Some stability returns to markets

After steep falls earlier in the year, stock and bond markets have both enjoyed a modest rebound over the summer. While reported inflation remains high, prices of many commodities have fallen, suggesting that inflationary pressure could start to ease over the coming months – especially for manufactured goods. Investors may be hoping this will allow the Federal Reserve to slow the pace of rate rises and achieve a “soft landing”. However, this could prove optimistic. The Fed may have to keep raising rates to ensure that inflation also slows in the larger services sector. And there are already signs that the US economy is slowing significantly, with early estimates suggesting that it experienced two consecutive quarters of contraction, the most common definition of a recession.

ECB raises interest rates for the first time in eleven years

The ECB announced a larger-than-expected rate hike last month, taking its deposit rate to 0% and ending a policy of negative interest rates. The ECB arguably has an even more difficult task than other major central banks in its efforts to bring inflation under control. European gas prices remain at record highs, keeping inflation high and depressing growth. Italy’s high debt and unstable politics are also becoming a concern for investors, reviving memories of the eurozone debt crisis. The ECB has introduced a new tool called the Transmission Protection Instrument that is intended to prevent bond spreads from widening and avoid a repeat of the events of a decade ago.

A change in direction for the UK

Italy is not the only European country grappling with political uncertainty, as the UK Conservative party picks a new leader – and a new Prime Minister. The Sterling has been weak, but for now this appears to be more a reflection of the country’s high inflation and low growth than the political situation. Even so, the outcome of the leadership contest could result in a meaningful shift in economic policy. Rishi Sunak has spoken against unfunded tax cuts, while his rival Liz Truss has pledged both tax cuts and higher spending. She has also said she would “look again” at the Bank of England’s mandate, suggesting it had not been “tough enough” on inflation. It is possible this will encourage the Monetary Policy Committee to follow the ECB and raise interest rates by a half percentage point when it meets early in the month.

Portfolio positioning

The risk of a global recession remains elevated and we therefore continue to focus on the defensiveness of our portfolios. We are in the process of reducing our overall equity exposure and have cut our allocation to smaller and more cyclical companies. Over the course of the year, we have benefited from our underweight position in fixed income and overweight allocation to alternatives. However, government bond valuations now look more attractive and we are likely to gradually add back to nominal government bond positions. This would further increase the defensiveness of portfolios. We also believe that real assets like property, renewable energy and infrastructure can benefit multi-asset portfolios in periods of high inflation. Safe havens such as gold and the US dollar should also provide some protection in more challenging environments.