This month, we expand the coverage of our asset class views and provide further granularity in each component.
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Our Investment Views by Asset Class
This month, we expand the coverage of our asset class views and provide further granularity in each component.
- We stay fully overweight cash for the optionality and yield.
- We shift marginally underweight in EAFE equities, due to already large gains since October last year and our hawkish ECB view.
- While we position for curve steepening in the US (overweight short bonds and underweight long bonds), we find value in Gilts as the BoE could be cutting by year end.
What We Learned in April – Big Tech Lead
Global equities rose in April, supported by some resilient economic data. Emerging markets underperformed developed market equities amid weakness in Chinese shares. In fixed income, all main credit markets generated positive returns despite fears of a possible credit crunch.
Gains from the index’s largest companies, including some large tech stocks, continue to influence equity market performance. Industrial and consumer discretionary stocks weighed, with automobiles notably weaker.
Narrow market leadership driven predominantly by big tech has resulted in only two factors outperforming the broader S&P 500 over the last three months – quality and growth. Indices with greater exposure to the more cyclical parts of the market severely underperformed, particularly value-based indices that carry a larger weight to regional banks.
Energy markets were volatile, giving up gains from the announcement of OPEC cuts. Natural gas prices in Europe continue to fall given record high storage, reducing risks for a large spike this winter.
In the near term, we are focused on four themes:
- US and global banking risks. We remain on the lookout for signs of deposits out of regional banks forcing sales of treasury securities and the reduction of commercial real estate loans.
Implications: regional banks to underperform, Fed to pause.
- US debt ceiling outcome. Only twice in recent history – 2011 and 2013 – has there been a political impasse that meant default became a very real scenario. During these debt ceiling episodes, agreement to raise the debt ceiling was reached very close to the X date – the date when the US Treasury would run out of funds to cover all required payments. A similar situation this year could prevent the Fed from hiking in June.
Implications: possible risk aversion around early June.
- Broadening inflationary pressures in Europe. This should allow the European Central Bank (ECB) to continue to hike.
Implications: adds downside risks to European stocks.
- Stalling China? Following the latest credit data which came in below our expectations, we continue to monitor our ‘China growth tracker’ to see how the recovery is evolving.
Implications: China growth will impact the commodity cycle, so stalling growth will provide downside risks.
Neither Crisis Nor Credit Crunch…
While many were panicking about a 2008-style bank crisis, we cautioned against such predictions. So far, our view has been right. US equities have bounced back from the declines following Silicon Valley Bank’s failure, credit spreads have started to narrow, and US banks are using less of the Fed support facilities than a few weeks ago.
At the 22 March FOMC, the Fed also expected the banking crisis to be contained but ‘result in tighter credit conditions for households and businesses, which would in turn affect economic outcomes.’
Since then, the data has supported the Fed’s expectation that the banking crisis would be contained: Fed lending to banks has fallen, deposits have fallen roughly in line with quantitative tightening (QT) and flows into Money Market Funds (MMF) have turned negative.
In addition, small banks’ lending growth has resumed. The sharp decline in deposits and smaller decline in lending after the-Silicon Valley Bank failure lasted only a few weeks.
As a result, real wages are rising and the share of wages in GDP has increased, while that of profits has decreased (Chart 2). This could set the stage for an acceleration of inflation in H2 as the strong economy could see corporates attempt to restore their margins.
Rising wages should pressure corporate margins unless companies continue to push prices higher.
EAFE Equities Priced for Perfection?
EAFE equities have rebounded strongly since October last year, outperforming the US by c. 16%. European fears regarding the winter were overdone, and Japan continued to ease domestic Covid restrictions (Chart 3).
Since the turn of the year, euro area and Japanese PMIs have risen too, showing that growth had bottomed and was now accelerating. The nature of this rebound has been uneven, though, focused more on the services sector than manufacturing.
While the BoJ has signalled they may be on hold, we are more hawkish on the ECB. We expect a terminal rate higher than 4%, increasing the pressure on European equities. Further, analysts’ expectations for EAFE forward earnings remain strong, with the next 12-months of (NTM) earnings growth expected to be c. 4% compared with -2% for the US (Chart 4).
The EAFE index also has a higher percentage of its weighting in cyclical sectors at 53%, compared with just 34% for the S&P 500. This makes it more sensitive to a slowing economy. Relative to the S&P 500, over the last three months, EAFE operating margins have fallen by less than half the amount at 40bps.
And finally, European cyclicals (ex-financials) look stretched relative to defensives, particularly given the ongoing weakness in manufacturing (Chart 5).
This leads us to move underweight in EAFE from neutral last month.
Dovish BoE Presents Opportunity in Gilts
While wage outturns have been consistently stronger than expected, Chief Economist Pill has noted its momentum is slowing, and there are nascent signs of labour market loosening. Wage growth has been a thorn in the side of MPC policymakers, not only in terms of its overshooting versus forecasts, but also in terms of inviting PR gaffs in comments.
Further out, inflation will likely continue to undershoot the target, but potentially by less
The market is pricing a peak rate just shy of 5%. We think the market is overpricing future hikes. We expect the labour market will continue to loosen and inflation (particularly food) will see strong near-term deceleration. That would set the stage for bank rate to peak in June at 4.75%. This would also open the possibility for BoE rate cuts before the end of the year. Hence, unless the BoE clearly indicates they will continue to hike into such a situation, we would see room for paring current market pricing (Chart 6).
Given this view, we prefer to take duration exposure within the Gilts market. With 10Y Gilts currently yielding 3.8%, almost 40bps higher than 10Y Treasuries, they look attractive to us. Despite our view that rates are likely to rise and remain higher than market consensus in the US and Europe, we think duration risk is lower in the UK.
If we are wrong and the BoE hikes to 5%, the downside should be limited given market pricing.
The correlation between US stocks and bonds has turned negative again, falling by almost 40% since 2022. This means when that when stocks fall, bonds rally and vice versa. This is important as it shows US bonds are once again offering diversification benefits versus US stocks.
A positive stock vs bond correlation was one of the key risks we flagged over 2022 in our ‘everything breaks’ portfolio as inflation became the key risk for markets.
A negative correlation between stocks and bonds shows that this year the market has become less concerned by inflation risks as growth comes back into focus, driven by the US banking crisis and falling energy prices (Tables 1 and 2).
Precious metals continue to add diversification from a portfolio perspective by offering limited correlation to equities. Over the last three months we have seen the correlation against US government bonds increase by almost 27% versus 2022.
Our Core Investment Themes
We also introduce our core investment themes, which shape our asset allocation views over the medium term.
1) The Economy Remains Stuck in a High Inflation Regime
We believe we are in a high inflation regime where wage and price behaviours have become impacted by already high inflation.
BIS research sheds light on inflation inertia in high and low inflation regimes. Low inflation regimes are characterized by ‘rational inattention’, that is, economic agents tend to ignore inflation changes. By contrast, in high inflation regimes, price inflation becomes high because wage inflation has become high and vice versa. Prices across most categories become correlated and shocks, such as energy price increases, spill over into the whole economy.
Investment implications: We continue to prefer inflation-linked bonds within fixed income.
2) Terminal FFR Moving Much Higher
Growth is not slowing as the Fed expected, and this does not reflect policy transmission lags. The Taylor rule indicates a terminal FFR as high as 8%.
Monetary policy changes have two speeds of transmission, fast and slow. Fast speed applies to policy transmission through financial markets, where the impact of policy announcements is instantaneous. For instance, equity prices are down 15% since the Fed announced it would tighten policy, at end-2021. Similarly, 30-year mortgages rates have increased by 350bp over the same period.
Yet home prices are stabilizing, and household net worth, relative to income, remains well above pre-pandemic levels. This reflects two broad factors: the enormous scale of easing during the pandemic, as well as structural factors that have made the US more immune to monetary policy tightening.
Without further supply shocks, and with fiscal and monetary policy too loose, we expect the FFR to approach 8% over a longer timeframe.
Investment implications: We continue to like cash, yielding 5%, and short duration over longer duration treasuries.
3) Large Fiscal and Strong Consumption Keeps Growth Surprising to Upside
We believe the link between financial conditions and growth has shifted.
Strong household balance sheets should insulate the economy even as residential real estate prices soften. Second, after four decades of falling yields, households have locked in low funding rates. Like households, businesses will likely be insulated from tighter financial conditions through locking in low long-term funding costs. Due to supply-chain disruptions, growing geopolitical risk and government intervention, US manufacturers have been investing more at home and less abroad – further encouraged by the Inflation Reduction Act.
Investment implications: Real economy to outperform ‘new’ economy within equities. Commodities are also structurally more attractive.
What Is the Consensus Asset Allocation?
We continue to disagree with the emerging consensus among asset managers to move overweight US government bonds. We also see underweight US equities becoming an increasingly consensus position with all but two of the asset managers we follow now underweight.