WINTER IS COMING
The predictable and the unexpected
Financial markets often follow standard patterns of behaviour, and we’re always looking out for any shifts in order to adjust portfolios.
Recent history reminds us that the unexpected happens frequently, which can send financial markets in new directions. The global pandemic caused a sharp sell-off in share prices at the start of 2020, although they soon recovered. More recently, Russia’s invasion of Ukraine and the disruption to energy supplies has pushed up inflation to record levels. Central banks have hiked interest rates and government bond yields have risen.
Markets are also prone to throw a tantrum if they don’t like the look of something. When the UK’s ‘new’ Prime Minister Liz Truss (who has recently resigned) and her Chancellor Kwasi Kwarteng announced a mini-budget of unfunded tax cuts, the pound collapsed to a record low against the US dollar, and 10-year gilt yields soared to above 4% for the first time in many years. The Bank of England had to step in to reassure investors, a new Chancellor has already reversed many of the measures and now Rishi Sunak is Prime Minister.
These events also remind us that markets tend to follow long-established patterns. Our job as investors is to keep a close eye on what’s happening throughout the world so that we can position investment portfolios accordingly. After having further reduced our exposure to eurozone and global equities while raising USD cash, we’re holding steady for now. Despite the recent market correction, valuations aren’t necessarily attractive yet. We’ll be looking for a decisive drop in inflation or a meaningful slowdown in economic activity before contemplating further shifts.
Daniele Antonucci, Chief Economist & Macro Strategist
WINTER IS COMING
Emerging markets: challenges or opportunities?
Financial markets across many developing regions are looking relatively attractive on various measures of value.
Interest rate hiking cycles in emerging markets (EMs) are more mature than in developed markets (DMs), which are playing catch-up. These conditions have provided a buffer to EM assets by limiting their downside during the recent market correction. The relative rate of economic growth remains stronger across many EMs, and both equity valuations and foreign exchange rates look attractive.
Source: In-house research, IMF, Refinitiv; 2022–27 = IMF forecasts for GDP growth.
Note: past performance is not a guarantee of future performance.
WINTER IS COMING
Tensions on many fronts
High inflation, rising interest rates and slowing economic growth continue to dominate the investment environment.
A recession in the UK and Europe now looks all but inevitable given high inflation, energy constraints and the ongoing conflict between Russia and Ukraine. We believe a deterioration in European earnings has not been fully priced in yet. Meanwhile, higher interest rates in the US and the economic slowdown have already led to a repricing in US earnings. In China, any news from the Communist Party’s Congress will be critical for our emerging market investments.
The UK fiscal U-turn – followed by Liz Truss’s resignation as UK Prime Minister –is a reminder of tough policy choices. We revised our GBP trajectory higher, partly also because we now expect the Bank of England will hike more aggressively in the near term. But we still believe that our strong dollar view isn’t about return; it’s about mitigating downside risks, so we’re maintaining our exposure to this key hedge at this stage.
A dovish pivot by the US Federal Reserve – whereby the central bank slows the pace of interest rate hikes or even cuts at some point – is likely to be a key catalyst for us to revisit our exposures to high-quality fixed income and riskier assets, but we’re not there yet. While we think a peak in Treasury yields is in sight, US inflation is still too high and declining slowing, while core inflation (excluding energy and food) are still rising. The European Central Bank’s window for large hikes is closing soon as the recession deepens and borrowing costs rise.
What we’re watching
The economic cycle is continuing to slow and recession odds have risen on the back of the energy crisis affecting the UK and Europe, tighter financial conditions in both those regions and the US, and geopolitical uncertainty globally. We’ve already reflected these risk when we recently further reduced our exposure to eurozone equities.
The liquidity cycle is driven by the expectation of large rate hikes at the next central bank meetings, but the pace of tightening will probably slow thereafter. The US dollar remains strong, and some central banks are being forced to defend their bond markets and currencies, particularly in the UK and Japan. Meanwhile, China continues to ease monetary and fiscal policy.
The political story in Europe is focusing on fiscal support to cushion the blow of the energy crisis. Risks of fiscal policy ‘mistakes’ (such as the recent one by the UK’s government) and geopolitics tensions (notably, the Russia–Ukraine War) are likely to continue impacting markets.
Although the northern hemisphere is heading into winter, Covid-19 doesn’t appear to pose a major threat to economic activity. New cases are on the rise again in Europe, which may be a prelude to a wave of infections. Cases are rising again in China too, after the ‘Golden Week’, triggering new lockdown restrictions across the country.
Headline US inflation appears to have peaked. But the decline has so far been disappointing, with core inflation (excluding energy and food) not peaking yet.
WINTER IS COMING
What we’re doing in our Portfolios
A defensive bias
Portfolios remain positioned for uncertainty ahead.
Near-term uncertainty remains elevated, with risks skewed to the downside. The escalation of the energy crisis and oil cartel OPEC’s recent decision to cut production adds additional downward pressure on global growth and upward pressure on inflation, particularly in Europe.
Given this evolving environment, in early October we reduced our exposure to equities, with a focus on the eurozone, in favour of cash. We’re maintaining this lower equity, neutral fixed income and higher cash exposure, along with our strong (not stronger) US dollar near-term view.
We still see opportunities in trading within asset classes. We maintain our overweight to US and emerging market equities. Within fixed income, we are overweight emerging markets (EM) hard currency sovereigns to EU/UK government bonds.
Given that global growth is slowing, we have reassessed our exposure to EM assets. Despite a deteriorating economic outlook across the world, we think too much bad news is priced into pockets of EMs. So we’re maintaining our selective exposure within equities and bonds.
Our investment strategy
The recent move to increase the allocation to cash provides an additional defensive element to the portfolios whilst also increasing the flexibility to take advantage of volatility in markets at the appropriate time.
Our tactical asset allocation is summarised as follows:
US equities versus Eurozone Equities
We believe US stocks will outperform Eurozone stocks. With recession our base case in Europe, the stubbornly high earnings per share (EPS) expectations for euro area equities are likely to become increasingly challenged, especially relative to EPS expectations for US equities.
Emerging market sovereign debt versus Eurozone government bonds
Emerging market sovereign debt offers additional yield over Eurozone government bonds. The loss in value of Russian bond has been a drag, but that’s now behind us. Credit risk for most EM sovereigns is unaffected by the war in Ukraine.
Emerging market equities versus Global equities
We believe Emerging market (EM) stocks will outperform global equities as EM equities are trading close to a record discount compared to global equities. As EM growth stabilizes and monetary policy eases, especially in China, we expect EM stocks to be well supported.
US Cash versus Eurozone Equities
Near term uncertainty remains elevated with risks increasingly skewed to the downside. We reduce our exposure to Eurozone equities and instead increase our holding in US dollar cash as we view this safe-haven asset as providing protection to our portfolios.
WINTER IS COMING
What to look out for
Geopolitical uncertainty is high, commodity prices are declining but remain elevated, and US inflation may have peaked but it’s not a straight line down.
↓ Outlook is less certain than last month
↑ Outlook is more certain than last month
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Information correct as at November 2022.
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