Facing the consequences

There is renewed stress and tightening in financial markets. It was first seen in problems at US regional banks, while in Europe, a large Swiss institution faced a liquidity issue. The negative consequences of a series of rate hikes, after a long period of very low interest rates and cheap money, are now appearing.

Bank regulators and central banks are focused on supporting financial institutions and adamant about the strength and resilience of banking systems. Central bankers also appear resolute in continuing their fight against inflation with further rate hikes. The European Central Bank (ECB) went through with its planned 50-basis-point rate hike on 16 March, stressing that inflation remains a problem. We expect that the Federal Reserve will also proceed with its rate-hiking trajectory. Central bankers appear confident that solving inflation and returning to target rates is worth the pain.

The base-case scenario that underlies our investment strategy has long called for recession in Europe and a downturn (or textbook recession) in the US as well. We continue to believe recession lies ahead, most likely along the lines of contraction and then stagnation. Markets have not priced-in this risk. The asset allocation is therefore positioned defensively at all levels of the portfolio: equities are underweight, and the sector allocation is tilted to the defensive health care sector; there is a neutral stance toward fixed income; high-quality bonds are preferred, while more risky bonds, such as high-yield, are not. At the latest meeting of the ABN AMRO Investment Committee, this asset allocation was retained.

Over the past few months, the rate hikes by the Federal Reserve have resulted in tightening financial conditions and has led to an underperformance of US and emerging markets equities. European markets have fared better. But the recent banking crisis generated a new wave of volatility and engulfed European markets as well.

Despite evidence that economic momentum has been improving, it is now pressured by the threat of recession. Positive economic news had encouraged central banks to reiterate their plans to hike interest rates and quash inflation. We now do not think that the central banks will reverse their rate hikes until very late this year, when the first rate cuts are expected. This is a later course reversal than we had previously estimated.

In line with the looming economic recession, we continue to believe that an earnings recession (i.e. two quarters of negative earnings growth) will also be evident in the coming months. Historically, market corrections are highly correlated with negative year-on-year earnings-growth forecasts. The earnings recession has been delayed in Europe, as growth has been stronger than expected and earnings have been supported by a weaker euro. Nonetheless, we expect demand to suffer from the impact of monetary tightening.

Against this background, we continue to support an underweight equities position. In terms of regions, we are overweight emerging markets versus developed, given that the reopening of China could support economic momentum in regional economies.

With recession risks and the expectation for higher interest rates amid a climate of uncertainty, we continue to prefer a neutral stance towards fixed-income markets. In times of stress, an allocation to high-quality bonds can act as a buffer against swings in more risky assets. We therefore continue to prefer sovereign, government-related and covered bonds, while avoiding riskier bond segments, such as high-yield and lower-rated corporate credits.

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 expect financial conditions to continue to be tight and this can lead to more uncertainty in financial markets. What we see in the US banking sector only reinforces our thesis that financial condition tightening will be a painful process. We have faith in the ability of US and European regulators to stabilise markets. And, in fact, it was the strength seen in macroeconomic data, manufacturing and jobs reports over the past months that encouraged central banks to be resolute in hiking rates and tightening monetary policies. The consequences, however, are now coming more clearly into view.

In this environment, we are comfortable with our underweight equities position and our slightly defensive portfolio stance overall. We remain exposed to the investment opportunities that we see in today’s market and see value in diversification across asset classes, regions, sectors and investment themes. At some point, market volatility will reveal opportunities, but for now, it is too early, given that the deteriorating economic scenario is not priced-in to valuations. Instead, it remains a time for caution and patience.

Reinhard Pfingsten
Acting Chair, ABN AMRO Global Investment Committee

Given the turmoil in the banking sector, two decisions were made  shortly after the conclusion of the March meeting of the ABN AMRO Investment Committee. In the equities portfolio, there was a decision to reduce exposure to the financials sector, which was moved from neutral to underweight. The proceeds were used to increase exposure to the communications services sector (moving from underweight to neutral) and the information technology (IT) sector (moving from neutral to overweight). 

While we believe that the banking systems in US and Europe are strong and stable, the effect of recent bank-specific problems have negatively affected sentiment, which we do not expect to improve significantly within the next six months. At the same time, the outlook for the communication services sector has improved. After a long period of underperformance, the sector has focused on top-line profitability. We believe it is now in a position to benefit from the positive elements seen in the media and entertainment segments. Finally, we are adding exposure to the IT sector. Valuations have retreated off their peak levels, and the sector has pivoted to focus more on margins than growth. 

Within the fixed income portfolio, the decision was made to selectively reduce the US duration (sensitivity to interest rates) by one year for high-return bonds (high-yield bonds and emerging-markets debt). The decision will enable the portfolio to benefit from an expected bounce in US yields as markets normalise after the banking crisis, while maintaining exposure to the spreads offered by higher yielding bonds.