Not yet out of the woods

The US Federal Reserve recently decided to pause its rate hike trajectory, for the first time since it started in early 2022. But Fed Chair Jerome Powell also indicated further hikes may be necessary. We expect just one more 25-basis-point hike in the US in July. 

The European Central Bank is also not yet quite finished hiking. At its June meeting, it raised rates by 25 basis points to 3.5%. Moreover, ECB President Christine Lagarde said that inflation in the eurozone looked to remain “too high for too long.” We expect one more rate hike by the ECB in July before the ECB also stops hiking rates.

Both central banks are acknowledging that the end is near – and that is good news, as it means that inflation, while remaining stubborn and “sticky”, is coming under control. But we are not yet out of the woods, as we expect repercussions from the long period of steep rate hikes to slow economic growth. 

We continue to believe that mild recessions will be seen in both the US and Europe. In Europe, a technical recession is already documented. After such a long period of interest rate hikes, an economic downturn was almost unavoidable. There is generally a lag of five or six quarters before the full impact of rate hikes on an economy is seen. And some signs are already visible. Credit conditions and loan demand in the US and Europe, for example, are deteriorating to levels similar to what was seen in the financial crisis. The expected economic downturn will also negatively affect earnings momentum, which we expect will suffer in the second half of the year.  

In this environment, the overall asset allocation remained unchanged at the latest meeting of the ABN AMRO Investment Committee. Equities remain underweight, with a neutral stance toward bonds. One shift, however, was made within a small portion of fixed income assets. In the least aggressive portfolio in terms of risk (client risk profile 1), the allocations to higher return (higher risk) bonds and alternative assets were sold, with the proceeds going to cash. The move is designed to provide clients with access to a portfolio of lower-risk assets with better returns than cash deposits.

Equity markets have so far been fairly resilient, with a regional divergence in performance. Europe, for example, is now lagging both the US and emerging markets. But the strength seen in US markets may be deceptive. While the S&P 500 Index has risen by more than 10% year-to-date, it is largely due to the performance of seven large technology stocks. Their stellar performance masks the much more modest performance of most other US stocks. 

There are also significant regional differences in terms of earnings growth. In emerging markets, for example, earnings growth has been negative for the last few months; US earnings are now flat (on a year-on-year basis); while European earnings are continuing to be resilient, having benefited from stronger economic growth than expected, a weak euro and optimism regarding the consumer recovery in China.

Given our expectation for a US and eurozone recession, we believe that earnings will be under pressure for the next few quarters. We therefore retain our underweight stance toward stocks. 

In terms of regions, we prefer emerging markets (overweight) to developed markets (underweight). 

Our sector allocation provides exposure to the areas where we see opportunity. This includes overweight positions in information technology (IT) and health care. IT is benefitting from significant trends related to artificial intelligence, digitalisation and security. Health care is attractive for its defensive characteristics and ability to weather an economic slowdown.

We are overall neutral regarding bond investments and within this positioning, we favour high-quality bonds, such as sovereigns and investment-grade European corporate credits, where credit quality is historically high. These bonds are also useful for portfolio diversification and can act as a buffer when more risky assets are volatile. Higher risk bonds, such as high-yield and emerging markets debt, are out of favour, given expected recession, tight spreads and other uncertainties.

Markets have stabilised. But we are still dealing with the consequences of the inflation that arose from the reopening of economies after pandemic lockdowns. Central banks were reluctant to start fighting inflation, but once they started were fairly relentless. Now inflation is coming under control, and central banks, while still wary, are acknowledging that the end of their rate hike cycles is nearing. We expect rate cuts by both the ECB and Federal Reserve at the end of the year.

The current uncertainty in markets is largely driven by fear regarding the ultimate impact of the significant increases in interest rates since 2022 and a darkening economic environment. As we work through this uncertainty, some bright spots have emerged. High-quality bonds, for example, are again a relatively safe alternative to cash and with better returns. Rising interest rates have also positively affected savings rates, which while still low, are positive and tracking upward. There are also specific areas of equity markets that continue to offer opportunities. Outside of these areas, however, the main hurdle to further equity investment is our belief that the coming economic downturn has not been fully priced-in. 

We therefore believe that an underweight position in equities is the best course. Well-diversified portfolios should also include a balanced position in high-quality bonds and a healthy cash position, for when a more favourable investment environment returns in the months ahead.

Richard de Groot, Chair, ABN AMRO Investment Committee