A softer landing

30/08/2023 • 4 minute read

Richard de Groot

While growth is under pressure, the resilience of the world economy, and especially the US economy, is surprising. Where we previously expected the US to face a recession this year, we now believe a softer landing to be more likely. This is one of the reasons why we are increasing our equity allocation from underweight to neutral. Caution, however, continues to be required.

US economy holds up surprisingly well
Europe unlikely to escape a (mild) recession
Neutral equity positioning justified
Caution is still advised

In recent months, differences in direction between the major economies have widened. The US economy showed impressive strength, while the eurozone economy weakened. And in China, the growth recovery after the pandemic proved disappointing.

US economy holds up surprisingly well

We still believe that economic growth in the US will slow significantly in the coming months. Growth is held back by the Federal Reserve’s tight monetary policy. In addition, US consumers – who have long been the engine behind the growth of the economy – are starting to run out of savings.

But we no longer expect this slowdown to turn into an actual recession. Instead, we foresee a softer landing of the US economy, with growth slowing and then stagnating in the coming quarters. From the second quarter of 2024, GDP in the US is expected to start growing again, albeit at a slower pace than we previously thought.

Europe unlikely to escape a (mild) recession

While domestic demand in the US has so far remained strong, this is not the case in the eurozone. In both the last quarter of 2022 and the first quarter of 2023, domestic demand in the euro area declined sharply. And it looks like that trend continued in the second quarter. The eurozone is likely to experience a mild recession in the third and fourth quarter, followed by a slight growth recovery in the first quarters of next year.

Earnings recession is less likely

In recent months, we have regularly expressed the view that analysts’ earnings expectations were too optimistic, as an economic recession could lead to an earnings recession (a period of declining corporate earnings). The economic headwinds we still foresee will lead to modest earning growth. But the scenario of an earnings recession has become less likely.

Neutral equity positioning justified

What does all this mean for our view on equities? For equity markets, 2023 has been a positive year so far, with the exception of Chinese markets. Now that we foresee a softer landing of the US economy and no earnings recession, we believe a neutral view on equities is warranted. We therefore suggest investors to increase their allocation to equities from underweight to neutral, at the expense of cash. In recent weeks, equity markets have taken a step back. This slight market correction provides a more favourable entry point to buy equities.

Emerging-market equities less attractive

We also think that the time has come to make some changes at regional level. Whereas we previously preferred emerging markets to developed markets, we now believe that emerging markets have lost some of their appeal. An important reason for this is the situation in one of the largest emerging economies: China. The reopening of the Chinese economy after the corona lockdowns resulted in a period of growth recovery. But that period was short-lived. Growth in China is already slowing again, driven by ongoing problems in the Chinese real estate sector, local governments’ debt issues and underwhelming consumer demand. We therefore suggest investors to reduce the weighting of emerging-market equities in their portfolio from overweight to neutral. Proceeds can be allocated to equities in developed markets (increase from underweight to neutral). Within developed markets, we now prefer US equities (overweight) to European equities (underweight), given the better growth prospects of the US economy.

IT sector increasingly appealing

At a sector level, we suggest investors to increase their allocation to information technology (IT) from a moderate overweight to an overweight, at the expense of industrials. IT companies are expected to benefit increasingly from strong long-term trends such as digitalisation (for example cloud computing), artificial intelligence and cybersecurity.

By contrast, we believe the outlook for the industrial sector has become less positive, partly because of China’s deteriorated growth prospects, as well as the sluggish economic trajectory that is expected for Europe in the coming quarters. Our suggestion to investors is therefore to reduce their allocation to industrials from neutral to underweight.

Caution is still advised

Although the US economy is holding up better than we expected, economic conditions overall remain challenging. Inflation is declining but still too high – and the full impact of the interest rate hikes is yet to be felt in the economy. The changes described above result in an overall asset allocation that continues to reflect a defensive stance – but to a lesser extent than before, as we now shift to a neutral positioning in equities. The allocation to bonds remains neutral. Within bonds, we retain a preference for high-quality bonds, such as government bonds, and remain cautious on riskier bonds, such as high yield.

Richard de Groot, Chair ABN AMRO Investment Committee