All eyes still on inflation
Central bankers may well start to sound less anxious about inflation in 2023. However, investors must still contend with the slowdown that will result from the steep rises in interest rates we have seen over the past year. If inflation cools quickly, this slowdown could be relatively shallow and short-lived, as central banks signal a willingness to cut interest rates to support growth. Schroders’ economists anticipate that the Federal Reserve may be in a position to cut rates in the second half of 2023, with the Bank of England and European Central Bank to follow. However, the path of inflation remains far from certain. Markets could become more volatile if it becomes apparent that interest rates will need to rise higher – or stay high for longer – than is currently anticipated.
China’s Covid u-turn
Beijing has surprised investors by quickly dismantling the coronavirus restrictions that have been weighing on Chinese activity for over two years. At some point, this is likely to result in a strong rebound in economic activity, potentially boosting global demand and complicating efforts to bring inflation under control. However, the timing of this recovery remains unclear and China could face a prolonged period of weakness as it experiences a Covid “exit wave.” This uncertain outlook is reflected in the performance of commodities, which are still highly dependent on Chinese demand. Prices jumped late last year as it emerged that Covid restrictions would be eased: they have since retreated as it has become more likely that the boost to activity may be delayed.
Geopolitics will remain crucial to the outlook
Russia’s bombardment of Ukrainian cities over the holiday season is a sad reminder that there is little prospect of a de-escalation of the conflict any time soon. By contrast, it looks increasingly likely that both sides are preparing for renewed offensives in the spring, as Schroders’ Senior Adviser General Sir Nick Carter suggested in a recent webinar. Besides the humanitarian cost, this will have global economic implications as the world grapples with continued uncertainty over energy and agricultural supplies. There are other international flashpoints to worry about. Taiwan is likely to remain a source of tension between China and the US and could lead to further disruption in global trade and supply chains. Iran’s nuclear programme, alongside the challenge from domestic unrest, could also be a source of instability in the Middle East.
Portfolio positioning
There are three key indicators we are looking for before turning more positive on equities: a peak in US interest rates; a softer US labour market and corporate earnings forecasts that better reflect the likelihood of recession. It is very possible that these conditions are met over the coming months. We already have a more constructive view on fixed income and have gradually been increasing our exposure to government bonds. We also still like alternative assets, which have an important role to play in portfolio construction. 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
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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
| Medium
| Current views |
Equities | 🟠 | ⚪ | Concerns over further monetary policy response to elevated levels of inflation, the rising risk of recession and deteriorating corporate earnings could all keep equity market volatility elevated. We remain underweight and continue to prefer higher-quality companies which can better navigate a more challenging environment. Valuations are more supportive and over the medium term, signs that US interest rates have peaked and earnings have stopped being downgraded could support a move to increase exposure. |
Bonds | ⚪ | 🔵 | Nominal government bonds have defensive characteristics in a more challenging macro-economic environment and look more attractively valued relative to recent history. We prefer US treasuries where we feel there is more certainty around the path of monetary policy. Within credit we like short-dated, high-quality securities which offer a relatively attractive yield and are less sensitive to further changes in interest rates. |
Alternatives | 🔵 | ⚪ | Continue to offer attractive diversification characteristics in a volatile environment. We favour absolute return strategies with the ability to deliver less correlated returns as well as real assets with long-dated visible revenue streams and commodities. |
Cash | ⚪ | 🟠 | Cash has defensive qualities in potentially volatile markets, while rising interest rates may offer some potential for returns. |
Equities
Asset | Current
| Medium
| Current views |
Equities | 🟠 | ⚪ | Concerns over further monetary policy response to elevated levels of inflation, the rising risk of recession and deteriorating corporate earnings could all keep equity market volatility elevated. We remain underweight and continue to prefer higher-quality companies which can better navigate a more challenging environment. Valuations are more supportive and over the medium term, signs that US interest rates have peaked and earnings have stopped being downgraded could support a move to increase exposure. |
UK | 🟠 | 🟠 | Investor sentiment on domestic UK equity remains weak given concerns over the inflation and economic growth outlook. The move towards greater fiscal austerity will weigh on the consumer which could have further implications for economic growth. Valuations are cheap relative to recent history. |
Europe | 🟠 | ⚪ | Given Europe’s greater economic exposure to Russia (particularly through energy) the inflation and growth outlook for the region remains challenging, particularly over the winter months. Valuations now look attractive relative to recent history and earnings growth has been resilient. Interest rates are likely to rise, but there is the potential for a lower than expected peak which would support the consumer |
North America | ⚪ |
| The US economy has the potential for greater self-sufficiency in both energy and agriculture and is therefore more insulated from geopolitical unrest. Further interest rate rises are likely whilst inflation remains elevated and the labour market remains robust. Recent corporate earnings have been mixed and could drive further volatility. |
Japan | ⚪ | ⚪ | Lower risk of inflation, more fiscal support combined with accommodative monetary policy could lead to improved domestic economic growth driven by consumption. Weakness in the Yen is putting increasing pressure on the Bank of Japan to amend policy which could have implications for markets. |
Asia/ Emerging markets |
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| In the near term, investor sentiment may be tested by uncertainty around China’s Covid “exit wave” and the property sector. Investors will be monitoring changes in Chinese domestic social and economic policy under Xi’s new Politburo standing committee. valuations look increasingly attractive relative to 15 year averages. |
Bonds
Asset | Current
| Medium
| Current views |
Bonds | ⚪ |
| Nominal government bonds have defensive characteristics in a more challenging macro-economic environment and look more attractively valued relative to recent history. We prefer US treasuries where we feel there is more certainty around the path of monetary policy. Within credit we like short-dated, high-quality securities which offer a relatively attractive yield and are less sensitive to further changes in interest rates. |
Government bonds | ⚪ |
| Valuations look relatively more attractive given the sizeable yield moves we have seen this year, although remain vulnerable to further interest rate rises. We prefer US treasuries where yields are higher and we feel there is more certainty around the path of monetary policy. We prefer shorter maturity bonds at this stage, although could look to lengthen duration to add further defensiveness to portfolios. |
Investment grade |
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| Yields look attractive relative to other asset classes. We prefer shorter-duration and higher-quality credit in the near term given the potential for further spread widening and higher interest rates. Opasset-backedremain within asset backed securities which benefit from floating interest rates, which are more appealing in a rising interest rate environment. |
High-yield | ⚪ | ⚪ | Higher yields and shorter duration characteristics look attractive. Default rates remain low although face headwinds from a rising cost of debt, weakening earnings and a more challenging economic backdrop. There remains the potential for spreads to widen if corporate earnings deteriorate. |
Inflation-linked |
| ⚪ | The potential for more persistent inflationary pressures could keep inflation expectations elevated relative to recent history. Valuations are looking more attractive and 10 year US TIPS now offer a positive real yield of over 1% for the first time since 2010. |
Emerging markets | 🔴 | 🟠 | Certain emerging markets could see near term balance sheet deterioration as a result of a more uncertain global economic backdrop. Valuations are supportive and there are select opportunities across both US dollar and local currency debt. |
Alternatives and cash
Asset | Current
| Medium
| Current views |
Alternatives |
| ⚪ | Continue to offer attractive diversification characteristics in a volatile environment. We favour absolute return strategies with the ability to deliver less correlated returns as well as real assets with long-dated visible revenue streams and commodities. |
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 exposure to private companies. Valuations are attractive following recent market volatility. |
Commodities |
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| Broader commodities can hedge against further rises in inflation although areas of the asset class are sensitive to slowing economic growth. Longer term, increasing demand from energy transition could support industrial metal prices. |
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 meaningful equity market correction or economic growth shock 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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