Monthly house view | May 2023
Global purchasing manager indexes (PMI) showed manufacturing activity expanding in emerging economies but continuing to contact in advanced economies in April. But the growth in global industrial production has been accelerating and global services PMIs have been resilient all round. We expect the US economy to continue to slow and to head into a mild recession in H2. While we think risks are skewed to the upside on inflation, we think the Fed will leave the Fed funds rate untouched at 5-5.25% until the end of the year. The euro area could, we believe, skirt a recession this year, although the lagged effect of monetary tightening will be a drag on growth. We also expect core inflation to remain sticky in the euro area. Stronger-than-expected Q1 growth in China and the prospect that policies will remain supportive have led us to lift our full-year GDP forecast to 5.5% (from a previous 5.0%). The economy in Japan continues to improve, although we see no imminent change to the Bank of Japan’s ultra-accommodative monetary policy under incoming governor Kazuo Ueda.
Equities Companies’ Q1 results have been beating (low) expectations. Good performances in terms of revenue and net income have been helped by signs that margins have held up better than feared, and earnings guidance is good—more so in Europe than the US. Overall, equity valuations look rich, particularly in the US, which explains our relative caution. Sector wise, we continue to prefer European banks to their US peers. While Big Tech-related companies have been driving much of the positive performance in stock markets recently, we can detect some nervousness around fundamentals and high valuations.
Fixed income While we do not expect the US Treasury to default on its debts, concerns over the federal debt-ceiling deadline have been causing distortions in the short-dated T-bill market. The longer the uncertainties over the debt ceiling last, the greater the angst over the outlook for risk assets and the US economy. In the circumstances, we remain comfortable with our overweight stance on US Treasuries. While corporate bonds performed well in April, a look below the surface shows that spreads on the lowest-rated debt have been reaching distressed levels. The spread premium on financial bonds over non-financial ones and on subordinated debt over senior debt is still wider than before the recent turmoil in banking.
Currencies, commodities We have seen oil demand pick up in emerging economies of late, particularly in Asia ex-China. We believe that a revival in international travel around Asia will boost oil demand even further. Given limited supply elasticity, these developments could be factors in keeping oil prices aloft—although a possible US recession could relieve price tensions. Gold has recently been hitting historic highs (in nominal USD terms), helped by derivatives demand but also official demand. In the short term, the debt-ceiling drama in the US could help gold to a limited extent, while official demand could continue to drive gold in the medium term.
Asset-class views and positioning
We remain comfortable with our equity calls, including our underweight position in US equities. We are neutral on other large developed markets and emerging Asia, where valuations (and the risk of recession) are lower. Sector differences and better earnings momentum explain why we prefer European equity indexes over their US peers. While neutral on alternatives overall, we are underweight REITS in light of issues in commercial real estate. Although we are neutral on government bonds in general, we are overweight US Treasuries. While acutely aware of the approaching federal debt ceiling deadline, we see longer-term US Treasuries (which now offer decent yields) as protecting portfolios in the case of market upsets and a possible US recession. In corporate bonds, our belief is that spread movements in high yield lately have not been reflecting tightening credit conditions and (in the US at least) the risk of recession. We have a more positive view of investment-grade (IG) credits, particularly euro IG, as well as Asian IG in hard currencies.
Three investment themes
i. A time for active management. Upheaval in markets as companies adjust to higher interest rates and slowing growth means the conditions are ripe for an active management approach that can identify both inefficiencies and opportunities. This means looking at equities stock by stock and exploiting low intra-sector correlations. A similar approach is warranted when it comes to corporate debt within a broad preference for investment-grade bonds over noninvestment-grade ones.
ii. Preferring fixed-rate to floating-rate debt. Treating volatility as an asset class in its own right is an important investment theme for us. We believe recent drops in bond and equity volatility represent a good opportunity to build up positions in instruments like equity hedges, principal-protected notes and commodity derivatives. These could protect portfolios and help earn superior returns once volatility returns.
iii. Volatility as an asset class. At a time of high rates and amid risks of funding stress in some sectors, a preference for fixed-rate over floating-rate debt remains an important investment theme for us. This means we prefer countries (and their currencies) where mortgages are largely at fixed rates over ones where variable-rate mortgages are more prevalent.