Mounting concerns

We are now a little more than halfway through 2022, and it is increasingly clear that this is and will remain a difficult year for investors. The economic rebound generated by pandemic-related catch-up growth has been stymied by very high inflation. Central banks are now taking significant steps to raise interest rates and to tighten monetary policies.

The central bankers are walking a tightrope between fighting inflation and keeping economic growth alive. And just as such high inflation was not expected, neither was the eruption of a war in Ukraine. The war has hurt market sentiment and exacerbated already high energy and food prices, while adding a cloud of uncertainty over Europe.

As central banks around the world raise interest rates, the US Federal Reserve is in the forefront. Fed Chair Jerome Powell recently admitted that while the central bank did not intend to provoke a recession, “it is certainly a possibility.” We believe that a recession will likely be avoided, although it could come down to semantics and definitions. That is to say, we expect a period of very low (Europe) or almost no (US) growth through 2023. And as growth slows and interest rates rise, businesses and consumers will be further pinched.

The addition of higher energy prices and possible shortages adds a further depressing complication to evaluating what comes next. Some of this gloom, however, is offset by very strong household balance sheets and significant buffers in the economy that we think will prevent any prolonged deep downturn. For the rest of 2022, there are also some supportive tailwinds owing to easing supply-chain bottlenecks and a bounce in services activity.

Given the concerning economic picture, the ABN AMRO Investment Committee took steps at its latest meeting to reduce risk and move towards a more defensive positioning of the portfolio. At the asset allocation level, equities have been reduced from neutral to underweight, with the proceeds added to cash. The allocation to bonds remains slightly underweight, but we have taken steps to shed risk here as well, by reducing, in equal amounts, high-yield and emerging-markets debt. These proceeds have also been added to cash.

As the year began, we expected that the outlook for equities would diminish as the months progressed. This view informed our decision to move from an overweight to a neutral equities allocation in February. Our outlook materialised, when, after some short-term resilience, earnings momentum slowed and a bear market began. Even though equity markets have already dropped significantly, we still believe further risk reduction is justified, as we expect earnings growth to further decline due to pressure on corporate margins from rising inflation. We are therefore again trimming the equity allocation by moving from neutral to underweight.

We are also increasing the defensiveness of the portfolio by reducing positions in the financials and the consumer discretionary sectors, while increasing exposure to the utilities, communication services (especially telecoms), health care and industrials sectors. Our two preferred sectors (both overweight) are health care and materials.

We favour the health care sector due to its offer of growth at a reasonable price and its recession-proof characteristics. The materials sector is favoured given that it is positively linked to inflation, based on exposure to commodities and physical asset prices.

Bond yields, which move in the opposite direction of bond prices, have risen in 2022. After years of negative yields, core European government bonds are now in positive territory. German Bunds and French government bonds, in particular, have become more attractive, offering returns significantly better than savings accounts. Nonetheless, bonds, as an asset class, remain vulnerable to rising inflation, which erodes value.

The decision was made to maintain the current slight underweight position in government and investment-grade corporate bonds, which we increased in April; and to reduce the position in riskier high-yield and emerging-markets debt. These higher-risk bond segments are particularly vulnerable to an economic downturn and rising US interest rates.

Our decision to reduce risk in our stock and bond portfolios is the result of our analysis of a number of factors and the obvious circumstances of rising (and possibly higher-than-expected) interest rates, a significant economic slowdown, a war in Europe and the potential for an even more dire energy situation. And while we do not expect a textbook recession, the threat of it is enough to destabilise financial markets across the board. We therefore believe it is better to have a small underweight in stocks as we enter a bear market and to reduce holdings in the more risky bond-market segments.

As the war in Ukraine endures, there are also rising fears of the potential for an actual energy crisis in Europe, which would occur if Russia would fully cut-off its supply to European markets. We do not expect this, in particular, because it is not in the financial interest of Russia. Nonetheless, it is certainly a strategic threat that Russia will likely try to use to its fullest effect. This will necessarily affect Europe more than the US.

One bright spot is the reopening of the Chinese economy, which could provide a boost as supply shortages ease and inflation retreats. It is also positive for investors that bond portfolios can again offer some buffer against volatile stock markets.

Richard de Groot
Chair, ABN AMRO Investment Committee