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 issue of Top Down, equity markets have recovered some lost ground: in local currency terms world equities returned nearly 5% and in euro terms nearly 6%. The same cannot be said for fixed income markets. Despite the higher geopolitical risk – which is generally a positive for bond markets – the return from the euro aggregate fixed income market was -3.5%.
So, what caused this divergence between these asset markets?
In essence, this divergence can be attributed to the actions and words from central banks, with the sharpest coming from the largest, the US Federal Reserve.
Expectations about the number, speed and the ultimate end point of interest rates in the US and to a lesser extent the euro area have continually increased over the last month as central banks have become more focused on controlling inflation.
Why the change in central banks’ thinking?
Since the start of the year, we have seen precious little decline in core inflation and the recent spike in commodity prices mean that headline inflation will accelerate further. At the same time, data related to economic growth remains robust. There has been some easing in both business and consumer sentiment since Russia’s invasion of Ukraine, but the scale of this remains relatively modest.
Most importantly, we continue to see strong labour markets. For example, in the euro area, each month has brought a new low in the unemployment rate. Meanwhile, over 500,000 jobs have been created every month since the beginning of the year in the US. With this level of momentum in developed economies, it is little wonder that central banks feel they can concentrate more on controlling inflation rather than supporting growth.
And this is why there has been a difference in asset performances. For fixed income markets, rising interest rate expectations are bad news – and it is difficult to find ‘a silver lining’.
For equity markets, it is less clear cut. If interest rates are rising because strong growth is leading to inflationary pressures, then equities can benefit from the higher level of nominal growth. That is the world we have been living in over the last number of months and to some extent the one that still exists.
Asset allocation: what’s changed?
As I have mentioned, equity markets have recovered since we published the March edition of Top Down, and the world index is now 3% above where it was before Russia’s invasion of Ukraine in euro terms. At the same time, 10-year yields in the euro area and US are 0.7% higher over the same period and almost 1% higher than at the beginning of Russia’s large-scale attack on Ukraine.
Consequently, the relative value of equities has declined, while that of fixed income has improved over the last month.
Equities were benefiting from their ability to provide a hedge against inflation. However, going forward, inflation will be increasingly coming from cost pressures rather than demand-pull pressures. This is a more troubling environment for equities – and we are seeing the early signs of this.
Earnings forecasts are still being upgraded for 2022 and 2023 by about 1% per month. However, in the last month, this has all been coming from commodity sectors. Outside of these sectors, it is a mixed bag with some downgrades. And so, the earnings story, while still positive, is not as strong as it was.
Taking this all into account, we are bringing our equity weighting to a neutral position. We are not turning negative because, despite all that has happened, the global economy is still expected to deliver above-trend growth in 2022 and 2023. Indeed, this is a good background for equity markets but, with the earnings cycle maturing faster than we would have thought, the potential return and in particular relative return is not as attractive. It is likely to give the best return, but the margin is less.
On the other hand, fixed income markets are looking relatively more attractive and so, we are reducing our underweight position. Interest rate expectations keep rising and this keeps bond markets under pressure. That said, we are now seeing the potential for positive returns from bond markets.
What are we selling?
In reducing our equity exposure, we have two targets in mind. Firstly, we wanted to reduce our euro area exposure. One longer term implication of Russia’s invasion of Ukraine is that the euro area will have to spend more on physical and energy security. This will cause a drag on the potential growth rate as it is non-productive spending thereby reducing the longer-term attraction of the region.
Our second target was to reduce cyclicality in the portfolio as the economic cycle is maturing. We were cautious in making this adjustment as the early cycle sectors can benefit from rising bond yields. However, this has not been the case over the last month. As bond yields have risen, defensive sectors have outperformed. Investors are switching to dependable growth over cyclical growth. As a result, we reduced our exposure to Industrials, Consumer Discretionary and Financials.
We have increased our fixed income exposure through increasing our holdings in corporate debt. This we believe will still give the best protection against rising interest rates and, with a firm economic background, spread levels should be stable.
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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