China’s reopening is yet to gather momentum. Having been expected to drive growth in Asia and offset slowdowns in Europe and the US, the reality – so far – has been less impactful.
Rather than looking to China, global equity markets have fixated on the hype around generative artificial intelligence (AI). This has bid up a small number of technology companies into what could be a mini asset bubble. Just seven stocks account for the lion’s share of the rise in the S&P 500 this year.[1]
A second prop for markets is the sheer resilience of company earnings. Large companies have been able to raise prices rapidly and offset cost inflation, pushing corporate earnings well above their historic trend. Higher interest rates, tighter credit and lower liquidity may eventually take their toll on economic activity and risk assets, but not yet.
For the first time in many years, we find that bonds present attractive value. Higher yields, resilient company earnings and strong balance sheets make good-quality corporate bonds a viable alternative to equities, and we have been adding long-term income generators to the portfolios. Even cash is coming into its own once again with low-risk returns that are able to compete with absolute return strategies.
Given the above, we have made the following portfolio adjustments:
- A small increase in equity exposure, complemented with cheap portfolio insurance
- Absolute return funds decreased to underweight from overweight
- Cash increased from neutral to overweight
Equities: marginally underweight or neutral with portfolio insurance
Despite the damp-squib start from a newly reopened China, we remain hopeful. The Chinese government has taken steps to stimulate the economy and this, combined with looser travel restrictions, should support a more durable recovery and benefit our Asia-orientated stocks.
Companies listed in Hong Kong and mainland China are cheap relative to global markets. This presents opportunities to add consumer and technology companies where sentiment is depressed and the potential for recovery underestimated.
Hopes that generative AI will soon be vastly profitable for some tech companies have propelled the valuations of the seven largest US companies to optimistic levels. Meanwhile, valuations for the rest of US market appear fair, at best. This offers limited upside from a soft landing, together with potential for considerable downside in the event of widespread de-risking and declining profit expectations.
The dominance of US markets in equity indices also limits upside for global equities. In view of the balance of risks across global equity markets, we have an even-handed underweight/neutral exposure to both developed and emerging markets.
Until there is confidence that the global economy can escape late-cycle pressures, defensive franchises and disruptive growth companies will form the core of our global thematic equity holdings. Opportunities to add more risk to portfolios will arise. In the meantime, discretion is the better part of valour.
Bonds: overweight
Bonds present a window of opportunity to add strong income-generators to our portfolios. Corporate bond spreads are attractive relative to historical levels, while government bonds are close to fair value in the US, Europe and UK.
We continue to be overweight corporate bonds, while keeping government bonds and overall duration at neutral. We particularly favour higher-quality corporate bonds, with a focus on areas where monetary support can materially lower risk, such as bank bonds issued by strong global franchises.
UK bonds also offer good long-term value relative to global peers. Financial and political risk has moderated from nine months ago and diminishing fiscal risks have prompted S&P Global Ratings to shift the outlook for the UK from negative to stable. This, combined with a sharp repricing in future interest rate expectations has pushed UK government bond yields above those available in the US, a trend that may well entice international investors.
Alternatives: underweight
The higher returns now available on bonds prompt a rethink of the pros and cons of holding alternatives. As well as offering competitive returns, carefully selected bonds can also provide better liquidity and lower risk profiles than some alternative investments.
Given our cautious view of equity markets, we have been underweight alternatives that show correlation with equity markets. We are now also underweighting uncorrelated investment strategies, such as absolute return funds. These served us well during periods of market volatility last year, and they may do so again. For the time being, the relatively low returns from such strategies may struggle to compete with bonds and cash.
We are overweight gold, which continues to have a role to play as an inflation and tail risk hedge in the event of rising market volatility.
Cash: overweight
Cash now presents an attractive and relatively low-risk source of returns. The Bank of England base rate has risen by 4.4% in the space of 16 months and, at the time of writing, markets expect it to reach 5.75% by February 2024. [2] Twelve-month fixed term deposits offered by top tier, A-rated institutions have been as high as 5.4% in recent weeks.[3]
Holding a store of cash is also prudent, given that we have not yet seen the full effects of interest rates in the economy. We prefer to err on the side of caution and keep a store of cash available to invest when we feel prices are more compelling.
We continue to see opportunities to enhance returns in currency markets and particularly in sterling, which tends to regain ground slowly after political crises. Following the Truss government’s debacle last autumn, sterling is again in a recovery phase as global investors return to UK assets.
Portfolio insurance
Where our mandates permit, we will continue to use portfolio insurance to hedge equity positions. The recent decline in market volatility has made this a more cost-efficient option for reducing equity risk.
Liquidity could trump all
There is one factor that could have a greater impact on financial markets than interest rate rises, company earnings, China’s reopening and AI all put together. This is liquidity: the amount of money being allowed to circulate in the economic system.
Having pumped large quantities of liquidity into the global economy both before and during the pandemic, central banks are now keen to remove it through quantitative tightening (QT), and thereby help reduce inflation. QT has not been a major constraint on markets so far, thanks in part to emergency funding provided by the US Treasury when three banks failed in March. However, with the threat of a banking crisis receding, central banks are likely to refocus their efforts on QT.
Any sharp reduction in liquidity just as economic growth slows, corporate profits fall and unemployment rises could trigger a correction across risk assets. In the event, our portfolio protections, gold, uncorrelated alternatives, cash and government bonds may prove to be extremely useful portfolio holdings.
Cautiously adding to risk through corporate bonds and emerging market equities
| Bonds Overweight |
|
| Equities Neutral with insurance |
|
| Alternatives Underweight |
|
| Cash Overweight |
|
| Risks |
|
[1] Bloomberg, 13.06.2023, market-implied OIS rate.
[2] Bloomberg, 01.06.2023, indicative Santander PLC UK money markets rate.
[3] Bloomberg, 30/06/2023
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