Compounding uncertainties

Last month, in the face of rising uncertainties, the ABN AMRO Investment Committee took a more defensive stance by reducing equity exposure and moving to a neutral equity position in its asset allocation. The underweight position in bonds was retained. At its latest meeting, this overall asset allocation was left unchanged. The defensive positioning of the portfolio was slightly strengthened, however, by reducing exposure to the financials sector while increasing exposure to health care.

In recognition of the effect of rising energy prices and Europe’s exposure to Russian gas and its proximity to Ukraine, it was decided to change from a neutral exposure to equity regions (US, Europe and emerging markets) to one tilted in favour of the US (overweight) versus Europe (underweight). Economic growth in the US is expected to be more resilient than growth in Europe. There was no change to the neutral stance toward emerging markets.

The base-case scenario that underpins the ABN AMRO investment strategy expects that growth in the eurozone will be lower than had initially been expected, owing to rising energy and commodity prices, including metals and agricultural goods. This will not only lead to industry disruptions, but also hurt consumer purchasing power, which will, in turn, weigh on confidence and personal consumption.

Consumer confidence in Europe in March, for example, fell, declining almost to the low point registered during the first wave of the pandemic. The positive effect of a rebound in services consumption, that was expected as lockdowns ended, will now be lower due to soaring energy prices. On balance this will slow consumption growth during the first six months of 2022. The war in Ukraine also weighs on European consumer sentiment.

The US is somewhat more insulated from the war in Ukraine. It is, however, dealing with a hawkish central bank, that in March started an extended rate-hike cycle to tame inflation. Seven rate hikes in a row are now signalled this year, and four more next year. This points to a Fed Funds rate of 2.8% in 2023. US economic growth is expected to slow, as it moves to growth below the historical average next year.

The effect of the war in Ukraine is a worrisome backdrop for markets even though they have recovered over the last weeks.. The human costs are, of course, paramount. We can only hope for a swift end to the war and the eventual rebuilding of a free Ukraine.

For European consumers, the war has meant higher prices across a range of goods. When Russia invaded Ukraine, higher oil, gas, wheat and other commodities triggered a considerable rise in inflation expectations. These expectations outpaced the rise in nominal yields, resulting in lower real yields in the major economies.

Nations around the world have imposed stiff sanctions against Russia. We expect the sanctions to lead to a lasting global realignment in trade, as reliance on Russian energy and other commodities is reduced and replaced with alternative sources. It is also difficult to envision how or when the sanctions will be lifted, even if there is a de-escalation.

We assume that we are in for a year of very elevated prices and supply disruptions due to the war. This time will be needed to secure new, non-Russian sources of commodities and for global trade flows to adjust. But even when the supply disruptions ease, prices are likely to remain elevated, which will continue to weigh on economic activity for some time.

Rising uncertainties call for a balanced approach to equities. Earnings expectations have declined significantly since the third quarter of 2021. And while we expect earnings growth to be positive in the first quarter of this year, we believe that earnings will be revised lower in the coming months, as higher costs pressure margins. Earnings momentum in the US, however, is expected to be slightly more resilient than in Europe.

Bond markets have been extremely turbulent so far in 2022, as inflation was higher and more persistent than had been expected in both the US and Europe; and also, of course, due to the invasion of Ukraine. The European Central Bank has been more hawkish than expected, as it focuses more on inflation than on growth concerns.

We continue to prefer the government bonds of peripheral European governments to core eurozone government bonds. European investment-grade corporate credits are also favoured and have recently become more attractive due to spread widening. Among higher-return fixed income segments, we have a positive bias towards emerging-markets debt and high-yield bonds.

There are a number of overlapping factors arguing for a balanced approach to investing. The inflation threat that emerged last year has been exacerbated by the war in Ukraine and higher energy prices. Central banks are taking steps or indicating that they will fight inflation by tightening their monetary policies, which presents another risk for investors. Overall, the combination of these uncertainties reinforces our conviction to take a more defensive stance within our investment strategy. We expect markets to continue to be volatile and responsive to news flow. Diversification is one way to buffer the effect of market volatility on a portfolio.

Richard de Groot, Chair,
ABN AMRO Investment Committee