Waiting for clarity

The current market themes of inflation, central bank hikes and recession are unfolding along unpredictable time lines. What we do know, is that they typically follow one another. 

We saw inflation – rising stubbornly since mid-2021 and then moving higher and lasting longer than expected. This provoked interest rate hikes by central banks around the world -- with the Fed hiking by more than 4% in 2022 alone; and the European Central Bank (ECB) acting more aggressively to hike rates than it has ever done before. Central banks now appear on the cusp of believing that inflation is coming under control. As a result, we expect a recession. Central bank tightening will rein in overactivity funded by cheap money and low borrowing costs. 

In the meantime, we have seen a rebound in equity markets, based on better-than-expected growth in Europe and China, and the market’s hope that the Fed will reverse its hiking course sooner than expected – contrary to all the Fed’s indications. In response to this uncertainty, markets are volatile and divergent.

The base-case scenario that informs our investment strategy calls for a shallow but protracted recession in Europe and a more benign but real downturn for the US economy in 2023. Earlier, we thought that the situation in Europe would be more dire. But given the improvement in the energy outlook and the effect of lower gas prices on consumers, the eurozone is in a better position than expected. 

Europe is also benefitting more than the US from China’s opening-up after zero-covid lockdown policies. Economic growth in China is expected to reach 5.2% this year, well above the already upwardly revised growth estimates for Europe (-0.3%) and the US (0.7%). China’s growth will likely also positively influence other regional economies.

In this challenging environment, the ABN AMRO Investment Committee decided to leave the overall asset allocation unchanged. It continues to reflect an underweight equities position, a neutral stance towards bonds and an overweight in cash. The regional equity allocation has been adjusted to favour emerging markets (overweight) versus developed markets (underweight). Within the bond portfolio, a shift was made involving the purchase of government-related and covered bonds, funded by the sale of core European sovereign bonds.

We retain an underweight allocation to equities based on the key factors of earnings and valuation. Despite the fourth quarter earnings season being marginally positive, there are signs of a slowdown in earnings dynamics. 

Analysts, for example, are, on balance, still downgrading their earnings expectations; and outlooks have deteriorated. Earnings expectations for 2023 are around 1-2% for the MSCI World index, while they stood at around 3-4% in late 2022. And, US fourth-quarter earnings surprises were at the lowest level in four years. There are also regional differences. Earnings in the US are negative, while in Europe, earnings were supported by stronger than expected growth and the weakness of the euro. We expect further deterioration in the US and Europe, with a corporate earnings recession expected in the next nine months. We also do not believe the deteriorating economic scenario is priced-in to valuations. Instead, there is little buffer, which could exacerbate losses when markets decline.

We are tilting the equity portfolio toward emerging markets, moving from a neutral to an overweight positioning. While earnings in emerging markets had been under pressure for the past 18 months, we believe that the reacceleration of the Chinese economy will support Asian economies, and, in turn, corporate earnings. We expect positive earnings growth over the coming quarters in these markets. In addition, our conviction that the Federal Reserve will begin reducing interest rates toward the end of the year, coupled with a weaker US dollar is generally positive for emerging-markets financial conditions.

No changes were made to the sector allocations. Health care remains overweight; small underweights are held in the communication services and consumer discretionary sectors, all other sector allocations are neutral.

Bonds became more attractive this year, and positive returns are expected in most bond segments.  But, given recession risks, we are still cautious about adding more risk in the corporate high-yield or emerging-market segments. We have, however, sold some German and French government bonds in order to purchase higher yielding government-related and covered bonds. The spreads on these bonds are relatively attractive, with room to tighten. They are also believed to be fairly invulnerable to recession risk. 

We  believe more time is needed before investors will see a sustainable recovery. In the meantime, we expect volatile markets, as they jump in response to macro data, central bank actions, inflation releases and job reports – among other factors. Both the Fed and the ECB are resolute in stating that they are not finished with hiking interest rates. We expect that their last hikes will dove-tail with a protracted recession in Europe and a sharp downturn in the US. It therefore remains a time for caution and patience in both bond and equity markets.

Richard de Groot
Chair ABN AMRO Investment Committee