Stay ahead of the curve with our experts’ breakdown of this month’s market shifts and the insights shaping our portfolio positioning.
Fast reading:
- The market is now worried about the potential for a US recession. Our view remains that while the economy is slowing, fears of recession appear unfounded. Instead, the economy bears the hallmarks of being in a more-late cycle phase.
- We remain positioned for cautious optimism on equities, with portfolios holding neutral to modestly underweight exposure and a bias towards defensive as well as structural growth characteristics.
- Within fixed income, we have incrementally added duration across the portfolios, which are now closer in line with the Euro Aggregate benchmark duration profile but ultimately still remaining underweight on a relative basis. Our preference to euro area fixed income remains.
Fears of a US recession appear unfounded
It has been anything but dull in equity markets since our last publication of Portfolio Perspectives in July. The market has gyrated sharply on more than one occasion since then and one could come up with many different reasons for the volatility for instance AI monetisation fears, the unwinding of the Yen carry trade or even the US Presidency. But these individual reasons only mask what the market is now really worried about, and that is fear of a US recession. Inflation is increasingly being seen as having been tamed. Even higher-than-expected US core inflation readings for August weren’t enough to upset the disinflationary consensus when the data was released earlier this month.
So, growth is now where it’s at. And given that the greater part of the US economy is consumer driven, that puts US consumer focused data in the spotlight. This means keeping a close eye on jobs data such as weekly initial jobless claims, jobs vacancy rates and monthly non-farm payrolls, as well as consumer data like US retail sales and consumer sentiment surveys. Indeed, the US Federal Reserve (Fed) is now watching the US labour market very closely given that unemployment is the other half of its dual mandate programme in addition to inflation. With greater confidence about inflation, it reduced rates by a larger 50 basis points (bps) at its last meeting in a likely bid to stay ahead of any significant weakening in the labour market.
To date, the US consumer has been strong, boosted by lower savings rates and steady employment. No doubt the labour market has shown signs of weakening demand reflected in lower vacancy rates, a falling average hourly earnings growth rate and revisions lower of prior job numbers. However, there are no mass layoffs and monthly job numbers are still at healthy levels. We would also note that companies continue to report good earnings, there are no signs of credit stress and oil prices are relatively well behaved. So, our view remains that while the economy is slowing, fears of recession appear unfounded. Instead, the economy bears the hallmarks of being in a more-late cycle phase.
That informs our modestly underweight stance in equities and within that, our positioning in stocks with a defensive quality and that have structural growth characteristics. Our confidence in their earnings capacity dilutes concerns around valuation. These are mostly to be found in the IT, Industrials and Healthcare sectors.
Strong performance from sovereign bonds as rate cut expectations come to the fore
Since the last edition of the Portfolio Perspectives in July, markets have been experiencing a tumultuous time navigating unexpected outcomes from data releases such as the weak US jobs report in August, the acute volatility in Japanese markets and differing commentary surrounding the timing and pace of the US Fed’s rate cuts.
The Fed has been watching the labour market very closely, and to much relief, the jobs report from the US economy in September showed payrolls rebounding. This in turn helped to reduce investor concerns about the economic picture. Coinciding with this more positive data was commentary from Fed officials cementing investor conviction that rate cuts were almost certainly on the table for the September meeting. This possibility was realised when the Fed cut rates by 50bps at their monetary policy meeting on Wednesday, 18 September. Across the Atlantic, inflation has continued moving downward toward the European Central Bank (ECB) 2% target; the ECB again lowered rates by 25bps to a 3.5% policy rate last week.
But what has all this investor and central bank activity meant for fixed income markets? With US investors pricing in and subsequently receiving an aggressive 50bp rate cut, sovereign bonds have been the stronger performers in recent weeks. The strength of US Treasuries has reverberated across the Atlantic with Government bonds in the euro area also outperforming their corporate counterparts.
With all of this in mind, the Fixed Income Strategy team has incrementally added duration across the portfolios, which are now closer in line with the Euro Aggregate benchmark duration profile but ultimately still remaining underweight on a relative basis. Our preference to euro area fixed income remains, where volatility from swings in rate cut expectations appear to be more controlled.
Portfolio positioning: a steady course through much volatility
There have been no major portfolio changes since our last update. July and August saw some dramatic market volatility but, in the end, there was little net movement in equities. The euro strengthened by about 3% over July and August, which had a negative impact on portfolio valuations due to the typically significant levels of US and other foreign equity holdings. As the dollar and other foreign currencies fall, the euro value of foreign currency assets of course falls, all else equal. Between the modest net rise of the equity market (in local currency terms) and the rise of the euro, the total return on the All-World equity index was broadly flat. Portfolios still mostly saw some gains as bonds rallied through the equity dip.
After a very dull first half, bonds experienced strong gains with the Euro Aggregate index returning nearly 2.5% over the past two months. The big driver of the bond rally was the fall in interest rate expectations for major central banks. As longer-dated bond prices are most sensitive to interest rates, these assets outperformed and provided support for portfolio performance. Mid-duration bonds lagged behind but still showed a gain of near 2%, but outperformed short-maturity exposures. Having lagged behind corporate bonds for the year-to-date, government bonds fared very slightly better in the past two months. Year-to-date, mid-dated corporate bonds, where our exposures remain most concentrated, have been the best performing segment of the euro investment grade bond market.
Within equity markets, our defensive positioning remains intact and produced mixed results over the volatility and subsequent recovery of the past two months. Healthcare and Industrials, our two largest overweight positions in equity portfolios, were among the strongest performers. Healthcare was only bettered by the interest-rate sensitive Utilities sector which reacted strongly positively to the fall in bond yields. Our modest underweight position in Utilities was a drag, but compensated by our underweight exposure to Energy which has been the weakest global sector. The more notable underweight in Financials was a drag on equity portfolio performance, as it also responded strongly to expectations of lower refinancing rates.
Overall, we remain positioned for cautious optimism on equities, with portfolios holding neutral to modestly underweight exposure with a defensive sector bias and a focus on structural growth themes.