Top Down
Still cautious
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.
It has been a period of negative returns for asset markets since our last edition of Top Down. European bonds declined by 1.1%, while global equities declined by 4.3% in euro terms. US and European central bankers have indicated a pause in rate hikes seems appropriate, particularly as the rise in longer-term interest rates tightens financial conditions, but economic data remains stronger than forecast, underpinning the 'higher for longer' interest rate outlook. Yield curves have steepened as longer duration bonds have sold off, while the front end of the curve is relatively stable in the US and Europe over the last month. More recently, geopolitical issues have flared, pushing up oil prices and raising future growth and inflation risks. Government bonds rallied somewhat, playing their typical safe-haven role in risk-off episodes. Overall, our cautious stance still seems appropriate. We recently moved to buy some longer-term bonds, adding some duration to bond portfolios.
The US economy has continued to run ahead of expectations and is showing few signs of weakness. Retail sales, industrial production, housing, and employment indicators have all been stronger than anticipated. The US economic surprise index has moderated slightly but remains at high levels despite recent forecast upgrades. The concern remains that higher interest rates will undermine business and consumer confidence and the ability to drive growth.
China’s economic surprise index has also moved into positive territory recently. This reflects lower expectations as well as stronger than anticipated Q3 GDP, retail sales, industrial production, and exports. The property market remains challenged and to date the impact of stimulus measures appears limited. Europe remains the laggard with both the consumer and industry showing weakness. Still, the economic surprise index is less bad than it was as expectations have reset.
The trend to lower inflation continues but remains choppy. US core CPI came in at 0.3% month-over-month (m/m), flat compared to the prior month, and the year-over-year (y/y) figure declined to 4.1% from 4.3%. However, headline inflation came in about 0.1% higher than anticipated both m/m (0.4%) and y/y (3.7%). In the US, core goods are seeing lower prices, but services inflation persists, particularly for the important shelter component. In Europe, CPI was in line with expectations at 0.3% m/m, which was down from 0.5% the prior month, but the y/y figure remains at 4.3%, with core CPI also stable at 4.5%.
Central banks are caught between the rapid monetary policy tightening implemented to date with delayed impact still to be felt, and persistent inflation above targets. There have been indications of concern by policy makers about the market induced tightening of financial conditions due to rising longer-term government bond yields. The US Federal Reserve is expected to pause hiking interest rates at its pending meeting but if the recent economic strength persists into year end, analysts expect it could raise rates again in December. In Europe, the European Central Bank (ECB) is expected to remain on hold at current levels given currently restrictive policy and weak economic data. Analysts are watching for other policy moves around the ECB’s balance sheet. Expectations for policy rates through 2024 are relatively stable over the past month.
Growing geopolitical risks weigh on market
As I mentioned already, it was a negative month for fixed income as longer term bond yields moved up and yield curves steepened. European bonds were down about 1.1%, but outperformed US bonds. Euro corporate bonds (-0.8%) outperformed government bonds (-1.2%) over the period. As noted above, market expectations for future policy rates were relatively stable. While the geopolitical issues that have come to the fore recently are a humanitarian tragedy, from an investment perspective it is positive that government bonds have been acting as safe-have assets during risk off episodes, i.e. their prices rise and yields decline.
Meanwhile, equities fell sharply recently as geopolitical risks in the Middle East have increased. Security/trade restrictions have also impacted some of the largest stocks. In local currency terms, global equities are down 3.7% since our last update (-4.3% in euro terms), with developed markets outperforming. Oil prices have reacted to supply concerns and moved higher but are still below recent highs. Energy is not surprisingly the best performing sector. The more interest rate sensitive Utilities, and Real Estate have been weakest. Consumer Discretionary was also very weak reflecting the impact of mega cap autos within it.
The Q3 earnings season has begun. Only about 20% of the S&P 500 companies have reported, and some of the early reporters are in idiosyncratic sectors. Europe has reported less and provides less quarterly detail. So far, S&P 500 Q3 EPS has come in about 7% ahead of expectations, with about 4% EPS growth year-over-year; trailing 12-month EPS growth is still negative but improving. The surprise factor in Q3 seems well distributed across sectors with only Energy disappointing. The consumer sectors are leading the growth, with IT showing the weakest. Post results forecast revisions will be closely watched.
Asset allocation: what’s changed?
Overall, our cautious asset allocation positioning remains appropriate. We still favour fixed income over equities. Given the market’s outlook for policy rates and the change in prices/yields, we recently sold some short-dated bonds and bought longer dated ones. The trigger was euro area 10-year yields reaching almost 3% while shorter dated yields fell. The yield curve had almost flattened (short-dated yields were the same as long dated yields), which was an indicator we were waiting for to start lengthening the maturity of our fixed income holdings.
Within equity markets, the outlook for double digit earnings per share (EPS) growth in 2024 could be somewhat optimistic, although optimism is typical, and negative revisions are not always an impediment to market progress. The key question is if EPS growth remains positive. Within equities, our sector positioning and specific holdings favour more reliable earnings growth (less economically sensitive and more secular growth), as well as higher quality (higher profitability, stronger balance sheets). Hence, we remain overweight the Health Care and Consumer Staples sectors and underweight the more cyclical commodity sectors.
Looking ahead
Economic growth has been better than anticipated through 2023, but the related rise in interest rates has been the main driver of markets.
It seems inevitable that the US economy will slow from above trend growth rates, but the scale of slowdown and impact on earnings remains the key question.
Very recently, it is geopolitical risks that have impacted markets, driving a relatively modest flight to safety so far. Typically, the impact of such events on financial markets proves short-lived, but this depends on whether and how the impact is transmitted to the global economy, such as through higher oil prices leading to recessions. There is risk of escalation of the current situation, but so far it does not appear to warrant a change to our cautious asset allocation stance.
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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