Top Down
Much ado about nothing?
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.
If you look at the market moves since our last edition of Top Down in July, you would think that there has been ‘much ado about nothing’. Equity markets were down 0.1% in local currency terms (although a weak euro converted this into a total return of 3.4%). Bond markets were no more exciting with a total return from the euro area bond market of -0.6%. On the positive side, the belief in a ‘soft landing’ for the US economy gained further traction, which helped equity markets. Conversely, there was a growing acceptance that interest rates would be higher for longer in the developed world which depressed all markets. And growing troubles in the Chinese property market weighed on sentiment.
Against this backdrop, the outlook for the global economy is somewhat more challenged than it looked a couple of months ago. The euro area avoided a significant downturn in the early part of the year but has shown little momentum since then. The manufacturing sector is still declining, and the services sector is beginning to stall as the reopening impulse fades. Economic growth forecasts for the region have been cut and there is further downside.
Chinese growth has also been downgraded as the property downturn gained momentum and started impacting on consumer sentiment and consumption. The authorities have responded by bringing in measures to support the property market, so we could see some stabilisation soon. The one bright spot in the global economy is the US. The US consumer has proven stronger than expected due to a tight labour market and the scope to use pandemic-related savings to augment spending. As a result, forecasts for the US economy have been increased.
The mood music has changed
The biggest change since the summer has been the change in mood of central banks, the European Central Bank (ECB) in particular. Up to the middle of the year, ECB President Lagarde had maintained the line that ‘more had to be done’ to bring inflation under control. However, at the August policy meeting that line was dropped.
The ECB raised interest rates after September’s policy meeting – although the vote was not unanimous. Policymakers stated that: “rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target”. Once inflation continues its downward path, this amounts to a pause. At the start of the year, the ECB was expected to be later than the Federal Reserve in pausing, but it now looks like it will be pausing at more or less the same time. Owing to this, the euro has weakened over the last couple of months. The gap in interest rates between the US and the euro area will not be as narrow as thought before.
Looking at fixed income markets, in Europe, they recorded a modestly negative performance since the middle of July. Bond markets were pricing in the ‘higher for longer’ narrative across the developed world. Europe held up better because of the ECB’s change in mood. Yield curves flattened modestly (longer dated yields rose more than shorter dated yields) and we expect this process to continue. The belief in a ‘soft landing’ for the US economy resulted in credit spreads narrowing over the last couple of months.
Meanwhile, world equities traded sideways as they balance the push of a stronger US economy and the pull of interest rates being higher for longer leaving no big theme to drive sector performances. Energy was the strongest sector following a major recovery in the oil price since June. This was followed closely by Financials as interest rates in the developed world are likely to have peaked. Healthcare also enjoyed a strong performance thanks to some good product development news. The biggest laggard was IT as Apple’s woes in China dragged the sector down.
Asset allocation: what’s changed?
In the last couple of weeks, we have been reducing our equity weighting and increasing our fixed income exposure. The year has turned out more favourably for equity markets than we expected. But we believe that as equity markets have moved higher, they have priced in this surprisingly good news and the growth background will become more challenging. Meanwhile, bond yields, in particular at the short end, are offering attractive rates of return against cash deposits. It does look like we are close, if not at the peak in interest rates in the euro area – and this would remove a major uncertainty for bond markets and a prop to valuation.
Within our equity portfolios, we have remained defensive but we have added exposure to the energy transition theme. We also included an ETF which gives exposure to the capital expenditure that must go into upgrading and increasing the capacity of the electricity networks. It does have cyclical exposure, but we believe the secular growth trend will outweigh its past cyclicality. In our fixed income portfolios, we added short-term government debt as we still feel that the lower yields on longer-dated debt are not as attractive. Our non-euro area exposure is reduced further, as the hedged yields we get elsewhere in the world are less than short-dated euro-area debt.
Greater challenges ahead?
Financial markets treaded water in the last couple of months but they will probably face greater challenges to the end of the year.
The US economy has been performing well. However, it is unlikely to maintain that momentum. Fiscal policy was looser than expected in the first half of the year and this is likely to go into reverse. Consumers cannot draw down savings forever, especially in the face of rising energy costs, and consumption growth is likely to slow. China may stabilise but it is difficult to see it re-accelerating. Meanwhile, the euro area will face another winter of energy challenges. So, as we look to the months ahead, it looks like a better background for fixed income than equities.
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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