Amid turbulent markets, the impact of a long period of rising rates has exposed cracks in the banking sector. In this environment, ABN AMRO continues its defensive asset allocation. Equities are underweight, and high-quality bonds are preferred.
There is renewed stress and tightening in financial markets. It was first seen in problems at US regional banks, while in Europe, a large Swiss institution faced a liquidity issue. The negative consequences of a series of rate hikes, after a long period of very low interest rates and cheap money, are now appearing.
Bank regulators and central banks are focused on supporting financial institutions and adamant about the strength and resilience of banking systems. Central bankers also appear resolute in continuing their fight against inflation with further rate hikes. The European Central Bank (ECB) went through with its planned 50-basis-point rate hike on 16 March, stressing that inflation remains a problem. We expect that the Federal Reserve will also proceed with its rate-hiking trajectory. Central bankers appear confident that solving inflation and returning to target rates is worth the pain.
The base-case scenario that underlies our investment strategy has long called for recession in Europe and a downturn (or textbook recession) in the US as well. We continue to believe recession lies ahead, most likely along the lines of contraction and then stagnation. Markets have not priced-in this risk. The asset allocation is therefore positioned defensively at all levels of the portfolio: equities are underweight, and the sector allocation is tilted to the defensive health care sector; there is a neutral stance toward fixed income; high-quality bonds are preferred, while more risky bonds, such as high-yield, are not. At the latest meeting of the ABN AMRO Investment Committee, this asset allocation was retained.
Over the past few months, the rate hikes by the Federal Reserve have resulted in tightening financial conditions and has led to an underperformance of US and emerging markets equities. European markets have fared better. But the recent banking crisis generated a new wave of volatility and engulfed European markets as well.
Despite evidence that economic momentum has been improving, it is now pressured by the threat of recession. Positive economic news had encouraged central banks to reiterate their plans to hike interest rates and quash inflation. We now do not think that the central banks will reverse their rate hikes until very late this year, when the first rate cuts are expected. This is a later course reversal than we had previously estimated.
In line with the looming economic recession, we continue to believe that an earnings recession (i.e. two quarters of negative earnings growth) will also be evident in the coming months. Historically, market corrections are highly correlated with negative year-on-year earnings-growth forecasts. The earnings recession has been delayed in Europe, as growth has been stronger than expected and earnings have been supported by a weaker euro. Nonetheless, we expect demand to suffer from the impact of monetary tightening.
Against this background, we continue to support an underweight equities position. In terms of regions, we are overweight emerging markets versus developed, given that the reopening of China could support economic momentum in regional economies.
With recession risks and the expectation for higher interest rates amid a climate of uncertainty, we continue to prefer a neutral stance towards fixed-income markets. In times of stress, an allocation to high-quality bonds can act as a buffer against swings in more risky assets. We therefore continue to prefer sovereign, government-related and covered bonds, while avoiding riskier bond segments, such as high-yield and lower-rated corporate credits.
We expect financial conditions to continue to be tight and this can lead to more uncertainty in financial markets. What we see in the US banking sector only reinforces our thesis that financial condition tightening will be a painful process. We have faith in the ability of US and European regulators to stabilise markets. And, in fact, it was the strength seen in macroeconomic data, manufacturing and jobs reports over the past months that encouraged central banks to be resolute in hiking rates and tightening monetary policies. The consequences, however, are now coming more clearly into view.
In this environment, we are comfortable with our underweight equities position and our slightly defensive portfolio stance overall. We remain exposed to the investment opportunities that we see in today’s market and see value in diversification across asset classes, regions, sectors and investment themes. At some point, market volatility will reveal opportunities, but for now, it is too early, given that the deteriorating economic scenario is not priced-in to valuations. Instead, it remains a time for caution and patience.
Reinhard Pfingsten, Acting Chair, ABN AMRO Global Investment Committee
