Patience required

We believe that inflation in the US and Europe has peaked and that the US Federal Reserve and the European Central Bank will continue to hike rates into 2023, but by smaller increments than previously. After raising interest rates by 425 basis points in 2022, the Fed will likely pause its hikes early in the year. The ECB, which started later, is likely to make its last hike in May, reaching a peak rate of 3%.

The recession scenario is also playing out, but in a slightly different manner than we first expected. While we continue to expect a mild recession in the US, with dampened consumer demand and higher unemployment; there is a bit of good and bad news about the recession in Europe.

Europe’s energy situation has developed more positively than expected, given that the winter weather has, so far, been mild and there has been no rationing to industry or consumers.

We therefore now expect a less severe impact from the energy crisis on the eurozone economy in 2023. The outlook for a recession remains, but with a decline of -0.3% in economic growth versus the sharp hit of -0.9% which we had expected previously. It is not an entirely positive story, however, as we now expect Europe’s recession to last longer, with low negative growth continuing through the third quarter of 2023, followed by a muted recovery.

Given the mix of uncertainties in the investment environment, related to inflation, recession and the unrelenting war in Ukraine, the ABN AMRO Investment Committee left the overall asset allocation unchanged at its latest meeting. It continues to reflect an underweight in equities, a neutral stance towards bonds and an overweight in cash.

In consideration of the improved outlook for Europe in the near term, the regional equity allocation was adjusted to move Europe to neutral (from slightly underweight) and the US to neutral (from slightly overweight). A neutral allocation continues for emerging markets. Sector adjustments, in line with the improved eurozone outlook and a recovery in China, are described below. Duration was also adjusted in the fixed income portfolio.

Equity markets in Europe and China have made a strong start to the year, based on factors such as an improvement to the Chinese economy later this year after Covid lockdowns were ended, Europe doing better than expected and the hope of fewer rate hikes by the Federal Reserve.

But the overall outlook for corporate earnings remains bleak, given our expectation for recession in the US and Europe. This economic slowdown is expected to have a knock-on effect on earnings. We continue to believe that earnings momentum will remain under pressure for the next three quarters; and we expect an earnings recession in the coming nine months. Moreover, an earnings recession will also pressure valuations and feed volatility. We do not believe that this is currently priced-in.

We therefore continue to consider that an underweight stance to equities is warranted. But we have adjusted the equity portfolio’s sector preferences to take advantage of the improvement seen in China and its effect on some European sectors.

We are slightly reducing the defensiveness of the equity portfolio by increasing the allocation to the industrials and consumer discretionary sectors. These sectors are expected to improve, based on exposure to Chinese economic growth and pent-up consumer spending. In turn, the allocation to the health care and consumer staples sectors was reduced. After these adjustments, the sector allocation consists of an overweight in health care; and small underweights in the communication services and consumer discretionary sectors, with a neutral allocation to all other sectors.

Bond markets continue to be volatile, affected by easing inflation and hawkish sounding central banks, intent on further rate hikes. We continue to prefer safe government bonds and investment-grade corporate bonds, as a recessionary environment exerts pressure on lower quality (higher return) bond segments. The duration (sensitivity to interest rates) of the bond portfolio was lowered to a more neutral stance.

We have witnessed extraordinary events over the past two years – and they are still unspooling -- as witnessed by China’s recent decision to “open up” from Covid lockdowns. China’s further economic recovery may benefit more European markets and is likely positive for other emerging markets as well. But Chinese policymakers, still confronting problems in the property sector and with the goal of more deleveraging, will apply the brakes if growth outpaces policy goals. In the US and Europe, the effects of aggressive cumulative rate hikes on consumers and businesses are also likely still in the pipeline, as they generally lag rate hikes by three to five quarters.

We believe that investors will need patience as economies and markets transition from inflation to recession to eventual recovery. Our current asset allocation (underweight equities, neutral bonds and overweight cash) positions us to both weather what lies ahead and to act opportunistically when feasible. For now, there are more than enough reasons for caution.

Richard de Groot
Chair ABN AMRO Investment Committee