A new market cycle<br/> Seizing opportunities and managing risk

A new market cycle
Seizing opportunities and managing risk

The divergence of growth is becoming evident across regions, and we will now likely see the emergence of asynchronous market cycles.

Introduction

Daniele

Daniele Antonucci
Chief Economist & Macro Strategist

As we reach the midpoint of 2023, it's worth revisiting the predictions we made earlier in the year. Specifically, our three key macro calls that would take place around Q2: a peak in inflation (starting with the US), a pivot in central bank interest rate policy (starting with the US Federal Reserve, Fed), and a pick-up in China's growth. We refer to these as “the three Ps”.

The macro rationale behind these calls was based on the expectation of a recession in developed markets due to monetary tightening, which would curb inflation and lead central banks to pause rate increases. Meanwhile, a recovery would gain momentum in China, where there is no inflation problem but, rather, central bank stimulus and reopening.

So, were our predictions right? Yes, partly. Inflation is showing clear signs of moving past the peak (in the US at least), leaving the door open for the Fed to pause its interest rate hiking cycle, and China’s growth has accelerated sooner - though perhaps less strongly - than expected and recent indicators point to slower progress. However, the prediction of a developed market recession has not yet come to fruition. Developed markets have proven to be more resilient than expected – the Eurozone and the UK in particular – thanks largely to energy disinflation and a mild winter, despite periods of weak growth. However, given the lagged impact of past interest rate hikes and the credit squeeze we envisage, a mild recession in the US now looks more likely in the second half of this year.

So, has our outlook changed as we look ahead to the rest of the year and beyond? Not a huge amount. We continue to believe we will see a divergence of growth and the emergence of new market cycles, driven by the so-called “three Ps”. We think the Eurozone and UK are probably where the US was six months ago, with inflation yet to peak convincingly and central banks looking to continue to raise rates – although not for long. Therefore, the balance of risks is skewed towards more European Central Bank and Bank of England hikes vs Fed.

We also think the currency outlook is unlikely to shift significantly over the next couple of quarters. We believe the US dollar (USD) remains overvalued and the Fed pausing rates could lead to some USD weakness. As the Fed pauses, the real interest rate differential between the US and the Eurozone/UK should diminish. The euro and pound sterling should strengthen vs the USD, though moderately given weak domestic growth. 

When it comes to the market landscape, our overall stance is also largely unchanged. Relative to our long-term asset allocation, we still prefer allocating slightly more to high-quality bonds and slightly less to equities and credit, given market uncertainty and that we think the peak in interest rates is in sight. So, rather than an overhaul of our asset allocation, we’ll continue to make tweaks as trends and risks emerge.


How our worldview is changing
The West is slowing with bouts of financial instability, while the East is accelerating. Market volatility resurfaces every now and then and a shallow recession is still likely in the US. China and Japan have more room to continue to rebound. Contrary to our initial expectations, the Eurozone and UK appear to have avoided an outright recession due to receding energy risks. This limits any market expectation for interest rate cuts in developed markets, which we think are more likely in 2024.
A continuation of 2023’s three major shifts: peaks, pauses and pickups
At the beginning of the 2023 we were expecting three major shifts, which have come to fruition to some extent, and we expect to continue for the rest of the year:
Inflation peaks
Inflation peaks

Inflation begins to ease in the US and, with a lag, in the Eurozone and the UK, where it’s still elevated but will likely moderate.

Central banks pause
Central banks pause

The US Federal Reserve’s latest rate increase was, in our opinion, likely their last of the year. We believe the European Central Bank and the Bank of England will follow suit but later in the year as they continue to battle elevated inflation. We don’t expect rate cuts in 2023.

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China’s economy picks up
China’s economy picks up

In the absence of inflationary pressures, China has room to continue to implement stimulative policy measures to support its economy.

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How our worldview is changing
Markets: high-quality bonds and defensive equities are attractive in a volatile late-cycle environment
As interest rates peak, growth slows and inflation eases, high-quality bond markets look attractive as history has shown they tend to outperform equities in these conditions. Even now, the risk-reward for equities is poor relative to high-quality bonds – a 6-month Treasury bill is currently yielding more than the S&P 500.

The late-cycle volatility we expect limits upsides in equity performance, and we therefore do not believe it is time to re-risk portfolios yet. Thus, low-volatility equities are more attractive as they mitigate downside risks while partially capturing the upside. In addition, as inflation is not an issue in Asia, and China’s re-opening accelerates, Asia-Pacific equities including Japan are also attractively valued.
Click here for a summary of our investment views for the year ahead.
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Key macro and market views
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Portfolios
Our flagship portfolio positioning
We have made two key calls heading into the second half of the year: increasing exposure to US investment grade bonds (hedged) and European minimum volatility stocks.
Equities
Not time to re-risk yet

Our overall equity exposure is still marginally reduced vs our strategic (long-term) asset allocation. Although stock markets have performed relatively well this year, we do not think it is yet the time to increase exposure to risk in our portfolios.

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Not time to re-risk yet
Credit
Add high-quality, reduce low-quality

We maintain a slightly cautious stance on credit, mainly the US high yield market, where banking-sector stresses, tighter credit standards and rate rises will likely be most acutely felt.

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Add high-quality, reduce low-quality
Government bonds
Stay constructive as rates peak
We maintain our increased exposure to high-quality government bonds, particularly in the US where a pause in interest rate increases alongside recessionary pressures should be supportive.

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Stay constructive as rates peak
Cash and gold
Keep unchanged as strategic diversifiers

We maintain our local cash balances and continue to hold gold as a strategic hedge at a neutral level relative to our long-term allocation.

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Keep unchanged as strategic diversifiers
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