Risks to economic growth dynamics have increased, triggering a downgrade of emerging markets against an upgrade of the more insulated US stock market, now both "Neutral". In Fixed Income we expect the interest rate environment to remain at elevated levels for longer. In our current House View we also take a closer look at the correlation between equity returns and bond yields.
The anchor of our asset allocation is our Strategic Asset Allocation (SAA). This robust portfolio is derived from our long-term forecasts for expected returns, expected volatility and correlations across asset classes for equities, bonds, alternatives and cash. When we review the Tactical Asset Allocation (TAA) each month, we ask ourselves if there is a good reason to deviate from this long-term portfolio.
And sometimes the answer is no. At this point in time, we believe that our SAA gives us a good position in financial markets from a portfolio perspective. We believe that over the next few months almost all assets will be affected by two major market drivers: the Federal Reserve’s potential actions and the growth landscape in China. These drivers are highly uncertain and unpredictable. With a lack of visibility and the risk of seeing strong swings in asset prices depending on a binary outcome, we think that active TAA positions at the large asset class level are unattractive.
Therefore, we prefer to go back to the long-term fundamentals with our SAA rather than trading on low conviction views on policy decisions. This does not mean that there is nothing to discuss in the markets – far from it.
In our macro assessment, we take a closer look at growth indicators. As expected, we have seen a further deterioration in the data over the summer. This leads us to reduce cyclicality in the equity space. In the equity section of the House View, we explain why we are downgrading emerging markets equities to “Neutral” and industrials and consumer discretionary to “Underweight”.
In our investment strategy and fixed income view, we discuss why interest rates are likely to stay high for longer and what this means for the relationship between equity and bond yields. In the last month, a move higher in yields triggered a sell-off in equities. This correlation is extremely important to consider when building a portfolio, and it also gives an indication of how equities might react to data in the short term.
Finally, in the foreign-exchange space, the dramatic moves in USD/JPY over the past twelve months have attracted a lot of attention. We weigh the yen’s cheap valuations against other factors.
Global growth has continued to cool since the middle of the year. In the US, a further slowdown in consumer activity threatens to bring GDP growth to a standstill by the end of the year. In addition, a broad-based growth slowdown in China and its spill over effects - particularly on the export-oriented eurozone - harbour further potential to slow down the global economy. For the second half of 2023, we expect very weak or zero growth in the United States, a continuation of the slowdown in China and an increased risk of recession for the euro area. At least weak demand pressure provides further disinflation potential, which should ease the monetary policy outlook somewhat.
The correlation between equity and bond yields has turned negative again, reaching levels last seen more than 20 years ago. However, we do not believe that this is the beginning of a new structural regime as we saw between the 1960s and 1990s. We believe that inflation will be well anchored for the next few years and that central banks can return to managing growth rather than inflation. This is an important point because a positive correlation in the medium-term calls for both equity and bonds to diversify a portfolio. In the short-term, the recent move in yields support our positive views on government bonds.
Gloomy economic growth prospects, heightened uncertainties in China and the rise in government bond rates in the US and Europe create a challenging environment for equities. We are responding by downgrading emerging markets to "Neutral", abandoning our "Rest of the World" preference over US equities, and reducing weightings in the cyclical industrials and interest-rate sensitive consumer discretionary sectors.
In the fixed income segment, we continue to favour government and corporate bonds in the investment grade range, while remaining cautious on high-yield bonds due to the unsustainably low credit risk premium. Against the backdrop of a still inverse yield curve, but also to keep credit risks low, we prefer securities with short maturities in the case of corporate bonds, while we tend to favour longer maturities in the case of government bonds. This is not least due to the significant rise in real yields.
Valuation indicates that USD/JPY should trade at lower levels in the mid- to long term, yet there are several factors curbing the Japanese currency’s performance. The unexpected and widespread weakening of the yen has taken many investors by surprise this year. To bolster the yen’s position, the implementation of policy normalisation is viewed as the essential pathway and indeed, the Bank of Japan has tweaked its policy recently. Nevertheless, the carry cost and substantial yield differentials relative to its G10 counterparts limit the yen’s potential for appreciation in the short-term.
Regarding the Strategic Asset Allocation, we have already emphasized that we do not consider the current time to be ideal for major tactical positioning. In alternative investments, too, we temporarily prefer a neutral positioning on the SAA, where we have increased the strategic importance of gold by raising the neutral gold quota for cross-asset investments from 2% to 4% in spring.