Volatility creates opportunities

The first quarter of 2024 was a period of rising equity markets. But markets were surprised by stubborn inflation in the US. Investors had been counting on the US Federal Reserve starting to cut rates in June. But three consecutive months of stronger-than-expected US inflation data dashed those hopes and saw a rise in bond yields.

ABN AMRO still expects a hearty US rate-cutting cycle that includes three cuts in 2024, starting in July. Significant disinflation is expected to resume. Wage growth, for example, has declined and is now consistent with target levels. Housing (shelter) costs, a lagging inflation indicator, have also declined. A soft landing for the US economy is still expected, with few recession fears. By year-end, the upper bound of the Fed policy rate is expected to have declined to around 4.75%, with the return to a neutral rate of around 3% by November 2025.

In Europe, where economic growth is not as strong and inflation has been trending downward, the European Central Bank (ECB) is expected to cut rates for the first time in June. Current rates are restrictive, pressuring lending and investment. Eurozone economic growth is expected to begin to pick up in the fourth quarter and increase to 1.6% next year.

Despite US interest rates remaining higher for longer than had been expected, our base-case scenario, which informs our investment strategy, remains generally positive for both risky assets and quality bonds. The Federal Reserve is capable of pivoting quickly once inflation data cools, and bond yields could fall quickly. (When bond yields fall, bond prices rise.)

At its latest meeting, the ABN AMRO Investment Committee decided to maintain its slight overweight positions in both bonds and equities. Within the bond portfolio, a small shift was made to lengthen duration (price sensitivity to changing interest rates) and to expand the European covered bond position by selling European government bonds.

While we see increased market volatility within equities, we retain our positive equity view for the mid-term. The outlook for earnings, for example, is slightly improving. In the US, this improvement is based on economic momentum and stronger growth than expected. European earnings are also experiencing a small recovery, as earnings momentum rises above previously depressed levels.

In the US, earnings momentum is above one. This means that analysts are instituting more earnings upgrades than downgrades (i.e. the up/down ratio). In Europe and emerging markets, earnings momentum is stabilising and recovering from depressed levels. Japan is the only region where the up/down ratio of analyst expectations is convincingly above one.

On an aggregated level, multiples are close to long-term averages. There are, however, regional differences. US equity markets appear expensive. And while European markets and emerging markets are trading closer to long-term averages, their earnings outlook is weaker.

We continue to favour the US (overweight) over Europe (underweight), while taking a neutral stance toward emerging markets. Our preferred sectors are information technology and health care (both overweight), while financials is out of favour (underweight).

Central banks remain the main driver of fixed-income markets. When central banks cut rates, as we expect this summer, high-quality bonds generally perform well. We expect that monetary policy in the US and eurozone will temporarily diverge, as the ECB begins to cut rates in June, while the Federal Reserve holds firm. We continue to favour high-quality bonds, such as government and covered bonds. We recently made a shift from European government bonds to European covered bonds. The goal is to improve returns and lengthen the duration of the portfolio. (The higher a bond’s duration, the more its value will rise as interest rates decline.)

Surprises can derail markets, if only temporarily. They can be disruptive and create uncertainty. The higher-than-expected US inflation data was a surprise. But while US inflation is still too high, unemployment is low and growth remains solid. US consumers and corporates appear to have come to terms with higher rates, and it does not appear to be unduly reining in purchases or investments.

The situation in the Middle East was also a surprise. After the Iranian attack on Israel, oil prices initially rose, but later tracked downward. Israel’s retaliation, has, until now, had the same effect: an initial market shock and a spike in oil prices.

In short, Middle East tensions have so far failed to disrupt overall market conditions. But geopolitical risk is clearly heightened, as a volatile part of the world is erupting. In terms of market consequences, further escalation could disrupt oil shipments through the Strait of Hormuz and drive oil prices toward recessionary levels. We are monitoring the situation and its effects on portfolios closely. In general, we believe the best course is a diversified portfolio that includes equities and “safe-haven” high-quality bonds that can act as a buffer when riskier assets encounter problems.

Johanna Handte
ABN AMRO Global Investment Committee