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CURRENCIES
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 %
Style Preference
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.
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.
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.
Duration Preference
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.
Real 10-year bond yields
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.
USD Index (100=-1Y)
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.
Oil and gold prices
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.
