Views at a glance – December 2022
Central banks may soon slow the pace of interest rate rises. However, investors must still contend with recessions in major developed markets.
US rates to rise more slowly...but go higher
Stock and bond markets have been on better form in the fourth quarter as investors anticipate that a peak in US interest rates may be in sight. At its latest meeting, the Federal Reserve delivered a fourth consecutive 0.75% rate hike while acknowledging that "at some point...it will be appropriate to slow the pace of hikes." However, it disappointed markets by suggesting that interest rates may have to rise further than currently anticipated – and potentially above their pre-2008 peak of 5.25%. Wherever borrowing costs end up, the increases seen so far this year are already having a significant impact on US real estate markets, which is likely to reduce inflationary pressure from housing costs. There has not yet been much evidence of a slowdown in labour markets, the other key driver of core US inflation, but this is likely to materialise as the economy slows.
Little reason for cheer in the UK
Rishi Sunak’s premiership has helped to stabilise UK financial markets and longer-dated gilt yields are now significantly lower than their peak at the start of October. However, the good news may end there. To keep markets onside, Sunak and the new Chancellor of the Exchequer are now expected to deliver a combination of spending cuts and tax rises in this month’s Autumn statement. It’s a far cry from the significant tax cuts that were on the table just a couple of months ago. While this medicine may be necessary, it is likely to mean UK growth remains weak over the medium term. The one silver lining is that it may make it easier for the Bank of England to bring inflation under control, potentially meaning UK interest rates do not rise as much as might otherwise have been the case.
Gridlock the most likely outcome in US midterms
Polling suggests that the US democratic party is set to lose control of the House of Representatives at the upcoming midterm elections, undermining president Joe Biden’s ability to pass new legislation. Historically, this has been a favourable outcome for investors. Schroders’ economists note that US equities have averaged annual gains of 12.9% when a president has had to contend with a split Congress – compared to a more modest increase of 6.7% when a Democratic president has controlled both chambers. Of course, history may not be a reliable guide given today’s very unusual circumstances. However, “policy paralysis” could make it easier for the Fed to tackle inflation and, as in the UK, mean there is less conflict between fiscal and monetary policy.
Portfolio positioning
We expect that higher interest rates will lead to recessions in the UK, US and Eurozone. In this environment, we remain underweight equity, with a clear preference for higher-quality companies. Before adding back to equities, we want to see the prospect of recession reflected in earnings estimates. We are also looking for weakening of labour markets, which could be a signal that interest rates are at or near a peak. We recently upgraded our view on fixed income to neutral and are gradually increasing our exposure to government bonds. We also continue to favour alternative assets, including commodities. Historically, they have helped to protect portfolios from inflation shocks. Metals should also benefit from strong demand as a result of electrification and energy transition. 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
|
|
|
|
|
|
|
|
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 |
|
| In the near term investor sentiment continues to be tested by uncertainty around China’s property sector and China’s “Zero Covid” policy. 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 |
|
| 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 |
|
| 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 |
|
| 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.
Topics