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Reducing Consumer Discretionary to Neutral
Every month, our Asset Allocation Committee meets to discuss and debate our market outlook.
How has our asset allocation changed month-on-month?
Here Sebastian Orsi CFA, Senior Research Analyst, presents our views.
Global equities declined 2.2% in euro terms in August, although they are still well above the recent lows, while euro area bonds declined 4.9%. Some familiar factors were behind the declines: expectations for tighter monetary policy, European energy security, and China’s renewed Covid restrictions. Europe was the centre of weakness as euro area bond yields had a record monthly increase, despite rising recession fears. As the flow of natural gas through Nord Stream 1 was halted indefinitely, renewed European energy security fears drove a month-end equity sell off, although sovereign bond yields did fall slightly then (prices rose).
Expectations for monetary policy rose dramatically in August. US Federal Reserve (Fed) Chair Jerome Powell’s Jackson Hole speech mid-month pushed back on the dovish pivot view that the Fed will stop raising rates and begin cutting them in 2023. The speech was widely expected but bond yields rose anyway, and equities declined sharply. In the US, the market pricing of policy rates moved upward by 30–50 bps over the past month. The Fed is now expected to reach nearly 4% within the next six months and remain there longer than previously forecast.
Euro area inflation accelerated in August while unemployment remains at historic lows for the euro era. Combined with the weak euro, this put extra pressure on the European Central Bank (ECB) to accelerate policy rate increases and shifted yields higher by about 100 bps. The ECB moved rates up by 75 bps at its recent meeting and is expected to follow with another outsized increase at the next meeting. This is despite the squeeze on European consumers and businesses from inflation, particularly higher energy costs, which is undermining growth.
Consensus global economic growth forecasts were cut again in August, while inflation expectations rose. All the major global economic blocs are now expected to grow at below-trend rates in 2023. The ECB cut its euro area real GDP growth forecasts by 1.2% to 0.9% for 2023 and by 0.2% to 1.9% for 2024. The cuts were mainly due to higher inflation and energy prices. The ECB now expects euro area inflation to be 8.1% in 2022 (up from 6.8% previously), 5.5% in 2023 (up from 3.5%) and still above its target at 2.3% in 2024 (up from 2.1%). The forecasts assume a decline in energy and commodity prices. The risks to euro area growth still seem to the downside, and stagflation is an increasing probability.
China’s growth is also struggling with energy supply issues and renewed Covid lockdowns. The transmission mechanisms to the global economy are mixed and relatively limited. Exports have generally continued to flow and lower commodity prices are a positive.
Recession worries
For markets, the US is the most significant economy and clearly the probability of recession there has increased over the last few months. Real GDP is now forecast to grow at only about 1% for 2023, with inflation expected to average 3.7%. The Fed’s stance will likely remain restrictive. However, there are some positive signs. The US labour market remains robust. After a stunning July report, the August non-farm payrolls increase of 315k was also very strong. Importantly, there appears to be a labour supply response as the unemployment rate rose to 3.7% from 3.5% last month, due to higher participation. US inflation has also come down on a month-on-month basis – too early to call it a trend, but it is encouraging that the driver of central bank hawkishness may have passed its peak. Oil prices, which have historically been highly positively correlated to inflation expectations, also pulled back about 15% in August.
With rising interest rates the main driver of markets, bonds underperformed equities in August. Concurrent declines of the two major asset classes are uncomfortable for investors, but as we saw at the end of August, in a panic, bonds still provide ballast for portfolios and can preserve capital.
Within bonds, the euro area was weaker than the US and corporate bonds typically performed better than government bonds in August. Bonds with shorter maturities outperformed longer dated maturities.
We have noted previously our preference for shorter duration and corporate debt given the higher yields on offer with lower interest rate risk. We have not added to our fixed income holdings this month, but fixed income returns are looking more attractive again. Inflation expectations have been relatively stable and real interest rates are at recent highs.
Within equities, Europe was the weakest region. Sector moves were mixed, with some cyclicals outperforming defensives. All sectors aside from Energy declined. Health Care and IT were the weakest sectors. The last three months are similarly mixed between defensives and cyclicals and only the Consumer Discretionary sector outperformed, but even this performance was concentrated in a few stocks. Overall, what we are seeing in markets is consistent with what we expected coming into the year – lower returns (clearly, we did not expect a war and the scale of declines seen at the trough) and more volatility as the underlying macro-economic outlook becomes more uncertain as it moves later in a cycle.
Asset allocation: what’s changed?
Changing our equity mix
While we have been travelling through a period of forecast downgrades, the much-anticipated recession may or may not arrive soon. In the meantime, sentiment is poor and equity market valuations have declined, discounting a higher level of risk. Earnings revisions have been slightly negative recently, but this is typical and not always an impediment to market progress. Overall, earnings growth is expected to slow to mid-single digit percentage rates in 2023, supported by inflation. This is only slightly below trend. Hence, we have maintained our neutral stance in equities this month.
However, we have moved to reduce our Consumer Discretionary holdings again, to a neutral stance. This reflects our later cycle view and that much post-pandemic reopening of developed economies has now occurred. Furthermore, consumers and businesses are being squeezed more materially by high inflation, particularly from energy prices.
We have been underweight Energy this year – a position that has been increasingly painful as energy assets have risen so sharply. We are reducing this underweight position. Energy security has clearly moved up the agenda in 2022. The situation in Europe is acute now and is expected to persist for the foreseeable future. While the Energy sector was a particularly strong performer earlier in the year, valuations remain attractive in absolute and relative terms.
Sebastian Orsi CFA
Senior Research Analyst
Sebastian joined Goodbody in 2015 and is a Senior Research Analyst. He has over 25 years of investment management and research experience.
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