Preparing for the next phase

We believe the investment environment is deteriorating. We previously noted the rising number of uncertainties for investors, including high inflation, central bank rate hikes and the war in Ukraine. We now believe that the eurozone will experience a recession in the coming quarters. We expect that the slowdown will begin in the third quarter of this year, with more severe contractions seen over the following six months.

The US will also not escape a recession, although its economic slowdown will not be as severe as Europe’s. In the US, we expect that unemployment will begin to rise in the fourth quarter and that consumption will cool as consumers feel the effects of inflation. There is, later, also the possibility of a situation of negative global growth, and the European Central Bank and the US Federal Reserve continuing to hike interest rates, with fighting inflation as their first priority.

Europe’s slowdown is exacerbated by its reliance on Russian energy. When the Nord Stream pipeline was reopened after maintenance this summer, the resumed supply, which is just 20% of capacity, portends ongoing high energy price inflation and possible significant reductions in industrial gas use. Despite a build-up in European energy inventories, it is unclear if there is enough to cover demand for the entire winter. Some sort of potential natural gas rationing for specific industries is therefore not out of the question. In any case, the cost of gas has already risen substantially, impacting both companies and consumers.

As a consequence of our expectations for diminished economic growth and its negative effect on companies and consumers, the ABN AMRO Investment Committee decided to further reduce its exposure to risky assets. Equities have been reduced to a stronger underweight versus our benchmark, with the proceeds of the sale going to cash. At the same time, we are strengthening the position in high-quality bonds, funded by cash. The resulting overall asset allocation therefore is a (further) underweight position in equities, a continued, but smaller, underweight in bonds and an overweight in cash.

After a rally in July and August, the outlook for risky assets has weakened. We are therefore taking this opportunity to make an across-the-board reduction in stocks. The main driver of this reduction is our expectation of diminished economic growth and an expected deterioration in corporate earnings. We believe that company margins will be under pressure, due to higher energy prices, slowdowns in sales and high inventory levels. High inflation and energy prices will also dent consumer spending and sentiment.

One of the reasons for investing in equities throughout 2021 was that investors had limited options, other than equity markets, for positive returns. But this support has been gradually removed over 2022, as bond yields rose and deposits began to offer slightly positive rates. These lower-risk assets have become more attractive and now offer an alternative for volatile equity markets.

Our equity allocation is invested with a preference for the US over Europe and emerging markets. Defensive sectors, such as health care and consumer staples are preferred while sectors more reliant on growth, such as consumer discretionary, industrials and communication services, are out of favour.

Bonds have slowly returned to their classic use as a buffer for portfolios when riskier assets encounter difficult circumstances. Most bonds now offer positive yields. We began increasing our exposure to high-quality bonds, such as government bonds and investment-grade corporates, earlier this year as yields turned positive. (Bond yields and bond prices move in opposite directions.) Now that we believe that yields are at or close to their peaks, we have further increased this position, moving from an underweight to a neutral positioning in high-quality bonds. In July, we reduced exposure to lower-quality, higher-risk bonds (high-yield and emerging-markets debt) as risks to the global economy increased.

We believe that the rally seen in equity markets this summer was a “bear market” rally and is a prelude to recession in both the eurozone and the US. Recessions, of course, can vary by definition and intensity; but regardless of what it is called, we are convinced that the period ahead will be one of higher interest rates and slower growth. We recently lowered our expectations for 2023 as well. We now expect negative growth (-0.9%) in Europe and just 1% growth in the US next year.

The war in Ukraine is six months old, and geopolitical risks are clearly growing. No one knows how the energy situation in Europe will play out over the winter. We therefore believe the most appropriate strategy for these uncertain times is to shore-up and diversify portfolios. This includes reducing risk, investing in defensive stocks and high-quality bonds, and stockpiling cash for better times ahead.

Richard de Groot
Chair, ABN AMRO Investment Committee