Asset Allocation Highlights – Exceeded Expectations
Given that the current slowdown is truly global, we are struck by the discrepancy between the bullish views of equity analysts and the caution expressed by economists. We also don’t follow the market’s belief that central banks won’t raise interest rates as much as previously thought given the bad economic news. Is the end of their rate hike cycle already in sight?
Not for us. Inflation is unlikely to fade quickly enough. The war in Ukraine is likely to keep (commodity) prices high; Supply chain bottlenecks aren’t going to ease anytime soon. High house prices will likely keep pressure on rents for months to come. Wage demands are rising in response to a tight labor market and high inflation.
We expect it will take more central bank tightening and a deeper slowdown in growth before inflation falls close to policymakers’ targets. Therefore, we are underweight duration.
In this context, the last earnings season was nevertheless encouraging. Excluding a strong performance in the energy sector and sharp declines in financials, sales and earnings growth were positive (and above expectations). We don’t think it can last. Current forecasts (see Table 1) are inconsistent with the economic slowdown we anticipate. Earnings will likely fall and stock prices should follow.
The absence of any contraction in global earnings now priced in stands in stark contrast to the 9-17% drop in earnings that is likely when it partially or fully returns to trend. A 9% drop puts the price/earnings ratio at 16.3x for the MSCI US – roughly where it stands today. A deeper drop of 17% is consistent with a P/E of around 19.5x, while a significant recession could lead to a 35% drop in earnings.
Our multi-asset portfolios are positioned cautiously: we seek to gradually increase risk in areas such as high quality corporate credit and commodities, while we are underweight duration and neutral on shares.
We made four changes to portfolio positioning during the month:
- First, we upgraded credit to favorable, focusing in particular on European investment-grade credit, where the distress is now pronounced and the opportunity for valuation looks increasingly attractive. European IG appears to be pricing an implied default rate of 8-10%, twice the worst rate in five years and eight times the historical average. This looks too bleak given the weak 2001-style correction we expect and generally healthy corporate finances.
- Second, in European duration, we tactically deepened our short. Responses to the gas crisis are likely to be fiscal given central bank concerns over short-term inflation and the drive for tighter policies.
- Third, we increased our tactical exposure to commodities. Fundamental supports include resource nationalism and greenflation, but also geopolitics – commodities typically benefit in times of uncertainty. There is also an obvious shortage of supply. Finally, there is the support of Chinese macroeconomic policy which continues to lean towards easing.
- Fourthwe sold our modest exposure to emerging markets, while maintaining our exposures to China and Japan in the face of a largely compensated European short position.
Asset class views
Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. All opinions expressed herein are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may have different views and make different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income from them can go down as well as up and investors may not get back their initial investment. Past performance does not guarantee future returns. Investing in emerging markets, or in specialized or restricted sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of developed international markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds investing in emerging markets may involve greater risk.