Asset Allocation Outlook
The highlights this month are:
- Aggressive tone of central banks spoils the equity party
- Recession becoming ever more likely
- Equity underweight increased
The performance of equity markets in August was a tale of two halves. Most major global stock markets rallied in the first half of August. Evidence of a decline in US inflation and an acceleration in job growth encouraged investors to bet that central banks will soon be forced to abandon their hawkish stance. The hope for an economic “soft landing” has been backed up by solid industrial production data and retail sales, as well as real wage growth, which turned positive. However, Fed Chair J. Powell’s wake-up call during the Jackson Hole Symposium made clear that markets may be underestimating the willingness of central banks to continue tightening monetary policy as they intend to regain credibility on inflation targeting. Powell clearly stated that the Fed “must keep at it, until the job is done” and erased any ambiguity over a softening over the Fed’s position. His statement delivered a stark warning that the fight against inflation will likely cause pain for Americans in the form of a weaker economy and job losses. The subject was reinforced by Isabel Schnabel, member of the ECB’s Executive Board, who reaffirmed the anti-inflationary priority from the ECB’s point of view.
The market reaction followed promptly, with bond and equity markets turning downwards, dashing hopes for a continuation of the recovery that began in July. Losses were widespread, with every major equity market finishing the month in negative territory, except for Japan and China. The MSCI World index lost 4.1% in August. The largest decline was seen in European equities markets, with MSCI Europe ex-UK down 4.7%. US Treasury yields increased during the course of the month to reach 3.2%. The markets for sovereign bonds performed incredibly poorly in light of the change in interest rate expectations. The Eurozone Government Bond Index depreciated by 5.4%. While the August composite US PMI at 45 suggests that recession risks remain elevated, economic data was generally a bit better than expected, as shown by the Citi Economic Surprise Index, and inflation pressures started to ease on the back of lower commodity prices. Lower petrol prices in particular were a key factor for US consumer price inflation slowing down to 8.9% y-o-y.
The supply side situation for commodities remains challenging and brings uncertainty for the global economic outlook. This uncertainty is especially elevated in Europe, where the energy crisis has become more acute, with Russia continuing to tighten energy flows and causing natural gas and electricity prices to soar to new all-time highs. The high energy prices are already taken a toll on economic activity as the disposable household income is melting away, and industrial users are cutting production due to high input costs. Producer prices in Germany increased by 37.2% in July. The expectation component of Germany’s most prominent leading indicator, the Ifo Index, remains close to all-time lows and was only worse twice in history, in December 2008 and April 2020. Europe has been able to rebuild gas inventories to about 80% of capacity, roughly in line with prior years. It has been able to achieve this by aggressively buying of gas on the open market, no matter the price. While this has caused gas prices to soar, it sets the stage for a possible retreat of prices in 2023, something that the future market is already discounting.
We expect a period of consolidation for equity markets as investors will be continuously challenged on their assumption of a “soft landing scenario” in the next months. Energy price spikes, negative earnings revisions, central bank rhetoric and economic data points will lead to increased volatility in the next couple of weeks. Although we believe current valuations already reflect much of the earnings weakness we anticipate, we continue to exercise prudence in our investment policy as the macro and monetary backdrop remains challenging and may require further adjustments. Markets remain trapped in their “bad news is good news” narrative and lack a clear direction. Given the deteriorating earnings dynamics, we have decided to cut back our exposure in US equities in August and reinvest the proceeds in US treasuries. Overall, we remain underweight government bonds.
Please find enclosed our Asset Allocation update for September.