Identifying opportunities

• Higher interest rates for longer
• Geopolitical risk is rising
• Equities under pressure
• Say good bye to TINA

Markets have been through a lot. Over the past three years and after a worldwide pandemic, economies reopened, inflation raged and central banks engaged in rapid rate-hiking to counter it. As a result, inflation has been coming down; and we believe that interest rates have likely peaked. We are now in a period where the effects of higher rates are impacting corporates and consumers, and central bankers are waiting to see if they have done enough.

The effects of higher interest rates (around a 5% increase over 19 months in the US) are evident and expected to increase, as financial conditions tighten further. The rate on a typical 30-year US mortgage, for example, is now 8%. The US economy still shows some continuing strength, but overall, recent economic developments in the US and the eurozone show core inflation slowing, labour markets deteriorating and financial tightening intensifying. This is all expected to result in an economic slowdown for the rest of 2023 and into 2024. It may be uncomfortable, but this has been the plan from the start of the inflation fight, and it appears to be working.

Central banks will likely sit tight as they wait to see the effects of their hiking cycles play out. The consensus view is a period of “higher-for-longer” interest rates. Markets have repriced to fit this scenario, resulting in a significant rise in US Treasury yields. With ten-year US Treasury yields now around 5%, they offer portfolio possibilities in terms of return and protection that were not available in the previous very low interest rate environment. The sharp increase in US long-term interest rates has also put equity markets and valuations under pressure. While, at the same time, the economic outlook is darkening and geopolitical risks are rising.

The war between Russia and Ukraine in Europe is now more than 18 months old, and the new war in the Middle East was unexpected. The proximity of the latest conflict to oil producers could spur supply challenges. There has already been a pick-up in oil prices, reviving inflation fears and leading to volatility in commodity markets that is reflected in the energy and industrials sectors as well.

In this environment, the ABN AMRO Investment Committee has decided to retain its neutral stance toward both stocks and bonds. Within the bond portfolio, a shift has been made to lengthen the duration of the portfolio and to increase exposure to longer-dated US government bonds or longer-dated European government bonds.

For some time now and as yields rose, we have advocated exposure to high-quality government bonds. They have been a bright spot for investors among uncertain markets. We are now suggesting adding longer-dated (euro-hedged) US Treasuries or longer-dated European government bonds to bond portfolios, at the expense of European government bonds with a shorter maturity.

Bond prices move inversely to bond yields. With a higher duration (sensitivity to interest rates), bond prices will rise more sharply when yields fall (and vice versa). We believe that weaker economic activity will weigh on short-term rate expectations and trigger lower US Treasury yields. As the economic outlook declines, the higher-for-longer view on interest rates will subside and lower rates will find support.

Corporate and consumer optimism is fading in both the US and Europe, as a consequence of higher interest rates, declining growth and rising risks. While corporate earnings have been better than expected, the overall picture in 2023 has been of a modest downward trajectory.

There are significant differences between regions, with the US market outperforming Europe and emerging markets – largely related to a handful of US technology giants. While Europe has done better than had been expected, corporate guidance is now softer, which explains why the earnings outlook for Europe is less optimistic than for the US. We expect earnings outlooks will be less upbeat as the reality of an economic slowdown sets in.

We therefore retain a neutral stance toward equity markets, with a preference (overweight) for the US market in comparison to Europe (underweight) and emerging markets (neutral). Despite the overall market malaise, opportunities can be found in selected sectors. We prefer (overweight) the health care and information technology sectors. Health care is a defensive, “all-weather” play, while the technology sector offers exposure to growth and innovation.

It is clear that we are no longer in the world of “there is no alternative” (TINA) to stocks. With government bond yields now at the highest levels in years, we believe that longer-dated euro-hedged US Treasuries or longer-dated European government bonds offer opportunities for diversification and portfolio resilience.

Richard de Groot
Chair ABN AMRO Investment Committee