Asset Allocation Augustus 2022

Jan Willem Verhulst
CIO

Asset Allocation Augustus 2022

22 August 2022

These are the highlights:

  • Further slowdown in global economy
  • ECB implements bigger interest rate hike than expected and announces new
    policy instrument
  • Lower bond yields: bond investors anticipate lower growth
  • Investment policy: underweight in (European) equities

Following a poor performance in the first half of the year, most global financial assets staged a strong recovery in July. Financial markets were dominated by expectations that weakening economic conditions would cause central banks to switch from hiking to cutting interest rates in 2023. Bond yields fell, providing a tailwind for global equities, which benefited from a broad-based rally led by the United States. In July, US and European equities gained 9.2% and 6.0%, respectively. Last month, Chinese stocks were the only major equity segment to post negative returns. In the face of falling yields, fixed income performed admirably, recouping some of its significant year-to-date losses. Brent crude oil suffered near-double-digit percentage losses as recession fears grew fears outweighing tight supply concerns to drive prices down to their lowest since the war began in Ukraine.

Economic data released in July provided additional evidence of a slowing global economy. In the United States, second-quarter GDP fell 0.9% year-on-year, the second consecutive quarterly decline. Flash Purchasing Managers' Index (PMI) surveys indicated a decline in business activity in both the United States and Europe. The deterioration in service figures is particularly concerning, as the impact of higher inflation on consumer confidence and disposable income is beginning to create a headwind. Labor markets continue to be a bright spot, with tight labor markets fueling nominal wage growth. However, the real wage component of the employment cost index is falling at the fastest rate on record.

Nonetheless, consumer spending remains astonishingly resilient, which can be explained in part by consumers' willingness to reduce savings in order to increase spending power to offset the effects of higher prices. However, if the fear of unemployment grows, households may abruptly alter their behavior and increase precautionary savings. A combination of rising savings rates and falling real wages could result in a more severe economic slowdown. Despite rising headline consumer prices, the Fed appears to have been successful in reducing long-term inflation fears, with inflation expectations falling to 2.8% p.a. (University of Michigan consumer survey) and 2.46% p.a. (US 10-year breakeven inflation rates).

The Fed raised interest rates by 75 basis points after headline inflation in July exceeded expectations, coming in at 9.1% year-on-year. Inflationary pressures in the stickier housing and services sectors remained high. With its emphasis on inflation, the Fed is unlikely to acknowledge the trade-off that it faces until there is "very compelling evidence" that headline inflation has turned lower. With the unemployment rate falling to 3.5%, global markets ended the first week of August with the dawning realization that central banks are likely to continue raising interest rates aggressively even as the economy sputters.

Outside the United States, the outlook is more challenging. High inflation prompted the ECB to announce its first 50 basis point rate hike in more than a decade, lifting the eurozone out of negative interest rates. With inflation running hot, the ECB is trapped in a difficult situation, as gas supply remains a concern, raising the prospect of a recession at the end of the year. We anticipate that any potential recession will be short-lived, with European governments working hard to mitigate the effects of gas shortages through various income support schemes for the private sector. Growth in China is expected to pick up in the second half of the year. However, the threat of future lockdowns, a shift in global spending away from manufactured goods and toward services, and a deteriorating real estate sector will continue to weigh on Chinese activity.

The second quarter earnings of companies held up well, indicating that analysts were overly pessimistic. Profit growth estimates for the third and fourth quarter have slowed but remain strong. Much of this year's equity market decline has been driven by valuation derating. While valuations are not always a good predictor of short-term performance, they do correlate with long-term returns. Current equity market valuations are consistent with healthy annualized returns of 6.5% to 8% over the next ten years. Bond yields have also improved significantly this year, indicating that the long-term outlook for fixed income is now stronger than it has been for the majority of the post-financial crisis era. In the short term, investors' perceptions of economic growth, earnings, and inflation will continue to drive markets, and these perceptions can shift quickly. The risk of a more severe economic downturn has increased, and challenges such as ensuring European energy supply throughout the winter have yet to be overcome. Global geopolitical tensions have increased. While volatility may have subsided from its peak, we think it is likely to persist for the rest of the year. As a result, we continue to be cautious in our investment policy and maintain an underweight position in European equities.

Please find enclosed our Asset Allocation update for August. 

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Jan Willem Verhulst
CIO