It’s only a few weeks since our last Top Down (26th April), so the broad themes running through markets are unchanged: the outlook for a ‘soft landing’ in the US, slowing but still high inflation, and earnings resilience. There has been relative calm within the US regional banking sector. The Q1 earnings season continued as it began, better than expected. Markets seem relatively sanguine about the potential for an agreement to raise the US debt ceiling, although nothing has been confirmed at the time of writing. With these tailwinds global equities have generated 3.7% returns in euro terms over the period. Fixed income markets have also generated positive returns, +0.2% for the euro aggregate bond market.
The most recent economic growth indicators from most regions have been better than anticipated. Services have been relatively strong, while more cyclical manufacturing surveys have been seeing slower contraction. Overall growth forecasts remain stable. There appears to be lower probability of a US recession. Still, growth is expected to remain below trend into 2024.
The divergence between US and European inflation trends has continued. In the US there have been greater signs of slowing inflation. CPI and Core CPI were broadly in line with expectations and year-over-year (y/y) trends are slowly ticking down. The Core Services ex-Shelter inflation rate that Fed Chairman Powell has flagged as something he’s watching as a broad inflation indicator, is now running lower. The Fed has indicated a pause is likely at its next meeting, and most analysts believe terminal policy rates have been reached in the US.
The ECB has more ground to cover. Headline euro area inflation was 7.0% in April up from 6.9% in March. Core CPI is running relatively steady at 5.6% year-over-year but ticked up to 1% sequentially in April. The ECB remains firmly focussed on bringing down inflation and is expected to make two further 0.25% hikes in the coming months.
Fixed Income
Fixed income markets have been slightly positive in Europe since our last update, 0.20%. US fixed income returns have been slightly negative. As growth indicators have come in better recently, yields have been ticking slightly higher across the curves. The US curve has become more inverted. There has been no recent change in market expectations for terminal policy rates. The moves in interest rates are thankfully modest compared to those seen in 2022, and fixed income returns remain modestly positive year to date. Government bonds have slightly outperformed corporate.
Equities
As noted above, equity markets have generated relatively good returns since our last update, +2.0% in local currency terms. Recent euro weakness has pushed up the returns to 3.7% for euro denominated investors. Global equities have had strong performance year-to-date, with 7.0% returns in euro. Geographically, Japanese and US equities are leading. Recent sector leadership is mostly consistent with year-to-date trends, with IT, Consumer Discretionary and Communications Services strongest. Cyclicals have generally outperformed defensives, although defensives proved themselves through the March/April volatility.
The Q1 earnings season has been stronger than anticipated in Europe and the US. US companies’ earnings have come in ~7% better than anticipated, but with -2% growth compared to Q1 2022. In Europe, there has been ~13% outperformance with 8% y/y growth reported (noting that European interim reporting is less detailed). So, earnings have been better than anticipated, but without an increase to full year earnings forecasts.
Still, the outlook for 2023 is one of flat earnings per share growth, with a high degree of variability between sectors. The outlook for sub-trend economic growth and falling inflation makes us somewhat doubtful about earnings forecasts. Despite this, equity valuations are now slightly below long-term trends.
Asset Allocation: Cautious Outlook
Positioning
We have not changed our model portfolios’ asset allocation since the end of April. We remain cautious, with the asset mix favouring fixed income over equites, reflecting where we are in the economic cycle.
There are two key features in fixed income markets that have influenced our positioning in the asset class. Firstly, US and euro area yield curves are steeply inverted, where short-term yields exceed longer term yields. This has typically predated recessions in the US (with a very uncertain lead time) but hasn’t featured in Europe previously. It also implies markets expect central banks to be cutting rates. With resilient growth, low unemployment, and persistently high inflation, we think markets may be too optimistic in their outlooks for central bank policy rate cuts in 2023/24, hence we prefer to keep duration short. Secondly, the spread between US 10-year bond and German 10-year bund yields has narrowed dramatically. Combined with high currency hedging costs to translate returns back to euro, this makes us prefer European fixed income over US.
Our equity exposure remains defensively positioned. We are concerned about the level of earnings growth that will be achieved this year and thus the portfolio is skewed to the sectors with the more reliable earnings. As a result, there are overweight positions in the Consumer Staple and Healthcare sectors and underweights in the cyclical areas of Energy and Materials.
An additional very near-term point of concern is the US debt ceiling. While there is recent optimism that a deal to raise it will be agreed, market volatility has historically increased as the deadline approached.
Sebastian Orsi,
Senior Research Analyst
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