This note contains an overview of our market views, what we are watching, and our portfolio strategy. Any reference to portfolio positioning relates to our Flagship Solution. Clients with bespoke discretionary or advisory portfolios should consult their Client Advisor for the latest update on your portfolio.
As a result, equities were generally weak, only staging a modest recovery in the US on Friday, following strong jobs data. Government bonds declined (as yields rose), offsetting the gains recorded earlier in the week before tensions flared again in the Middle East. Markets had previously rallied on hopes that the US Federal Reserve (Fed) could cut interest rates more than suggested at its September meeting.
For now, the recent market dynamics, while weaker than before, don’t seem to be morphing into a major sell-off, at least as long as geopolitical risks in the Middle East remain contained. Moreover, markets seem to be realigning their views closer to the Fed’s projections. Better-than-expected economic data reduce the need for the Fed to deliver significant interest rate reductions in its final two meetings of the year. Nonetheless, these factors have pushed volatility somewhat higher. We think we could be entering a period characterised by higher volatility relative to the first part of the year. This means that volatility spikes are more likely as incoming data and events (including the upcoming US election) could push markets to recalibrate their expectations.
Higher odds of slower economic growth, but also more interest rate cuts
Positive but slower growth over the next 6-12 months remains our base case. However, recently, economic momentum has weakened across a number of key regions. In the US, despite the occasional rebound and upside surprise (such as last Friday), job creation has generally been slowing, and the unemployment rate has risen in recent months, with job openings also continuing to moderate. While other parts of the economy, including the vast services sector, look more resilient, weakness in the labour market and manufacturing was one of the key fundamental triggers of the volatility spike this summer. In Europe, Germany isn’t growing and could be facing a mild, ‘technical’ recession (two consecutive quarters of negative growth). Some fiscal austerity in Europe and the UK, where the economy has been relatively resilient so far, could be a further downside risk.
As a result, while we previously thought that there was a 20% probability of a recession over the next 12 months, we now estimate it to be 30%. The silver lining is that we’re also revising our central bank forecasts. We now expect more interest rate cuts. We think the Fed will cut rates by a full one and a half percentage points between now and the end of 2025, with two quarter-point cuts in November and December. With inflation at target, we believe that the European Central Bank is likely to do the same. The Bank of England could reduce rates a bit less than the other two central banks as UK economic data look more resilient and inflation is stickier.
A slowing economy (but no recession) and more central bank rate cuts have two main market implications. First, bond yields will likely continue to trend down, though in an uneven fashion (spiking briefly when data turn out stronger than expected and then declining again). Second, the US dollar looks set to weaken further, again assuming that geopolitical risks remain contained. A moderate dollar weakness has been one of our key currency calls in 2024. With more Fed rate cuts and prospects of wider budget deficits regardless of the outcome of the US election, combined with expensive valuations, further dollar weakness is on the cards.
How we’re reshaping flagship portfolios to continue to navigate volatility
Market volatility tends to ebb and flow as economic, corporate and (geo)political events unfold continuously. Rather than knee-jerk reactions, we seek to maintain composure, anticipating potential developments. We’ll readjust portfolios as required and maintain a globally diversified approach to portfolio construction to mitigate the impact of local issues while staying invested for the long term.
As the potential for bouts of market volatility appears to be rising, our investment strategy is evolving as follows:
1. Recalibrate US equity protection & position for a weakening US dollar
Earlier this year, just before the start of the bout of Middle East tensions in April, we bought an ‘insurance’ instrument in portfolios where client knowledge and experience, regulation and portfolio eligibility permit. The instrument appreciates when US equities fall, partially protecting portfolios from market selloffs. We have now further adjusted the degree of protection this instrument provides so that it could kick in earlier should US equities unexpectedly fall between now and the middle of December. The broader point is that while US equities remain a compelling asset class, and rate cuts could be supportive in a non-recession environment, the longer-term economic outlook is weakening. While we’re confident with our current US equity exposure, we’re staying nimble and looking for triggers for recalibrating in either direction, tactically and strategically, as opportunities arise. Separately, although it is one of our longstanding currency calls, we now have more conviction that the US dollar is likely to weaken. Therefore, in some conservative profiles, we are increasing our euro exposure and reducing our dollar one.
2. Reduce exposure to risky bonds & increase exposure to money-market funds
With a global economy that’s growing more slowly, we think the risk-reward of some of the risky parts of the fixed-income market looks more unattractive, as they don’t reflect lingering risks. In essence, the spread (the interest rate differential between risky bonds and safe ones, such as government bonds) looks too tight to us, and so it might widen if economic growth were to surprise to the downside, leading to lower risky bond prices. Given these risks, we have reduced our exposure to emerging market debt and, in some conservative profiles, further lowered our exposure to high yield. Instead, we have reinvested in short-term money market instruments where we seek to harvest the extra yield on offer for a low level of risk. For the time being, we believe money markets are a more compelling option than short-dated bonds, as the yield is higher.
3. Reduce exposure to US Treasuries & increase exposure to UK gilts
Within government bonds, we’re also seeking to tactically exploit differences in market expectations for central bank policy rates. Relative to our forecast, the government bond market expects many rate cuts from the Fed and very few from the Bank of England. It likely expects too many for the US and not enough for the UK. To exploit a probable convergence, albeit a partial one, with the Fed cutting just a bit more than the Bank of England, we have further increased our exposure to UK gilts and further reduced our exposure to US Treasuries in sterling portfolios. Importantly, for UK investors, the yield pick-up to invest in gilts is higher vs US Treasuries when converted into sterling.
What we’re watching this week: US inflation
While the Fed made clear it’s watching the labour market, a message to be featured prominently in the minutes of the September meeting (Wednesday), the central bank will continue to look at inflation, too. This week, inflation data out of the US (Thursday) will be key. We expect headline inflation to have moved closer to the 2% target, though core inflation (excluding volatile components such as food and energy) could have stayed unchanged at around 3.2%. Barring any major surprises, we think the market will likely readjust its expectations and no longer expect exceptionally large rate cuts in the near term (as it did after the upside surprise in job growth last Friday). In Europe, while not typically a market-moving event, France’s 2025 budget announcement could grab investor attention. The government is planning tax hikes and cuts in public spending, possibly weighing on economic growth in the context of an uncertain political situation. In China, investors will be on the lookout for extra policy stimulus or clarifications on the recently announced measures to support the economy and markets.
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Information correct as of 7 October 2024.
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