China’s reoening bolsters our base case scenario of a relatively soft landing.
China’s re-opening bolsters our base case scenario of a relatively soft landing. The start of the year brought relief for some of the risks overshadowing the world's economy. First, the rapid ending of Covid lockdowns in China should prompt a rebound in domestic demand which will also be good news for its trading partners. Elsewhere, the easing of pressures on Europe’s energy markets helps alleviate some of the continent's problems. These pieces of good news confirm our belief that the economy is headed for a relatively soft landing, with recessionary environments not unlikely but playing out comparatively mild by historical standards. While above-average inflation continues to weaken household purchasing power and tighter interest rates discourage corporate investment, households are still sitting on substantial, albeit falling, Covid savings and labour markets continue to be strong.
In the United States, growth remained solid in the last quarter of 2022, at +2.9% year-on-year. Leading indicators for the start of 2023 suggest an ongoing deterioration of activity in some sectors, particularly industrial production and real estate. While persistently high inflation continues to weaken households’ purchasing power, a robust labour market is helping mitigate the hit to real incomes. At the same time, reasonable surplus savings built up during Covid are likely to provide a supportive cushion for consumer spending for now.
The UK’s local economy will continue to face challenges amidst the unfolding cost of living crisis and a relatively tighter fiscal policy: conditions are exacerbated an unusually high exposure to whole-sale gas prices due to lack of storage, a high proportion of fixed-rate mortgages coming due, and a relatively inelastic supply of labour. However, relative calm has returned to its political environment and the FTSE 100’s favourable sectoral composition should benefit from China’s reopening.
In Europe, an easing of energy prices and the reopening of China’s economy reduces the chance of the kind of deep recession many feared when the war in the Ukraine broke out. Latest indicators also suggest a slight revival in Eurozone activity. Economies will continue to draw strength from solid labour markets and still significant Covid savings as well as the direct support from government fiscal policies.
China should enjoy a significant bounce in its domestic economy thanks to the cliff-edge ending of anti-Covid measures. Household consumption – having run well below its long-term trend for the last three years – should rebound as Chinese households have their own backlog of Covid savings and should be able to afford a spending spree.
Inflation will continue its rapid decline particularly in the US, but central banks will remain on alert. The easing of commodity prices, particularly with regards to energy, should bring a rapid fall in headline inflation for developed economies over the coming months. However, the ripples of the price shock that hit a year ago will continue to spread, notably through wages, keeping core inflation elevated. As a result, central banks will continue to tighten policy in the short term before calling a halt. They are likely to stick to their hawkish tone until sure that underlying inflation can be brought back to near target – their credibility is on the line.
In accordance with the regulations in force, we inform the reader that this document is qualified as a promotional document. Unless specified, all figures and statistics in this report are from Bloomberg and Macrobond on 27/01/2023, publication completion date.
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EQUITIES
Cautiously Optimistic
With the decline in headline inflation in developed economies and China’s reopening, hope has blossomed in equity markets since the turn of the year. That said, the outlook for the global economy remains uncertain as the United States economy continues to lose steam. We are Underweight.
United States. US stock market indices have done well since the start of the year on the back of globally declining inflation. Markets now seem to have priced in the coming fall-off in inflation rates and the end of the Fed’s monetary tightening cycle. However, the market still looks expensive based on its long-term trend, especially so at a time of positive real rates. What is more, corporate results season, which has been mixed so far, suggests corporate earnings growth could be slowing. Given this context, we maintain a prudent view on the US equity market and remain Underweight.
United Kingdom. In 2022, the UK’s main equity index FTSE 100 outperformed the MSCI World thanks in large part to its large energy and commodities share. Now, the Chinese reopening is set to continue to benefit the British market. This dependence on broad commodities also comes with risks, particularly if a sharper slowdown in the United States economy should translate into decline of energy prices; however, downside risks should be limited as the wider index’s valuations remain attractive, and we are Overweight.
Eurozone. The European market has performed well recently, outperforming other developed equity markets on the back of expectations for a sharper fall-off in inflation. Eurozone equities have benefited more specifically from worst-case scenarios for the energy crisis not coming to pass and the rapid reopening of the Chinese economy, likely to benefit many European firms. As a result, revenue forecasts are likely to be revised upwards. However, the ECB's determination to keep monetary conditions tight is likely to curtail the upside for European stocks in the short term. Overall, we remain Neutral on this market.
Now, the Chinese reopening is set to continue to benefit the British market.
Japan. We remain Underweight Japanese equities. China's reopening should be good for Japanese companies but the emergence of inflationary pressures casts doubt on the Bank of Japan's monetary policy direction, leading us to take a cautious stance.
Emerging markets. The unexpectedly fast reopening of China's economy should trigger a bounce in growth, notably as consumers rush to catch up on missed spending. Households are estimated to have a substantial amount of liquid surplus savings following year-long lockdowns. This consumption rebound in the Chinese economy would be good news not only for other economies in the region but also for many commodity exporters among the emerging economies. We are Neutral.
Equity markets: Price to expected earnings
Past performance does not prejudge future performance. Investments may be subject to market fluctuations, and the price and value of investments and the resulting revenues may fluctuate downward and upward. Your capital is not protected and original investments may not be recovered.
FIXED INCOME
Yields Remain Attractive
We remain Neutral on developed sovereign debt in an environment of slowing inflation and growth. Credit yields have stabilized at an attractive level; however, we are wary of the implications of the continuing economic slowdown and remain Underweight for the time being.
SOVEREIGN
US. Treasury yields continue their slide, with the 10-year T-bond dropping back below 3.5% in recent weeks. Underpinning this good performance by sovereign debt is the prospect of falling inflation and a pause in monetary policy tightening. In December 2022, annual headline inflation slowed to 6.4%, down from a peak of 9% in May. Core inflation, the measure targeted by the Fed, also eased, to 5.7%. The faster-than-expected slowdown of inflation in most components of the consumer basket - with the exception of rents - bolstered market expectations that the Fed would cut rates in the second half of 2023. Given our scenario of a modest economic slowdown and only gradual fall in underlying inflation, we expect the central bank to slow the pace of rate hikes to just +25 bp at each of its February and March meetings, on the way to a terminal rate of 5%. Then, we believe that the Fed is likely to stick for much of the rest of the year until it is fully persuaded that underlying inflation is on the way down. Taking into account these elements, we remain Neutral the US Treasuries market.
UK. Gilt yields also fell more than 30 bps since the beginning of the month, reflecting moderating inflation figures mainly off the back of lower energy prices. However, as in continental Europe, underlying inflationary pressures persist. This will lead the Bank of England to continue with its policy of hiking rates toward a terminal rate forecast of 4.5% and reducing its balance sheet. We remain Neutral on Gilts.
Eurozone. As with US Treasuries and UK Gilts, sovereign bond yields in the Eurozone have declined in the new year. The yields of Bund and OAT 10-year bonds have both dropped by 50 bps since the year began, now yielding 2% and 2.5%, respectively. Here again, the decline of yields was linked to expectations that inflation will fall quicker than expected largely because of fast-falling energy prices. Headline inflation for December also fell more sharply than expected, to 9%. But, unlike in the United States, core inflation in the Eurozone is still accelerating, to more than 5% in December. Against this backdrop, the ECB has maintained a hawkish tone and we expect rates to peak below 3.5% by 2Q23. We are Neutral.
Developed markets. Yields on investment grade Credit remain attractive and company balance sheets sound amidst a slowing economy. However, default rates have begun to tick up and we would like to see further signs of reassurance before adding to our position. We are Underweight.
Past performance does not prejudge future performance. Investments may be subject to market fluctuations, and the price and value of investments and the resulting revenues may fluctuate downward and upward. Your capital is not protected and original investments may not be recovered.
Currencies
Dollar Appreciation Reversed
The dollar’s rally in 2022 has gone into reverse this year as spreads between central bank rates have narrowed, the Chinese economy has reopened and energy prices in Europe have come down. In light of these factors, the dollar is likely to soften against main leading currencies for the next few months.
GBP/USD. The pound has strengthened against the dollar on receding fears of a deep slowdown and narrowing rate spreads to the Fed. The Bank of England is set to maintain a more restrictive policy than the Fed over the next few months. That said, given the United Kingdom’s still bleak growth outlook - it being the only major developed economy forecast to be in recession in 2023 - and with political instability still bubbling away, we do not expect a strong rally either way.
EUR/USD. The euro continues to gain ground against the dollar, stabilising around 1.08 EUR/USD, its pre-Ukraine war level. Its rally has been supported by falling energy prices, the narrowing of the rate spread between the United States and Eurozone, as well as China's reopening. We expect the Fed to slow the pace of its rate hikes and end its policy tightening phase in Q1 2023. The ECB meanwhile should continue to raise rates in 50 bps increments over coming months and retains a restrictive policy bias, at least in its public statements. Also, the ongoing fall in energy prices and reopening of the Chinese economy should bolster not only growth but also Europe’s current account balance, which was back in the black in November.
USD/JPY. The Japanese yen made gains against the US dollar, like other currencies, on the back of China's reopening, which should stimulate Japan's economy and help its balance of payments, and the prospect of a change to the yield curve control system. With the Bank of Japan taking a gradual approach to raising sovereign rates while managing the yield curve and the Fed likely to slow down its tightening, we expect the pair to trade close to its current level in the short term.
Dollar Index. The dollar has fallen sharply since the turn of the year not only in its crosses to the leading developed world currencies but also against emerging market currencies. Markets are no longer haunted by fears of a sharp slowdown in global growth, following the easing of energy prices in Europe and the reopening of the Chinese economy. Also, the perception that the Federal Reserve will likely be the first central bank to pause its rate tightening cycle is helping the general downward drift of the dollar.
Emerging market currencies. EM currencies reacted especially sensitively to a weakening dollar and even outperformed developed currencies over the past few weeks. A strengthening Renminbi further inspired currencies in the region and support should last at least as long as the optimism around China’s reopening.
The pound has strengthened against the dollar on receding fears of a deep slowdown and narrowing rate spreads to the Fed.
Past performance does not prejudge future performance. Investments may be subject to market fluctuations, and the price and value of investments and the resulting revenues may fluctuate downward and upward. Your capital is not protected and original investments may not be recovered.
Exchange rates against the dollar
ALTERNATIVES
Seeking Diversification
Commodities may be buoyed by the reopening of China's economy and gold will continue to play its traditional role as a safe haven. Hedge Funds may have lost some of their shine compared to the protective benefits of yield-bearing fixed income products, they remain a core pillar of our diversification strategy.
Diversified. The re-opening of China’s economy has understandably roused commodity markets. Specifically the oil price, which has been up and down like a yo-yo for just over a year, has been rising since the start of January in line with the general turn-up in markets, and now , at $85 a barrel, stands almost 13% above its November low. However, the global economy will remain wheezy and the uncertainties surrounding a likely downturn in growth will limit the upside for commodity prices over the coming year.
Gold. Gold has continued its strong positive momentum in January, buoyed by a weaker dollar, deteriorating economic growth, and big purchases by central banks. We remain Overweight on gold for the purpose of diversification – uncertainties around the global economy are likely to persist throughout the year – and expect further support from a stalling US monetary cycle.
Infrastructure & specialist property. We hold an allocation to a diversified portfolio of infrastructure (such as energy storage and efficiency, smart grids, waste-to-energy, air treatment and digital infrastructure) and specialist property assets (including care homes and e-commerce and logistics warehouses). These real assets offer additional diversification from other risk assets such as equities, as well as an attractive income stream and reasonable sensitivity to inflation.
Hedge Funds. In unstable market conditions hedge funds can help a portfolio, but selectivity is key. We prefer strategies which hold their own in bear markets, such as Merger Arbitrage, trend followers and Equity long/short. These strategies provide relatively safe, uncorrelated sources of returns from equities. Our hedge funds allocation has performed well over 2022 and have been a great diversifier in our strategies.
Tail Risk Protection Note. Tail risks are typically understood as unlikely but severe crisis events which shock markets and dramatically impact the value of risk assets negatively. The dot-com bust at the turn of the century and the Great Financial Crisis in 2008 and 2009 are examples of such events. Despite conditions not being favourable for it in 2022, we believe the Tail Risk Protection Note offers our portfolios yet another critical source of safety and complements the existing diversifiers.
Past performance does not prejudge future performance. Investments may be subject to market fluctuations, and the price and value of investments and the resulting revenues may fluctuate downward and upward. Your capital is not protected and original investments may not be recovered.
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