House View, October 2022
Asset class positioning
Aware of increased central bank aggressiveness, but with a recession looming and inflation possibly close to peaking, we are neutral on US and core euro area government bonds. At the same time, the rise in yields means we are finding shorter-dated bonds increasingly attractive. We are likewise finding opportunities in short-dated US investment-grade (IG) bonds, although we are neutral on IG in general (and underweight high yield). We remain underweight UK gilts as well as euro periphery and low-yielding Japanese bonds. We continue to overweight liquidity.
Sentiment towards equities has been hurt by rising rates. With bonds offering more attractive yields and with earnings and margins coming under increasing pressure, we remain underweight equities globally, but with exceptions for the UK, Swiss and Japanese markets, where we are neutral. We continue to favour defensive currencies like the Swiss franc, while we have a medium-term neutral view of the euro’s prospects against the US dollar.
The sensitivity of valuations to yields and the risk of a fall in earnings are the two main concerns hanging over equities now. While equity valuations have declined substantially, they have barely kept pace with the rise in bond yields and the equity risk premium is low by historic standards. Meanwhile, earnings expectations have only declined modestly. This could become an issue, especially for stocks in Europe, where the recession risk is greatest.
Our belief that inflation will start to ease leaves us expecting a 10-year US Treasury yield of 3% at year’s end and a 10-year Bund yield of 1.5%. Nevertheless, as the reaction in the UK gilts market to fiscal stimulus showed, there is scope for further volatility in government bond markets. Likewise, we remain vigilant with respect to the lowest quality of corporate credit, believing high-yield issuers’ exposure to leveraged loans makes them vulnerable.
The now high-yielding and safe-haven US dollar has continued to strengthen in recent weeks against a range of currencies. We see little likelihood of coordinated international moves to curb its strength in the short term. Meanwhile, we still await meaningful improvement in the outlook for dollar rivals, with European currencies particularly exposed to continued tensions in energy supplies.
Commodity prices are reflecting the deterioration in forward-looking economic indicators. Things will probably only look up when recessionary fears begin to lift. That said, we still believe there is scope for oil prices to rebound by the end of the year given weak supply elasticity and limited spare production capacity, among other factors.
The Korean and Taiwanese equity markets have been suffering as the global economy slows. We therefore maintain our cautious stance on both cyclical markets. While fundamentals for Chinese equities currently look relatively unexciting, we still see them as diversifiers in portfolios and they could benefit from relaxation of zero covid policies. The ASEAN and Indian markets are more defensive.
While Asian investment-grade (IG) bonds could experience some modest spread widening as global economic conditions worsen, they continue to have potential. We remain quite comfortable about the Asian IG universe’s exposure to Chinese names.
Asian currencies continue to suffer from a deteriorating economic outlook and fading rate differentials over the US. While the Chinese authorities have been intervening to support the renminbi, we do not yet see much inclination for a major push-back against US dollar strength. Helped by its energy exports, the Indonesian rupiah has been an exception to Asian currency weakness.