Consequences and uncertainties

Investors have been through a lot over the past 18 months. An energy crisis that grew out of an ongoing war in Europe, global high inflation, steady interest rate hikes and a banking scare have led to an environment rich with uncertainty. Inflation, which was more stubborn than expected, is coming under control in both the US and Europe. But despite inflation trending lower, the US Federal Reserve and European Central Bank (ECB) are likely to continue raising rates in the near term. And, for now, it appears impossible to avoid the pain that the rapid succession of interest-rate hikes has inflicted.

So far, the damage has been limited. But, the recent turmoil in the banking sector, being on the front line of interest rate hikes, was a sign that there will be consequences to the fight against inflation. Financial conditions are clearly tightening. Rising residential mortgage rates, for example, are already crimping the housing market. Borrowing costs have also risen for governments and corporates, as banks adjust rates in line with increasing credit risks. Tighter lending conditions are likely to lead to material weakening in advanced economies. China’s reopening could offset the slowdown in developed economies, but it could also slow the inflation fight.

We expect that a period of stagnation and contraction lies ahead, with mild recession expected in both Europe and the US. We do not believe that markets have fully priced-in this risk. At the latest meeting of the ABN AMRO Investment Committee, the existing defensive asset allocation was retained: equities are underweight and there is a neutral stance toward fixed-income markets. 

Most recently, equity markets have appeared resilient, rebounding from unrest in the banking sector and benefiting from some better-than-expected macroeconomic data. Given our expectation for an economic downturn, however, we continue to expect that earnings momentum will be under pressure for the next quarters. It has already been negative since the third quarter of 2022, as illustrated by the fact that more analysts are downgrading earnings expectations than revising them upwards. Twelve-month earnings growth expectations are actually now close to zero. 

With earnings momentum declining, valuations will also be under pressure and lead to higher market volatility. In line with these consequences, we are maintaining an underweight position in equities. In terms of regions, we prefer emerging markets (overweight) to developed markets (underweight), as growth in China will likely support economic momentum in regional economies. 

Our sector allocation is slightly less defensive after increasing exposure to the information technology (IT) sector (overweight), when we reduced exposure to the financials sector (underweight) in March. The IT sector became more attractive after valuations fell and the sector pivoted to focus on margins over growth. IT is also benefiting from trends related to digitalisation, artificial intelligence and security.

Given our expectation for stagnation/recession, we continue to favour an allocation to high-quality bonds, including sovereign bonds and high-quality European corporate credits, which are supported by historically high credit quality. Regarding the higher risk (higher return) bond segments, we remain neutral toward emerging-markets debt and negative on high-yield, where we believe spreads are too tight given the uncertain economic environment. High-quality bonds will be increasingly important in portfolios, based on their ability to act as a buffer when more risky assets face volatility.

Markets are working through a troubled period that grew out of the lingering effects of the global pandemic and rampant inflation. The good news is that inflation is coming under control, but stubborn, underlying pressures remain. Nonetheless, rate cuts by both the ECB and Federal Reserve  are expected at the end of the year. The energy crisis in Europe was less harmful than anticipated, but it will likely still lead to a shallow recession in Europe. And, the banking crisis appears solved – at least for now. Tightening financial conditions are a new but not altogether surprising concern, being a natural consequence of swiftly rising interest rates. 

All of these factors create uncertainty. We believe the environment continues to call for an underweight position in equities, while remaining exposed to areas, such as IT and health care, which offer opportunities. A major hurdle to equity investment is our belief that the economic downturn has not been fully priced-in. 

Diversification continues to be key, including exposure to high-quality bonds that can help stabilise portfolios when market swings negatively impact more risky assets. In short, we are further along in the journey to recovery than we had been, but given so much uncertainty, it remains a time for caution. 

Richard de Groot, Chair, ABN AMRO Investment Committee