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We remain Underweight sovereign bond markets. Interest rates look attractive in that they are again paying positive returns, adjusted for inflation hedges, amid rising uncertainty about global growth. Bond markets, however, remain vulnerable to fresh upside surprises on inflation.
United States. Treasury yields remain volatile against a backdrop of slowing growth, only gradually falling inflation and restrictive monetary policy. Having dipped to 2.6% over the summer, 10-year Treasury yields are now back above 3% following the Jackson Hole symposium. Jerome Powell used the meeting to stress that underlying inflationary dynamics remained high and would require a lengthier period of higher interest rates in response. His remarks triggered a substantial reset of short-term rates in the United States, with money markets now expecting rates to peak at 3.75%, and real yields now positive across nearly the whole curve. In these circumstances, we remain at Underweight on Treasuries. Fears of recession, ongoing political risks and some tempting carry are all bullish factors for Treasuries. However, any upside surprises on inflation could trigger a fresh jump in yields.
The Bank of England is scrambling to contain spiraling prices; however, its powers are limited in the face of exogenous factors such as theongoing energy shock.
United Kingdom. Inflation in the UK has been running hotter than in the US, and for different reasons. The Bank of England is scrambling to contain spiralling prices; however, its powers are limited in the face of exogenous factors such as the ongoing energy shock. This, the incoming Prime Minister Liz Truss is attempting to curb with the introduction of an energy price cap funded by additional borrowing. Gilt yields have surged in the last week to leave the 10-year bond paying above 3% as the BoE announced it would speed up its rate-tightening cycle, now expected to peak at 4.25%, and warned of a stagflation scenario for the next few quarters. We remain at Underweight.
Eurozone. Sovereign yields in Europe have also been volatile over recent weeks. The 10-year bund dropped below 0.8% in early August before rebounding back above 1.50%. These movements of course reflected the market's re-evaluation of monetary policy as inflation continues to accelerate in the wake of the energy shock and fears of second-round effects.
Several ECB members have already spoken in favour of accelerating policy tightening, fearing that current levels of inflation could majorly de-anchor the inflationary expectations of households and companies. In September the ECB raised its policy rate by 75 bps amidst warnings about a substantial slowdown in economic growth and markets expect rates to peak of 2% in H1 2023. Overall, given the weak growth outlook and an increasingly hawkish ECB, we remain Underweight European sovereign debt.
Developed Markets. We remain Underweight on investment-grade bonds. The recent adjustment in yields has made carry on these assets attractive, however risk premiums have widened considerably – now back to pre-Covid levels - as the prospect of recession stokes fears companies may struggle to refinance maturing debt.
Emerging markets. We remain Underweight emerging market debt. Monetary tightening in developed economies is generally bad news for emerging market assets and risks to growth remain high.
Real rates remain positive
Past performance should not be seen as an indication of future performance. Investments may be subject to market fluctuations, and the price and value of investments and the income derived from them can go down as well as up. Your capital may be at risk, and you may not get back the amount you invest.
With growth outlooks deteriorating and inflation still running high, we remain Underweight on this asset class and are picking sectors with even greater prudence. We favour the UK given its defensiveness, inflation sensitivity and attractive valuations.
United States. After the stock market slides of H1, global equity markets mounted a broad recovery during much of the summer. There was good news on corporate earnings and expectations that, faced with slowing economic activity and moderating headline inflation, the Fed might moderate its policy tightening.
However, the rally was not sufficient to offset first-half losses and the market was recently hit again by the Fed’s reiteration of its hawkish tone in Jackson Hole. While peak inflation may be behind us in the US, price pressures will take time to return to more moderate levels, and the Federal Reserve will continue tightening policy to achieve its 2% inflation target “whatever it takes” in terms of economic impact. Amid such uncertainty, we remain Underweight on this market and are bolstering our exposure to defensive sectors.
United Kingdom. Despite a grim outlook for the UK economy, set to contract between now and year-end with inflation hitting 10% in July, the British stock market is one of the few sitting on year-to-date gains. It is helped by its sector composition – resident energy behemoths played a significant role in its support - and relative disconnection from the domestic economy. A weakening Pound is providing additional support for British internationals generating large proportions of their incomes abroad, and valuations remain attractive. We are Overweight.
The British stock market is one of the few sitting on year-to-date gains.
Eurozone. The region is being deeply disrupted by tensions emanating from the Ukraine war and by energy costs. Growth prospects for 2022 and 2023 are worsening. Europe's key economies look set to contract between now and year end. Inflation, meanwhile, shows no sign of slowing. Various estimates suggest inflation is unlikely to peak before 2023, raising fears of gas and electricity shortages this winter. Core inflation, which excludes price movements in energy and food however remains somewhat more tranquil. We are Neutral.
Japan. We remain Underweight this market. True, the Japanese stock market has held up well all year, but the sharp depreciation of the yen and the Japanese economy's reliance on China counsel caution.
Emerging markets. We remain at Neutral on emerging equity markets. Like most stock markets, EM equities have corrected overall since the start of the year. Problems with the Chinese economy could slow recovery in neighbouring Asian economies, while exporters of raw materials should continue to do well out of spiralling commodity prices. We remain at Neutral and remain alert to economic indicators on the region.
Equity market performances from January, 1st
Sources: SGPB, Macrobond, MSCI 01/09/2022
Like most stock markets, EM equities have corrected overall since the start of the year.
The dollar has weakened over the last two weeks against most other currencies. It is still likely to remain high given the deteriorating economic outlook, the interest rate differential and geopolitical risks. This pause in the Dollar has given some relief for Sterling which continue to trade around -25% below its purchasing power parity to the Dollar.
Dollar index (DXY). The dollar has been strengthening for well over a year now against nearly all other floating currencies. It has weakened over the last week but a worsening growth outlook, expectations for a more hawkish policy tightening by the Fed and ongoing political risks will continue to buoy the greenback.
EUR/USD. The euro steepened its slide over recent weeks, touching parity with the dollar. Several factors have fuelled this depreciation: the transatlantic gap in interest rates, a deterioration of Europe’s balance of payments and mounting economic and political risks on the old continent. Primarily, the euro's weakening reflects the yawning gap between European and American real short rates, at its widest since 2012. Second, the sharp rise in energy prices has led to a deterioration in the balance of payments, dragging down the euro. Finally, fears that winter could bring an energy crisis and sharp contraction in the European economy have also hurt the euro's cause.
GBP/USD. The monthly GDP figure for the UK came in lower than expected at 0.2%, far lower than the expected consensus of 0.5%, suggesting a challenging picture and increased growth concerns. On a positive note, it was in expansionary territory and is more upbear that the contraction of -0.6% reported last month. The slightly weakening dollar over the last 2 weeks has caused the currency pair to touch off lows of 1.15 GBP/USD to almost 1.17. It is too early to tell if this trend will persist, all eyes will be on inflation to determine how aggressive each central bank will have to be in the future.
The slightly weakening dollar over the last 2 weeks has caused GBP/USD to touch off lows of 1.15 to almost 1.17.
GBP/EUR. Sterling has strengthened slightly in recent weeks amid fears of energy crises in continental Europe. The gap between nominal rates in the two regions is likely to remain stable.
Sterling has had some relief
Emerging market currencies. Emerging currencies remain on a downward trend. The larger than expected Fed tightening cycle is increasing the downward pressure on major floating currencies. The only exceptions to this trend are the currencies of the Latin American economies which benefit from improved terms of trade, very restrictive monetary policies, and low risk of an energy crisis.
The current climate of persistent inflation and uncertainties surrounding the economy is helpful for alternative assets. We retain our Overweight to commodities, gold, hedge funds and our Tail Risk Protection Note. We have recently added to real assets which offers diversification from other risk assets such as equities, an attractive income stream and reasonable sensitivity to inflation.
Oil. The oil price continues to weaken, Crude has sunk almost a third since June. Fears that the major developed economies could go into a recession continue to outweigh concerns about supply. In China, the world’s largest oil importer, lockdowns continue to intensify. Despite the recent OPEC+ supply cuts this has yet to stabalise the price.
Oil prices continue to fall on global recession fears
Gold. Despite the increased recession risks, gold has yet to stage another comeback. A strengthening dollar and the opportunity cost of other interest-bearing options has been a major headwind. We firmly believe that the environment remains rife with uncertainty; therefore, we still favour gold due to its safe-haven properties.
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 most significant allocation across balanced and growth multi-asset strategies and provide positive contributions to returns – and lowered risk – especially during periods of volatility. It is important to remember that our hedge fund allocation is flat this year while the equity market is down, this has been a great diversifier for strategies.
Real Assets. We have started to allocate 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 affordable housing, 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.
Such assets are often difficult to gain broad access to given the complexity in the underlying ownership structures and limited liquidity. However, we are able to take advantage of specialist inhouse expertise, oversight and liquidity management capabilities to gain exposure to these assets in a pooled investment vehicle (funded structure). We believe this vehicle will deliver sustainable returns over time at acceptable levels of liquidity with sufficient diversification in the underlying assets.
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.
We believe the Tail Risk Protection Note offers our portfolios yet another critical source of safety and complements the existing diversifiers.
