Views at a glance – September 2023
The interest rate outlook is still a headwind for equities.
Rate cuts off the cards
Coming into the summer, investors had been anticipating interest rate cuts late this year or early next. That now looks unlikely as core inflation remains high and central banks have indicated that interest rates may have to rise even further – or stay high for longer than anticipated. As a result, developed market government bond yields have been rising and are now at their highest levels in almost 20 years. Global equity markets have been under some pressure, but remain close to recent peaks. While developed economies have displayed an impressive ability to cope with higher rates, the interest rate outlook means we remain somewhat cautious on equities in the near term. The picture is further complicated by China’s weakening economy. The government in Beijing has announced measures to boost confidence, but markets have not responded particularly positively.
China’s property markets continue to weaken
Some of China’s largest property developers have announced huge losses and sought to restructure their debt in recent weeks. This is prompting questions about whether China now faces a “Lehman moment.” The very muted market reaction suggests that it does not – at least for now. Chinese government bonds have outperformed their US counterparts, while commodity prices and Chinese bank share prices are both above last year’s lows. Investors may be taking some comfort from the fact that recent stress is the result of deliberate policy shifts designed to reduce debt levels and property speculation. These developments will depress growth this year and could still be a source of volatility. However, the transition to lower, but more sustainable, growth may ultimately be a healthy development.
Don’t underestimate the AI revolution
In our view, the stock market’s excitement about developments in artificial intelligence is not unfounded. Schroders’ Head of Global and Thematic Equities recently suggested that AI could allow global companies to cut their wage bill by over $2 trillion per year, as it takes on more of the work done by approximately one billion knowledge workers around the world. Some of these savings will flow to the largest technology companies in the form of additional revenue, explaining the strength of their shares this year. So far, the “picks and shovels” companies that provide chips and computing processing power have been the most obvious beneficiaries. However, we believe that we are still in the early stages of the AI revolution and many other firms will do well. Companies in some sectors may well struggle as AI disrupts established business models.
Portfolio positioning
The probability that US inflation will fall without the economy experiencing a significant slowdown has risen in recent months. We have therefore slightly increased our exposure to equities. While we remain underweight the asset class, we may take advantage of further opportunities to add to our position. We are comfortable with our modest overweight position in government bonds. We anticipate gradually increasing the maturity of our government bond holdings to protect portfolios as the global economy slows. High levels of inflation in the UK have made meeting inflation plus return targets more challenging in the shorter term. Despite this, we remain confident in the ability to meet inflation-plus targets over the longer term.
Outlook
Economics |
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Valuations |
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Sentiment |
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Risks |
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Key
🟢 Positive
🔵 Positive/neutral
⚪ Neutral
🟠 Negative/neutral
🔴 Negative
🔼 Up from last month
🔽 Down from last month
Asset Classes
Asset classes | Current positioning | Medium term view | Current views |
Equities | 🟠 | 🔵 | We remain underweight equity in the near term, although we continue to look for opportunities to increase exposure. Corporate earnings have been relatively robust in the recent reporting season although forward earnings estimates are elevated. Valuations have re-rated driven by firmer investor sentiment and are less attractive than they were at the start of the year. Market leadership has been narrow this year, especially in the US with a focus on large cap technology companies. |
Bonds | 🔵 | 🔵 | Nominal government bonds have defensive characteristics in an uncertain economic environment and yields look more attractive relative to recent history. We have continued to gradually lengthen interest rate duration as we move closer to the end of the rate cycle. Elsewhere we continue to prefer the credit of higher quality issuers as well as emerging market debt where growth prospects are brighter. |
Alternatives | 🔵 | ⚪ | Continue to offer attractive diversification characteristics in a potentially volatile environment. Within absolute return we favour strategies with the ability to deliver less correlated returns. We remain positive on real assets with long-dated visible revenue streams and commodities where supply and demand dynamics could support prices over the medium term. |
Cash | ⚪ | 🟠 | Rising interest rates offer more attractive returns relative to recent history, while cash allows us to take advantage of tactical opportunities in potentially volatile markets. |
Equities
Asset | Current positioning | Medium term view | Current views |
Equities | 🟠 | 🔵 | We remain underweight equity in the near term, although we continue to look for opportunities to increase exposure. Corporate earnings have been relatively robust in the recent reporting season although forward earnings estimates are elevated. Valuations have re-rated driven by firmer investor sentiment and are less attractive than they were at the start of the year. Market leadership has been narrow this year, especially in the US with a focus on large cap technology companies. |
UK | 🔵 | 🟠 | The UK economic outlook remains challenging. Inflation continues to prove resilient especially as wage growth reaches record highs, so we expect it to remain elevated in comparison to recent history. The UK consumer could remain under pressure following further interest rate hikes and sentiment may continue to weaken. Whilst domestic companies face an uncertain backdrop and are pricing more downside risk, valuations are supportive and opportunities remain. |
Europe | 🟠 | ⚪ | Valuations in Europe have surpassed their long-term median and earnings expectations seem overly optimistic in the event of slowdown in the second half of the year. Further, cracks are beginning to emerge amidst a slowdown in retail sales, manufacturing and services. |
North America | 🟠 | ⚪ | US equities have performed well recently as resilient consumption and a peak in the interest rate cycle reduce the probability of a hard landing in the near term. Market leadership has been narrow, focused on a small number of large cap technology companies with A.I. related revenues, although there are signs that leadership has broadened out more recently which could suggest a more sustainable recovery. Recent re-rating has left valuations looking less supportive, although in the near term corporate earnings are holding up. |
Japan | 🔵 | 🔵 | The re-opening of Japan’s international borders, and the return of Chinese tourists in particular, could benefit the Japanese economy. BoJ widening of their Yield Curve Control bands helps remove some policy uncertainty, which could further support flows. In addition, equity valuations remain attractive, and signs of improving corporate reforms are supportive over the medium term. |
Asia/ Emerging markets |
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| Despite relaxation of China’s ‘Zero Covid’ and reopening of the economy, falling domestic consumption and troubles in the property sector have led to a sharp deterioration in economic data and further stimulus may be needed to improve investor sentiment. Elsewhere in Asian and Emerging Markets growth prospects look more robust but remain highly dependent on the global cycle, whilst valuations remain reasonable in the context of history. |
Bonds
Asset | Curren positioning | Medium term view | Current views |
Bonds | 🔵 | 🔵 | Nominal government bonds have defensive characteristics in an uncertain economic environment and yields look more attractive relative to recent history. We have continued to gradually lengthen interest rate duration as we move closer to the end of the rate cycle. Elsewhere we continue to prefer the credit of higher quality issuers as well as emerging market debt where growth prospects are brighter. |
Government bonds | 🔵 | ⚪ | Valuations look more attractive given the sizeable yield moves we have seen since the start of last year. We have continued to gradually lengthen interest rate duration as we move closer to the end of the rate cycle to add defensiveness in a potentially volatile economic environment. We prefer UK gilts given more attractive yields and market pricing of future central bank policy changes. |
Investment grade | ⚪ | 🔵 | Absolute yields continue to look attractive, although spreads are less supportive at current levels. We prefer shorter-duration and higher-quality credit in the near term given uncertainty around corporate earnings and the shape of the credit curve, but could look for opportunities to increase exposure to riskier credit if spreads widen. |
High-yield | ⚪ | ⚪🔽 | Higher yields and shorter duration characteristics look attractive. Default rates remain low although face headwinds from a rising cost of debt, tighter margins, weakening earnings and a more challenging economic backdrop. There remains the potential for spreads to widen if corporate earnings deteriorate which could present opportunities |
Inflation-linked | 🔵 | ⚪ | Valuations are looking more attractive with real yields in positive territory. US Breakeven levels remain low and inflation linked bonds continue to offer a hedge against more persistent inflation witnessed within developed markets. |
Emerging markets | 🔵🔼 | 🔵 | Emerging market growth prospects excluding China look relatively robust compared to developed markets whilst central banks have recently been cutting rates. The potential for further USD weakness remains and would be supportive for the asset class. Valuations are attractive relative to other credit markets. |
Alternatives and cash
Asset | Current positioning | Medium term view | Current views |
Alternatives | 🔵 | ⚪ | Continue to offer attractive diversification characteristics in a potentially volatile environment. Within absolute return we favour strategies with the ability to deliver less correlated returns. We remain positive on real assets with long-dated visible revenue streams and commodities where supply and demand dynamics could support prices over the medium term. |
Absolute Return | 🟠 | 🟠 | We see select opportunities in equity long/short strategies given increased stock dispersion and diversification characteristics. However, government bonds are now looking more attractively valued and may provide a better source of portfolio diversification over the medium term. |
Liquid private real assets |
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| Long-dated revenue streams and income characteristics remain attractive in select parts of the market. Within this space we see good opportunities in renewables, digital infrastructure, specialist property and and exposure to private companies. Valuations are more attractive following recent market volatility. |
Commodities |
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| Broader commodities can hedge against further disruption to energy markets, although areas of the asset class are sensitive to slowing economic growth particularly in China. Longer term, increasing demand from energy transition could support industrial metal prices against a backdrop of tight supply. |
Equity-linked income strategies | ⚪ | ⚪ | Offer attractive returns especially in times of heightened volatility, but we acknowledge the shorter-term correlation with equities. |
Gold | 🔵 | ⚪ | Gold should provide portfolio insurance in the event of a economic growth or an inflation shock and will benefit from further USD weakness, although could continue to face headwinds from rising real yields. |
Terms
Spread: the difference in yield between a non-government and government fixed income security.
Duration: approximate percentage change in the price of a bond for a 1% change in yield.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.
All data contained within this document is sourced from Cazenove Capital unless otherwise stated.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.
All data contained within this document is sourced from Cazenove Capital unless otherwise stated.
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