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.



Daniele Antonucci
Co-Head of Investment & Chief Investment Officer

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 are 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. 

Importantly, we have introduced a key long-term diversifier in our UK flagship portfolios - hedge funds - funded predominantly via reducing our gold allocation. Gold as an asset class provides attractive hedging properties by historically performing well in crisis periods. We decided to add hedge funds alongside gold as our historical analysis shows this would have led to improved risk-adjusted returns, lower volatility and less severe drawdowns. The goal is to achieve greater diversification. In this vein, we allocate to a blend of managers pursuing different investment strategies to reduce manager-specific risk.

How our worldview is changing
The West is slowing with bouts of financial instability, and banking-sector stresses leading to tighter lending conditions, 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.

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.
Key macro and market views

US inflation has moved past the peak, and the US Federal Reserve will likely pause rate hikes

US inflation is now below 5%. This gives the Fed room to pause and hold rates in restrictive territory in 2023 before cutting in 2024.

Eurozone/UK inflation and rates lag the US

In the US, inflation peaked in June 2022 but only in October 2022 in the Eurozone/UK, where it is still very high. The ongoing policy tightening from the European Central Bank and the Bank of England is weighing on inflation, with several indicators pointing to a slow easing of price pressures.

China’s reopening and stimulus looks set to continue

In the absence of upward price pressures in China, the People’s Bank of China will likely keep interest rates low or even reduce them. This, accompanied by the continued re-opening, means that activity on services and consumer spending are likely to expand.
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.
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
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, gold and hedge funds
Expanding the range of strategic diversifiers

We maintain our local cash balances and hold gold as a strategic hedge at a neutral level relative to our new long-term allocation. We add exposure to a new asset class: hedge funds. 

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Expanding the range of strategic diversifiers


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Information correct as at 25 May 2023

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