Continued uncertainty
The investment themes that have so far dominated the year are continuing through the summer. High inflation, central bank rate hikes, the war in Ukraine and rising energy prices continue to make headlines and dent the economic outlook. In the last couple weeks, the US Federal Reserve hiked key rates by 75 basis points (for a second time); and the European Central Bank (ECB) hiked by 50 basis points, as it too battles rising inflation risks.
These ongoing themes continue to inform our asset allocation. No changes were made at the latest meeting of the ABN AMRO Investment Committee. We continue to support an underweight stance in both equities and bonds and an overweight position in cash.
Uncertain outlook for stocks
Since February, we have been gradually reducing equity risk, trimming the equity position from overweight at the start of the year to neutral in February and moving to underweight in July. This reduction in risk was in line with a slowdown in economic growth and increasing uncertainties that could detrimentally affect financial markets.
Rising interest rates, inflation and high energy prices, for example, can have a direct effect on company costs and margins. Earnings remain resilient though, and the second-quarter earnings season, that is now underway, has been better than expected. However, earnings growth is expected to slow further in the coming quarters and into 2023, and analysts are, on balance, downgrading their earnings expectations.
The issues around Russian natural gas exports to Europe complicate the picture further, especially for European stocks. While we do not expect it, a threat hanging over the market is that, at some point, Russia could choose to cut off the supply of natural gas to Europe completely. Although this is not our base-case scenario, gas imports from Russia could well drop further, and securing imports will remain a major EU challenge, hurting the outlook for industrials, growth sectors and the economy.
Based on this outlook, there is more than enough uncertainty to continue to favour an underweight equities position. In terms of regions, we favour the US (overweight) over Europe (underweight) and emerging markets (neutral). As we reduced risk over the past months, we have also strengthened the defensiveness of our sector positioning. We now favour the health care and consumer staples sectors (both overweight), while communication services, consumer discretionary and industrials are out of favour (all underweight).
Bond markets remain challenging
We remain cautious regarding the bond market. A situation of rising interest rates affects bond markets negatively and erodes value. Nonetheless, investors seem to have already priced-in a lot of the negative news and central bank promises. Italian government bonds may be at risk, given an uncertain political environment. The ECB, however, has developed a new asset purchase programme that could be implemented if a country’s spreads widen unacceptably. Investment-grade corporate bonds appear to be at a crossroads. There has been a rally in the past weeks, but the effect of an energy crisis and geopolitical risks loom. Earnings at issuers, however, remain strong enough. In July, we reduced exposure to high-yield bonds, as current conditions could lead to rising defaults. Finally, emerging-markets bonds retain attractive valuations, although they face pressure from rising interest rates and a stronger US dollar. The reopening of China could be a silver lining for emerging-markets debt.
A complicated outlook
We believe limiting exposure to risky assets is the best alternative as we head into an expected period of lower growth and rising interest rates. And despite all of the negative news, there are some glimmers of light. China, for example, after experiencing a serious slowdown in the second quarter, is expected to pick up momentum in the second half of the year; in 2023, we now expect economic growth of 5.6% for China. Supply chain issues are also gradually resolving, which could provide some impetus for the global economy. Labour markets, especially in the US, are also strong; and US consumers are continuing to spend. US household finances are in reasonably good shape.
Corporate earnings results have also been better than expected, and the growth forecasts of larger companies will be closely watched as a guide to short-term economic activity. Nonetheless, the fact remains that both the US and Europe will likely be hurt by continuing slowing growth, geopolitical risks and higher energy prices. It also remains to be seen if central banks can successfully chart the narrow path of quelling inflation while preserving growth and avoiding severe recession.
Richard de Groot
Chair ABN AMRO Investment Committee