Top Down
Changing the equity mix
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 the last edition of Top Down, financial markets have staged a recovery. World equities are up 9% in euro terms and the euro area bond market has returned 3.3%.
Over the last month, views about where policy rates will peak in the US and euro area declined – and that has been the main driver of the turn in financial markets. Lower commodity prices (oil is down 12% and industrial metals are down 15%), which reduced headline inflation pressures, have also helped.
The risks of a recession arriving in the developed world rose notably during the month as data releases softened somewhat. In turn, this was the principal reason for the reduction in the scale of expected interest rate increases.
Interest rates are now expected to peak at 3.25% in the US and 1.75% in the euro area. Both are 0.5% lower than a month ago.
Global economic outlook deteriorates further
The forecasts for economic growth were reduced again, with the biggest cuts coming in the euro area for 2023 owing to the outlook for energy supply and continued dislocations due to the war in Ukraine.
For 2022, global growth is expected to reach 3.2% and hold at that level next year. This is just at trend level now and the bias is downward. The main positive remains the labour markets, with unemployment rates remaining at record-low levels.
On the other hand, inflation forecasts increased and, as a result, there was little change to forecast nominal growth. In the US, the core PCE index – the Federal Reserve’s (Fed’s) preferred measure of inflation – fell to a six-month low but it still stands at 4.7%, well above the 2% target level.
In the euro area, core inflation levelled off at the last reading but that is all. This higher inflation is also putting pressure on real consumption. This is evident from the very low readings of consumer sentiment in Europe and the US which is adding to concerns about the economic outlook.
Central banks continued on their tightening path. The US Fed, as expected, increased interest rates by 75bps while the European Central Bank (ECB) surprised markets with a 50bp rate rise. The weakening in the euro exchange rate was cited as one of the reasons behind the faster rate of increase.
The ECB also made an announcement about the Transmission Protection Instrument – an anti-fragmentation tool which allows the bank to try and control peripheral spreads. It was sparse on details and gave no indication of the target levels of spreads. As a result, peripheral spreads have widened. However, the amount of support that can be given has been left ‘unlimited’ which is a good sign.
Asset allocation: what’s changed?
Fixed income markets performed well over the last month with core sovereigns in the euro area leading the way. A weak Purchasing Managers’ Index reading (the composite figure dropped below 50) and a greater-than-expected interest rate hike left investors confident in the ECB’s goal of getting inflation under control.
Last month, we increased our exposure to euro area core sovereigns as we thought yields had risen to attractive levels. Since then, yields have dropped by almost 75bps, down to levels where we would not add exposure.
Meanwhile, equity markets rebounded strongly, helped by better bond markets and the second-quarter reporting season, which is proving supportive. Going into the reporting season, earnings forecasts had hardly changed. However, there were sectoral shifts.
There were upgrades to the commodity sectors, including Energy and Materials, and elsewhere, forecast growth rates are flat to down. Consumer Discretionary has seen the largest cut to forecasts coming from the retail sector as consumption moves from goods to services.
The beaten-up sectors (Consumer Discretionary and IT) have led equity markets over the last month, owing in part to a relief rally and also due to the better-than-expected earnings outturn.
This was followed by the defensive sectors: Healthcare; Consumer Staples and Utilities. With a slower growth environment, we expect defensive and dependable growth to attract more attention. Thus, we believe the defensive sectors will continue to outperform.
Changing our equity mix
We have held an overweight position in Consumer Discretionary in the expectation of the re-opening of economies. Earnings for some of the sub-sectors were particularly depressed and we believed there was scope for a large rebound in earnings. We think that has now been factored in. Forecast earnings are now back to where they were pre-Covid.
Consequently, the scope for material earnings outperformance is limited from here, especially with the headwinds that the consumer is facing in terms of the rising costs of everyday products and energy.
We are using the proceeds to increase our holdings in Consumer Staples. Valuations are reasonable, slightly below long-run averages, while earnings should prove more resilient than the broader market and could enjoy a boost should commodity prices continue to soften.
Bernard Swords,
Chief Investment Officer
Please note: the next edition of Top Down will be published in September.
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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