Asset Allocation Outlook
- Economic growth not as sound as it appears, except in China
- Central banks fail to persuade markets
- Larger underweight in US equities than in European equities
- Negative outlook for high yield credits
Financial markets got off to a good start in 2023. Global stocks delivered a total return of 7.2% in January. The performance of major markets reflects upcoming divergences in the growth outlook. China’s decision to drop its zero-Covid policy and to fully re-open is not only a game changer for the Chinese stock market (+ 11.7%) but will also have a lasting effect on its trading partners as well as the commodity market. The MSCI EMU returned 9.6% for the month, reflecting the surprising resilience of the European economy thanks to the relatively mild winter, well-filled gas storage reservoirs and substantial governmental support. Signs that inflation is ebbing, and that central banks may soon approach the peak of their hiking cycle also contributed to the positive sentiment. The U.S. stock market remained somewhat behind in January as signs of a slowdown in business activity and retail sales (+ 6.3%) overshadowed the otherwise robust macroeconomic figures. Global bond yields retreated on encouraging news on inflation and less hawkish statements from central banks, leading the Global Aggregate Bond Index to rally by 3.2%. Falling real yields also helped Gold shine in January (+ 5.7%).
As widely expected, the Federal Reserve slowed the pace of rate hikes to 25 basis points and downgraded the threat level from inflation. The biggest surprise was that Fed Chair Powell did not push back against recent loosening of financial conditions as a result of the latest equity rally, a weakening USD, lower bond yields and looser financial conditions as it could sow the groundwork for another wave of inflation which would forbid the central bank from meeting market expectations of rate cuts later this year. The less aggressive tone was also echoed by the ECB, which raised rates another 50 basis points and indicated that the risks to the economy were now “dual-sided”.
Markets have long held a more dovish interest rate outlook than the FED and ECB, and saw it confirmed in the statements of top policymakers in January. This optimism has been abruptly tempered with the latest employment report, which showed that unemployment in the US has fallen to 3.4%, the lowest since 1969. Average hourly earnings rose 4.6% (y-o-y). Even the Fed admitted that they did not expect the job's data “this strong”. As a result, market participants revised their expectations for the Fed peak rate back above 5% which puts the market back in line with the Fed's own assessment. Last week, J. Powell underscored that persistently elevated inflation or tight labor market conditions could lead to more hikes than what is currently priced into financial markets. Should expectations of the terminal rate need to be adjusted another leg higher, the current market rally would definitely lose an important pillar of support.
The labor market report coincided with a surprisingly strong rebound in the US service sector activity. The headline ISM index jumped six points to 55.2, returning to expansionary territory. However, given that real personal spending on services is nearing its pre-pandemic trend in the US, there is less scope for pent-up demand to continue to bolster service sector activity going forward. Furthermore, the rise in the saving rate and the third consecutive monthly drop in consumer spending could be signs that Americans have started to adapt their consumption patterns to the more difficult economic environment. We expect the lagged effects of tighter financial conditions will only really start to bite later this year as households and small businesses refinance at higher interest rates.
In the Eurozone, service sector activity expanded for the first time since July 2022. Forward-looking indicators raised hopes that the European economy may escape from recession. The composite purchasing manager’s index came out above the 50 level, pointing to marginal growth. Other leading indicators like the Economic Sentiment Index, the German IFO index do confirm the improvement in consumer and business sentiment. Eurozone headline inflation fell from 9.2% in December to 8.5% in January. Core inflation (ex - energy and food), however, was unchanged (+ 5.2%). The ECB aims to “stay the course” and is expected to deliver another 50 basis points hike in March, with more to follow in Q2. The effects of monetary tightening are becoming increasingly visible from the decrease in monetary growth and lending by banks, putting a lid on the strength of the economic recovery this year.
In China, consumption has staged a robust recovery, led by service activities due to the earlier reopening and peak infections. The service PMI rose to 54.4 to expand for the first time in six months, driven by retail and travel activity. We expect a further acceleration from the second quarter onward as the policy backdrop remains supportive and pent-up savings should provide an additional boost to consumption. We expect Chinese GDP growth to reach 5% in 2023, with risks to the upside. The reopening will impact Emerging Markets region and be beneficiary to companies that are highly exposed to Chinese spending. Higher commodity prices will pose new challenges for central banks.
US Corporate earnings continue to be lackluster. While revenue growth has decelerated from + 11% in Q3 to + 6% in Q4 2022, profit growth has come to a standstill, indicating pressure on company margins. Flat aggregate earnings also masks wide sector divergence with only three sectors generating positive growth in the quarter. Excluding the energy sector, earnings per share will likely decline by 6%. Even though only 20% of European companies have presented their figures for the fourth quarter of 2022, the first impression is convincing, with revenues and earnings growing 12% and 9% respectively. The tepid US reporting season reinforces our view that earnings will contract over 2023 and consensus estimates are still too optimistic. Even if bottom-up earnings estimates prove correct, we struggle to justify paying current high valuation (PE > 18) for the US market. With a risk premium at 1.9%, investors look poorly compensated for the equity risk (vs. treasuries). We therefore stick with an accentuated underweight position in US stocks.
While the strong start to the year is welcome, we believe the speed of the recent equity rally has been partly due to technical factors (light investor positioning) at the beginning of 2023. Over time, we expect investors to again focus on the fundamentals. While we recognize that for some parts of the market, the situation has improved, headwinds remain. The environment is still one of tepid growth coupled with a restrictive monetary policy. As a result, we favor a defensive portfolio positioning, including an underweight in equities and high yield bonds, which we downgraded lately.
Please find attached our last Asset Allocation Update for February.