We still believe in a soft-landing scenario, with recessionary environments not unlikely but comparatively mild by historical standards.
The economy is still ailing from the double shock of Covid and the Ukraine war, which makes it hard to read the usual indicators. Surveys of industrial and household sentiment suggest risks of recession continue to run high. The same message can be read into bond markets: medium-/long-term yields are well below short-term rates. Such an inversion of the yield curve suggests that markets are expecting sharp downturns in the economy and inflation, to the point that interest rates will have to drop off significantly.
On the other hand, the latest actual indicators show developed economies looking fairly healthy, holding up well despite the spike in inflation and interest rates, and the more recent energy crisis in Europe.
Labour markets are booming, with levels of employment above what they were pre-Covid in most economies. The rebound in equity markets since the start of the year also sends a clear signal that expectations are improving as investors move away from a scenario of imminent recession. We still believe in a soft-landing scenario, with recessionary environments not unlikely but comparatively mild by historical standards: while the signals may be mixed, we remain confident that most economies will be able to avoid severe downturns. Robust labour markets and falling inflation will bolster household incomes, while the remaining “Covid savings” continue to support demand.
That said, while headline inflation should continue its decline, underlying inflationary pressures will likely persist, keeping central banks on the alert.
Monetary conditions are likely to remain tight, damping down the vigour of economies. Past rate hikes have already stalled activity in most property markets and are inhibiting firms’ capacity to finance investment.
Energy prices have eased, and China has opened up its economy again, two bits of good news for the world economy. High inflation and policy tightening by central banks will continue to weigh on developed economies, but the support factors already at work (labour market in particular) should help mitigate these effects and reduce the risk of an overly deep recession.
This month Fahad Kamal, our Chief Investment Officer, and Andrew Thompson, our Head of Investment Management discuss the bright start markets have had this year compared to the end of 2022.
Is this optimism around economic movements in the months ahead justified? Tune in to hear our thoughts.
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EQUITIES
BACK TO NEUTRAL
We have raised our exposure to global equity markets from Underweight to Neutral. We continue to favour regions with more attractive valuations and favourable sectoral composition, such as Europe and the UK, and have reintroduced exposure to Japan, which is set to benefit from the Chinese reopening.
US. US equities have continued on their bull trend, with the S&P 500 up nearly 8% and the Nasdaq - heavily weighted toward growth stocks that suffered throughout 2022 - rallying nearly 14% since the turn of the year. The rally is mainly explained by investor expectations that the economy will pick up speed over the next few months and headline inflation will fall. January indicators for business activity, employment and inflation shows an economy that remains. resilient with price pressures gradually falling. However, the United States economy continues to slow, and it will be some time before core inflation (5.6% in January) gets back near its 2% target, suggesting monetary policy will retain its restrictive bias for the foreseeable future. We therefore think equity markets remain vulnerable to a downside correction, particularly as they are still trading on high multiples and remain Underweight.
UK. Recent data releases brought some welcome positive news about the UK economy: inflation undershot expectations on the back of cheaper energy prices, and the core metric dropped to 5.8% - its lowest reading in five months, and 0.4% lower than initially estimated. Wage growth surprised on the upside and the economic inactivity rate fell, suggesting a solid labour market. UK-based internationals are well positioned to take advantage of a more resilient global economy and we are Overweight.
Eurozone. European markets have also made big gains this year, with the MSCI Europe up 11%. The rally is mainly due to the easing of fears about the energy crisis - gas prices reached an 18-month low in February - and the unexpectedly fast reopening of the Chinese economy. A recession at the beginning of the year now seems less likely in the Eurozone. Secondly, labour markets remain buoyant and unemployment near historic lows, while falling energy prices should bring headline inflation down significantly throughout the year. We have adjusted our Europe exposure to recognise gains from the latest rally and are now Overweight, appreciating the region’s attractive valuations and favourable sector composition.
Japan. The Bank of Japan is likely to stick with a more accommodative policy than other central banks, and its economy is well positioned to take advantage of China’s reopening – indeed, the country is Japan’s largest export partner. We have reintroduced exposure to Japanese equities, however, remain Underweight overall.
Emerging markets. Weekly data already show a major rebound of the Chinese economy. We think the end of Covid restrictions will bring a bounce in growth, notably as households make up for missed shopping days. Consumers have a substantial surplus savings pile. Such a rebound by the Chinese economy would be good news not only for others in the region but also for many commodity exporters among the emerging economies, such as Brazil. We are Neutral.
Equity indices: dividend yields %
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
Attractive Return
On one hand, interest rates have already risen considerably, making some market segments very attractive. On the other, underlying inflation remains stubbornly high and this could lead central banks to maintain a hawkish tone and keep upward pressure on rates. We remain cautious for the time being.
rates
US. Treasury yields have been on an uptrend , with the 10-year T-bond breaking back above 3.5% in recent days. Yields at this level continue to make this market very attractive. The Federal Reserve is likely to maintain a restrictive tone on monetary policy in an environment where underlying inflation will take time to come down. However, much of the monetary tightening is now behind us and the Fed has continued to reduce the scale of its rate hikes. At its last meeting, it raised policy rates by 25 bp, to 4.5-4.75%. It could continue on this track with two further quarter-point rises at upcoming meetings before marking a lasting pause to assess whether its policy has worked. But overall, although underlying inflation may take time to fall back, the headline figure continues to drop (to 6.4% in January), reinforcing the idea that the deflationary process is under way. In general, attractive yields and the prospect of falling inflation and a monetary policy plateau persuades us to remain Overweight the Treasuries market.
UK. Gilt yields have also risen to over 3.4% in recent days. Until now, inflationary pressures have been more significant than in other developed economies, which led 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. However, after encouraging data releases in February, the possibility of only one further 25 bps hike – followed by a prolonged pause - has crept into forecasts. In this context, we remain Neutral on Gilts.
Eurozone. Euro area sovereign bond yields have also been on an uptrend. The 10-year Bund and OAT rates have increased to 2.4% and 2.7%, respectively. Also, risk premiums on bonds issued in peripheral economies continue to fall without any ECB intervention. At its last meeting, the ECB voted to increase policy rates by 50 bps, and now envisages another 50 bps hike in March, after which it will review the situation. This means the ECB is maintaining its hawkish tone, confirming its will to continue tightening policy rates to combat ongoing pressures on underlying inflation. While January's headline inflation figures fell faster than expected, to 8.5%, underlying inflation continued to rise, to over 5%. Overall, we remain Neutral on European sovereign debt, which pays less attractive yields than other segments of the debt markets.
Developed markets. Credit spreads have somewhat contracted as investors embraced the news of a more resilient economy. With the most adverse scenarios abating we have begun a gradual addition to our investment grade credit exposure, however, we remain Underweight for the time being. We also remain Underweight high-yield credits amid a slowdown of economic activity that could hit the riskiest companies harder.
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
Slight Moderation for the dollar
The dollar made up ground against other major currencies in recent weeks on the prospect of further rate rises by the Federal Reserve and a delayed policy pivot. However, we remain Overweight the euro and pound due to the continuing improvement in the balance of payments and the prospect of narrowing rate spreads.
GBP/USD. We remain Overweight sterling against the dollar. Sterling fell 1.5% against the dollar as the end of the US rate tightening cycle receded into the future. In the short term, the pound should be supported by an easing of external pressures, a reduction in perceived political risk and the Bank of England also likely to continue with its monetary policy tightening.
EUR/USD. Just like the pound, the European currency fell by 1.3% against the greenback last month as markets now expect the Fed to land on a terminal rate 50 bps higher than forecast at the start of the year. However, we think the euro should regain territory in coming weeks as Europe's trade balance move back into surplus, and the ECB sustains a restrictive policy bias that will narrow rate spreads. We are Overweight.
USD/JPY. The dollar continues to make gains against the yen, rallying nearly 3% since the beginning of the year. This downward drift in the yen, which started nearly a year ago, basically reflects the interest rate differential between Japan and other developed economies. Japan is, for now, sticking by its yield curve control system, in which the Bank of Japan caps the 10-year JGB yield at 0.5%. Markets expect the new
In the short term, the pound should be supported by an easing of external pressures, a reduction in perceived political risk and the Bank of England also likely to continue with its monetary policy tightening.
governor, Mr Kazuo Ueda, to gradually exit the YCC system because Japanese inflation has finally passed the 2% threshold, nominal wages are also starting to rise faster than 2% and the system forces the BoJ to keep buying sovereign bonds even though it already holds over 40% of the total outstanding.
Dollar Index. The dollar made up ground against the major developed and emerging market currencies over recent months due to the growing probability that the Fed will hike policy rates further and push back its policy pivot to later than previously expected. The dollar was particularly strong against emerging market currencies such as the ZAR, KRW and MYR.
Emerging market currencies. EM currencies fared especially poorly in the latest dollar rally. Egypt, Pakistan and Lebanon all abandoned their respective pegs to the dollar as their support increasingly depleted foreign currency reserves. This has raised concerns around a wider wave of devaluations, however China’s reopening should at least provide support to currencies in Emerging Asia regions.
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.
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.
Commodities. We remain Neutral on Commodities. Our scenario of a soft landing for global growth should limit any decline in demand for commodities. China's reopening will tend to support global demand. In the oil market, the International Energy Agency anticipates that demand for crude will hit a record high in 2023.
Gold. Demand for gold should remain strong due to significant purchases by central banks and the slowing of the Fed's rate hike cycle. In this context, and with an eye on diversification, we are retaining our Overweight on gold.
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.
Important Information – *Please Read*
IMPORTANT INFORMATION – PLEASE READ
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Hedge funds
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SG Kleinwort Hambros Bank Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The company is incorporated in England & Wales under number 964058 with registered office at One Bank Street, Canary Wharf, London E14 4SG.
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Jersey
SG Kleinwort Hambros Bank Limited, Jersey Branch is regulated by the Jersey Financial Services Commission. SG Kleinwort Hambros Bank Limited is also authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority in the UK. The bank's principal address in Jersey is PO Box 78, SG Hambros House, 18 Esplanade, St Helier, Jersey JE4 8PR. The company is incorporated in England & Wales under number 964058 with registered office at One Bank Street, Canary Wharf, London E14 4SG. Services provided by SG Kleinwort Hambros Bank Limited, Jersey Branch will be subject to the regulatory regime applicable in Jersey, which differs in some or all respects from that of the UK. For UK-resident clients certain FCA protections may apply in addition to those available under the Jersey regime in certain specific circumstances.
Guernsey
SG Kleinwort Hambros Bank Limited, Guernsey Branch is regulated by the Guernsey Financial Services Commission to provide banking services and investment business services and is also registered as a money services provider in Guernsey. SG Kleinwort Hambros Bank Limited is also authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority in the UK. The bank's principal address in Guernsey is PO Box 6, Hambro House, St Julian’s Avenue, St Peter Port, Guernsey, GY1 3AE. The company is incorporated in England & Wales under number 964058 with registered office at One Bank Street, Canary Wharf, London E14 4SG. Services provided by SG Kleinwort Hambros Bank Limited, Guernsey Branch will be subject to the regulatory regime applicable in Guernsey, which differs in some or all respects from that of the UK. For UK-resident clients certain FCA protections may apply in addition to those available under the Guernsey regime in certain specific circumstances.
Gibraltar
SG Kleinwort Hambros Bank Limited, Gibraltar Branch is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority and is authorised and regulated by the Gibraltar Financial Services Commission in respect of banking, investment and insurance mediation business. The company is incorporated in England & Wales under number 964058 with registered office at One Bank Street, Canary Wharf, London E14 4SG and is registered in Gibraltar under the Gibraltar Companies Act with its principal place of business in Gibraltar at Unit 5.02, Madison, Midtown, Queensway, Gibraltar GX11 1AA. The liability of the members of SG Kleinwort Hambros Bank Limited is limited.
Services provided by SG Kleinwort Hambros Bank Limited, Gibraltar Branch will be subject to the regulatory regime applicable in Gibraltar, which differs in some or all respects from that of the UK. For UK-resident clients certain FCA protections may apply in addition to those available under the Gibraltar regime in certain specific circumstances.
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SG Kleinwort Hambros Bank Limited, Guernsey Branch is a participant in the Guernsey Banking Deposit Compensation Scheme (the “GBDC Scheme”). The GBDC Scheme offers protection for “qualifying deposits” up to £50,000, subject to certain limitations. The maximum total amount of compensation is capped at £100,000,000 in any five year period. Full details are available at: www.dcs.gg. For further information about the schemes (including the amounts covered and eligibility to claim), please contact your Private Banker.
Jersey and Guernsey do not have compensation schemes in relation to investment services. However UK-regulated mortgage business conducted by SG Kleinwort Hambros Bank Limited is covered by the FSCS if you were resident in the UK at the time the service was provided.
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