Every month, our Asset Allocation Committee meets to discuss and debate our market outlook.
How has our asset allocation changed month-on-month?
Chief Investment Officer, Bernard Swords, presents our views.
When we published our last Top Down (15 March), we were in the middle of the US bank failures and the forced sale of Credit Suisse was about to occur. At the time, we said that the causes of these stresses were very much company specific, and the authorities were moving fast enough to make sure there were no broader effects. Thankfully, that is the way events have unfolded and security has returned to the market somewhat faster than we would have expected. World equities are up 3.2% in euro terms since then and are almost back to where they were before the crisis broke (in local currency terms they are higher). Bonds had rallied significantly since mid-March and have held onto those gains.
One of the reasons for these recoveries is the change in interest rate expectations that has occurred. Before the crisis broke, the market expected euro area interest rates to rise to 4.0% and stay there for the following 12 months. In the US, the federal funds rate was predicted to rise to 5.75% and decline to 5.5% a year later. Now the European Central Bank is expected to raise rates to 3.75% and then reduce to 3.5% in a year’s time. The Federal Reserve expectation has been adjusted as well, with a prediction to raise the federal funds rate to 5.0% and cut it to 4.0% over the next twelve months.
The market has very different ideas to the European Central Bank and the Federal Reserve. Comments from the board members of these institutions keep saying that inflation is too high and not coming down fast enough. They warn that rates may go higher than currently forecast and they do not envision them coming down anytime soon despite the downside to economic growth forecasts. The central banks are saying ‘higher for longer’ but the market seems to be ignoring that.
Another benefit to equity markets has been the continued stream of stronger economic growth data across the major blocks. In the euro area; US and China data has been well ahead of forecast. Expected growth rates for 2023 are being pushed up, even after the banking turbulence data for March remained strong. This is coming from the services and consumer sectors of the economies but manufacturing outside of China is contracting.
Unfortunately, inflation data has also remained strong. Headline inflation is coming down as lower energy prices impact. However, core inflation has yet to decline in the euro area and while it has subsided somewhat in the US, the pace of deceleration has been very slow thus far. This keeps us in the central banks camp of ‘higher for longer’.
Fixed income markets were close to flat since 15 March. The Euro Aggregate Index is up 0.2% and yield levels are virtually static. All this performance has come from the Investment Grade sector as the ‘flight to safety’ subsided. Shorter duration and higher running yield boosted Investment Grade. The fixed income markets now face a challenge should interest rate expectations move in line with central banks thought. Stronger economic data is not helping them either. For these reasons we are keeping duration short in our fixed income portfolios and continue to pick up yield from the Investment Grade Market.
Once it was clear that the banking stresses were contained and not causing any systemic harm there was a recovery in risk appetite along with better growth data across the globe. These were the primary drivers of the move up in equity markets. There has been some change in the ranking of sector performances. Up to 15 March, last year’s laggards (IT; communications and consumer discretionary) were the clear leaders followed by the cyclical sectors (energy, materials, financials and industrials). Since then, the defensive sectors (household products, food producers, pharmaceuticals, and utilities) have been the clear leaders with the cyclical sectors being the losers. In that period last year’s laggards have kept pace with the broad index.
Earnings resilience will become more important as we travel through this year. We are only starting to see the impact of the monetary tightening implemented last year and this will continue throughout 2023. At the moment earnings are expected to be flat in 2023 against 2022. With more pressure to come from tighter monetary policies this seems optimistic to us and so we will keep to the sectors that will be able to maintain earnings in a tough economic environment.
Asset Allocation: Cautious Outlook
Our model portfolios have not changed during the period. We had already moved to a more cautious asset mix, favouring fixed income over equities which reflects where we are in the economic cycle. Our fixed income exposure is driven by the belief that interest rates will remain higher for longer and thus we still favour short duration. There is a bias towards corporate debt where the higher running yield gives some protection against moves in capital values. 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 Staples and Healthcare sectors and underweights in the cyclical areas of Energy and Materials.
We have come through the recent banking turmoil in good condition with bonds and equities (in local currency terms) higher than before it began. Interest rate cuts are embedded in forecasts indicating concern about future economic growth. If this is right, then equity markets will face difficulties and fixed income markets will be supported. If they are wrong, as we suspect, then tight monetary policy will be here for longer than expected and will undermine economic growth going forward. This is a challenge for equity markets but not such a difficulty for short dated fixed income assets. From here, the risk reward looks better for fixed income and short duration in particular.
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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