Uncertainty fuels volatility

The main story for investors remains stubbornly high inflation and the steps that central banks are taking to fight it. In the US, the Federal Reserve has been unhesitating in its march toward higher rates, recently hiking for the third time by an outsized 75 basis points.

Key US rates now stand in the range of 3.0 to 3.25%, and we believe the Federal Reserve will end the year in the range of 4.25 to 4.5%. Moreover, Fed Chair Jerome Powell recently acknowledged that pain will be felt by households and businesses as it fights inflation. Already, US consumers and businesses are facing higher loan rates, with fixed-rate long-term mortgages now reaching 6% or higher. We expect the European Central Bank (ECB) to have moved to a 2% deposit rate by the end of the year.

While we had expected recessions in both Europe and the US, with the more significant impact felt in Europe; it is becoming likelier, but not certain, that the US could also face a more serious recession. This could occur if the labour market remains strong and the Fed misjudges the fine line between fighting inflation and extinguishing growth, resulting in what is known as a “hard landing” for the economy. In Europe, the economic situation for both companies and consumers is overshadowed by the war in Ukraine and the possibility of an energy crisis this winter. Against this background, the ABN AMRO Investment Committee chose to maintain its defensive asset allocation, reflecting a strong underweight in stocks and a small underweight position in bonds, with an overweight in liquid assets (cash and money market funds).

Equity markets remain under pressure, and we expect this to continue further. This is due to the willingness of the Fed and ECB to tighten monetary policies despite a slowdown of activity and recession risk – which we do not believe is priced-in to equity markets.

While earnings growth remained resilient in the second quarter, we believe that this is explained by decent final US demand in the second quarter and better-than-expected growth in Europe. Earnings growth was also not evenly distributed, given the outperformance of the energy sector. We therefore expect a decline in earnings growth in Europe and emerging markets and a mild decline in the US, and for this trend to emerge during either the third or fourth quarter. There have already been unexpected profit warnings from stalwart US consumer companies, as they confront lower demand, tighter margins and higher interest rates.

As we reduced equity risk over the past months, we also strengthened the defensiveness of the portfolio in terms of regional and sector positioning. We favour the US market (small overweight) versus Europe (small underweight), with a neutral stance toward emerging markets. In terms of sectors, we favour health care and consumer staples, given their resilience in uncertain markets.

Over the year, we have increased exposure to high-quality government bonds and investment-grade corporate bonds, while reducing riskier bond market segments, such as European high yield. Sovereign bond valuations became attractive again, but their positive returns are challenged as central banks hike rates. Credit spreads experienced a summer rally and moved sideways in September. But, the rally was unjustified and, overall, we do not believe that recession risk has been adequately priced-in to bond markets. Among higher return (more risky) bond segments, a European energy crisis would be harmful to high yield and lower-rated European credits, while a strong US dollar and rising yields are, in general, detrimental for emerging-markets debt.

For some time now, we have taken a critical stance toward risky assets and have expected that economic growth would deteriorate over 2022. Market threats include inflation, recession, geopolitical risks and the possibility of an energy crisis in Europe this winter. We have been in a bear market for some time, but the “good” news is that a normal bear market lasts, on average, for around ten months, and we are now nearing that mark.

At some point, central banks will regain control of inflation. In the US, it will likely require a sharp economic downturn and an increase in unemployment, which will be detrimental to earnings and the outlook. Our base-case scenario, which guides our investment strategy, calls for the Fed to begin modestly cutting rates in the second half of 2023. This is based on our view that inflation will significantly decline in the first half of 2023, helped by falling commodity prices, an easing of supply-side bottlenecks and cooling demand. We do not expect the ECB to cut rates until 2024.

For now, we consider that the best strategy is to hold a diversified portfolio consisting of defensive stocks and high-quality bonds, while maintaining a healthy cash position for future opportunities.

Richard de Groot
Chair, ABN AMRO Investment Committee