Top Down
Signs of Slowing Growth
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.
Macro Background
Since the last Top Down (26 May), financial markets have made more progress. Equity markets have led the way, returning almost 5.0% in euro terms, and the euro area fixed income market is also up by a more modest 0.6%. The US raising its ‘debt ceiling’ came as a relief to both equities and bonds. Economic data showing resilience in the global economy pushed equities up, as did a flurry of interest in AI. For the fixed income markets, the last inflation report in the euro area was significantly lower than expected and showed a decline in the annual rate for the first time in this cycle.
Global economic growth data continued to beat expectations, but the margin declined, and regional differences began to emerge. The euro area saw the biggest turnaround. At the start of the year, it was the strongest relative to expectations, but it is now beginning to underperform against forecasts. The post Covid-19 re-opening boost is declining in China and although it is still positive, overseas demand is subdued. This could be the impact of continued stronger demand for services rather than goods but could also be an indication of a weakening global background. In the US, the labour market and the consumer remain resilient and consequently it is the best performing region relative to expectations.
Inflation releases were better in the euro area. Both headline and core inflation came in much lower than expected with the drop in core inflation being driven by falling services inflation, which was a pleasant surprise. The hope is that we have passed the peak of inflation in the euro area, but only time will tell. Inflation continues to subside in the US, but the pace remains modest. In the last release core service inflation fell significantly and we had the first decline in shelter inflation so there is hope that the deceleration in inflation will gather momentum.
Despite this interest rate expectations have risen in the euro area, with the peak to be in the range of 4.0% to 4.25%. This is due to the European Central Bank (ECB)’s increasing emphasis on the inflation outlook and playing down the growth implications of further monetary tightening. Inflation may have peaked but it needs to subside quickly. The terminal rate for interest rates increased slightly in the US, however cuts have been pushed out to the first half of 2024.
Fixed Income
There were positive returns from the euro area fixed income markets, but the scale was small. Weaker growth data and a drop in inflation were major positives but the aggressive line that has been taken by the ECB affected the scale of gains. Recently sovereign debt has performed better than corporate but there is little to choose between them year-to-date. The fixed income markets are still pricing in interest rate cuts in the euro area and the US in the first half of next year. We are of the opinion that this will turn out to be optimistic, resulting in yield curves flattening and leaving the best returns in the short end of the market.
Equities
There was a strong move from equity markets led by a resurgence in IT, in particular any company related to AI, but stronger economic data also contributed. As a result, IT was the best performing sector followed by the cyclical sectors (Consumer Discretionary; Industrials and Materials). Equity markets are now expecting a ‘soft landing’ in the US, and thus in the global economy.
There was a regional shift in performance since the last Top Down (26 May). The US and Japan have been leading (as a result of higher IT exposure in these markets and better economic performance relative to expectations) and the euro area was the main laggard, although still up 3.0% during the period. Earnings forecasts were resilient with only small moves at the global level and the downgrade cycle seems to have ended for the moment. The last reporting period was strong relative to expectations, and this has probably put a floor under profit forecasts at the moment. We expect the nominal growth background will not be as strong in the second half of the year so there remains a high probability that downgrades could return.
Asset Allocation: Cautious Outlook
Positioning
We have not changed our model portfolios since the end of May. We still favour fixed income over equities. Fixed income assets had a significant repricing last year and at the short end are providing attractive returns relative to cash. Interest rates look like they will be rising further but this is priced into the fixed income markets. If interest rates rise significantly more than is currently expected, short-dated debt gives better protection.
Equity markets are expecting interest rates to peak soon and economic growth to be little different from the first six months of the year. We believe this is somewhat complacent. If they are right about interest rates, then they are likely to be disappointed about the growth rate and thus the earnings level. We agree with the view on interest rates, but we imagine that profit growth will disappoint. Hence, we favour sectors with more reliable earnings and are overweight in the Consumer Staples and Healthcare sectors and underweight in the cyclical areas of Energy and Materials.
Outlook
The global economy has performed better than expected in the first half of the year, which has supported equity markets. Now, this looks like it is changing as data from the euro area and China begins to disappoint. Interest rate cuts are still forecasted for early next year which, unless there is a rapid change in inflation, looks overly optimistic. As a result, we are keeping our fixed income exposure relatively short. Unemployment remains very low across the developed world and thus there is a risk that without a substantial drop in inflation, central banks might raise rates too high, causing ‘something to break’. Overall, this is a better environment for fixed income rather 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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