12 Oct 2023
Figure 1: All investments contain risk and may lose value. The above overview is intended to illustrate major themes for the identified period. No representation is being made that any particular account, product, or strategy will engage in any or all of the themes discussed.Our asset class overweights/underweights in our illustrative portfolio as of September 30, 2023 on a 3-month horizon. Up/down arrows indicate a positive (∆) or negative (V) change in view since the prior quarterly global house view meeting. These views should not be construed as a recommended portfolio. This summary of our individual asset class views indicates strength of conviction and relative preferences across a broad-based range of assets but is independent of portfolio construction considerations.
Our asset allocation decisions – in short
Cross asset allocation: We remain overweight fixed income and cash versus equities on a cross-asset basis.
We remain doubtful that central banks will be able to execute a soft landing going forward. Inflation has peaked but still remains well above 2% and recent messaging from the world’s major central banks has made it clear to the markets that fighting inflation is their priority. This has left the door open to a more prolonged period of higher rates, which equity markets had not been anticipating at the start of the quarter. This type of environment presents a headwind for equities and we expect earnings to decline further in coming quarters.
However, higher interest rates make fixed income—in particular credit, as well as cash—a more attractive asset class. The yield on cash and investment grade debt is now higher than the S&P 500’s forward earnings yield, which reinforces our positioning from a cross-asset perspective.
Within fixed income: Within fixed income we remain overweight in spread categories relative to sovereigns.
In the near term, the upside inflation surprise in recent months has put upward pressure on rates, particularly at the long end of the curve. Central banks have reiterated that they are data dependent and there is a tail risk that we will see another hike by the US Federal Reserve and the Bank of England later this year.
Our overweight positions in credit categories represent our continued preference for higher-yielding assets. Although the spread story is less compelling given current levels, all-in yields are attractive and continue to offer strong carry potential against our underweight in government debt.
Within equities: We have moved all of our regional equity preferences to neutral.
Our previous underweight positions in both US and European equities have been upgraded to neutral. Both markets were negative during the third quarter, so we are using the opportunity to take profits on a tactical basis. Although we see a possibility that both markets could decline further in the face of rising rates, we are mindful of the fact that the recent sell-off makes valuations more attractive and, as a result, we could see a short-term rebound. A neutral position therefore makes sense to us on a tactical basis.
Overweight positions in Japan and Asia ex-Japan have also been downgraded to neutral. Japanese equities have been the regional outperformer year to date. Again, we see this as an opportunity to take profits given its outperformance and on the basis that the MSCI Japan Index is heavily geared into the global economy and there is a risk that earnings will be impacted if demand, particularly in the manufacturing sector, starts to decline. Asian ex-Japan equities have also been downgraded to neutral. Some regions, in particular India and Indonesia, have experienced strong growth. But China’s demand has failed to rebound and given the size of that economy, there is a risk it bleeds over into the wider region.
Within currencies: We have upgraded our US dollar position to overweight.
The dollar now has a number of catalysts that can propel it higher heading into the fourth quarter. US exceptionalism has continued as macroeconomic data continues to outperform the rest of the world, which is supportive for the greenback. From a monetary perspective, a revised dot plot by the Fed has pointed to higher rates in the near term and fewer cuts in 2024 are now priced in, which should bolster the currency from a carry perspective. Finally, given that the USD has historically performed well in risk-averse environments, signs that the global economy is struggling should provide a further tailwind to the counter-cyclical USD.
Good news was bad news for financial markets in the third quarter of 2023. Robust economic data that provided a tailwind for US equity markets in the second quarter, acted as a headwind in the third quarter. Although investors have increasingly shifted their base cases to a scenario where the US avoids a recession, consumer strength has highlighted the fact that an inflationary risk remains and, therefore, so too does the prospect of more interest-rate hikes. Central bank policy makers have been quick to point out the latter, arguing that inflation remains well above 2% and economies are now set for a more prolonged period of high interest rates well into 2024. Headline inflation in fact rebounded during the quarter in most regions, owing mainly to a surge in oil prices. Brent oil futures rose 27% during the period, which has underscored to investors that although inflation has peaked, it has not gone away. The inflationary resurgence and central banks’ hawkish rhetoric were bearish for government bonds, with the 10-year US Treasury yield rising 73 basis points during the quarter.
Rates markets, which at the beginning of the quarter had forecast cuts by the US Federal Reserve as early as January, have now repriced their rate-cut expectations towards the tail end of next year. The prospect of a higher-for-longer interest-rate scenario was negative for most regional equity markets. US equities were among the worst performers, with the S&P 500 falling 3.6% in the third quarter. European equities also declined, as a rebound in Chinese demand failed to materialize and Europe’s own economy has shown more material signs of weakness versus that of the US. PMI’s, particularly in manufacturing sectors, have hit multi-year lows, while consumer spending has also declined. Meanwhile, UK and Japanese equity markets were positive during the quarter. Both have been supported by weaker domestic currencies, relatively attractive valuations and, for the UK in particular, rising energy prices given its higher proportion of commodity-linked stocks. On a sector basis, energy stocks outperformed in line with the rally in oil prices, while most other sectors were negative. Utility and real estate companies were noticeable underperformers, as both sectors have shown greater sensitivity to rising bond yields compared to others. Mega-cap tech names, which have been heavy outperformers this year following the emergence of artificial intelligence, declined on aggregate during the third quarter, a signal that these stocks aren’t completely impervious to higher rates.
Going forward, we maintain our base case that western economies are heading for a soft recession next year. Higher interest rates are slowly starting to drip feed into the real economy, which is becoming more evident particularly in Europe, where housing prices, consumer sentiment and PMIs are all declining. While the US has shown greater resilience, we believe that the consumer will begin to be impacted more meaningfully if the Federal Reserve keeps rates on hold for a prolonged period. In that scenario, the cost of refinancing for corporates would reduce investments and we would expect the unemployment rate to slowly tick up as a result. Other factors at play, including the restart of the US student loan repayment program, will provide additional headwinds for US consumers as we head into winter. Overall, we remain cautious in our outlook and our positioning reflects this.
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