Dialogue with a client

Inflation has certainly retreated. In Europe, lower energy prices have been the main driver of lower inflation. The mild winter really helped to bring energy prices down. And also in the US, we clearly see that inflation has peaked. We expect that inflation will fall back to 2% over the next 18 months.

However, it is too soon to state that the inflation problem is over. Core inflation (excluding energy prices and food) is still at very high levels and coming down more slowly. Core inflation is also called ‘sticky inflation’ because it is less volatile. As can be seen from the chart, core inflation still has to come down significantly. 

An important driver for core inflation is wage growth. Due to the tight labour market and high levels of inflation, we see that companies have to pay higher wages. In order for core inflation to fall back to 2%, the growth in wages needs to decline. We believe this can only happen if labour markets become less tight. In other words, the unemployment rate will need to increase.

We have been incorrect in the timing of the US recession, but we still believe that a recession is coming. The economy has been more resilient than we thought at the end of last year, and there are clear differences between Europe and the US. In Europe, the mild winter really helped. If this had been different, then the impact of energy costs would have been much bigger and we would have seen a deeper recession. Fortunately, this did not happen, but still we experienced a minor contraction in GDP growth. We also expect this to continue for the next few quarters.

In the US, our forecast was indeed for a mild recession, but we have not yet seen this happening. There are a couple of reasons why the economy is holding up better than we initially thought. The first is the high amount of savings coming out of the pandemic. This savings has been used by consumers to spend on goods and mainly on services. Second, credit growth has been a strong support. Third, “Bidenomics” translated into strong support from the US government to corporates and consumers. And finally, there is the still the very strong labour market, which remains unbalanced as job openings are historically high. As long as people feel secure about their jobs, they are inclined to spend money. 

However, some of the tailwinds described above are coming to an end. First, the high levels of savings is diminishing, taking away some of the tailwind. Secondly, credit conditions have tightened, making it much more difficult for companies and consumers to borrow. Historically, such a level of tightening coincides with a recession. 

The problems in the financials sector have been difficult and complex. The situation with the US regional banks was caused by a lower amount of confidence that turned into a bank run. Part of the problem hereby was also the impact of higher interest rates. This has led to losses in bank portfolios, as their fixed-income assets had become less valuable. This is a clear example on how interest rate hikes have impacted the real economy.

Due to actions taken by US authorities, the fallout has been limited. We also believe that banks are, in general, much better capitalized than before. We therefore do not expect to see the same problems as we had in 2008, but we are also still cautious about the sector in general. That is why we are currently underweighting the financials sector. 

Even though the fallout was relatively limited, there has been an impact on investment performance. The size of the effect differs per concept, but mainly in the ESG portfolios we had a larger exposure to some of the US regional banks. They scored well in our ESG screening (and most larger banks scored much lower). The impact of the Swiss bank was very limited as there was no direct exposure.

Yes, your analysis seems to be spot on. Most markets performed well particularly in the first six weeks of the year. Then, divergence increased significantly, depending on regions, sectors, and styles. 

European equity markets were supported by the mild winter in Europe, that helped companies to keep costs low, and by China’s reopening. However, since March, equity markets have been struggling as the economic outlook is deteriorating. 

Emerging markets also started out well in January, supported by the China reopening narrative and the expectation for monetary easing by the US Federal Reserve in the second half of 2023. But, during the last few months, emerging markets have been under pressure, as the Chinese recovery disappointed and the Fed has hiked by more than expected.

Last, for the US, the rising market was really based on a very limited number of stocks. The chart below gives an overview of the performance of the S&P 500 Index and the contribution from the different stocks. As you can see, over 75% of the performance came from only seven stocks. That is why they have been named “the magnificent seven.”

Looking at the seven outperforming stocks, there is, for most of them, a common source that has led to this strong performance. It all has to do with the emergence of artificial intelligence (AI) and the opportunities that companies see in this technology. While AI is not new, the introduction of ChatGPT has been a trigger for more optimism. The seven stocks are active in chips and in datacentre or cloud services. All benefited by being linked to the artificial intelligence theme.

For equity investors, this is causing a concern. First, these are all mega-cap companies and they therefore weigh heavily in the index. We are strong believers in diversification, via our direct equity portfolio and our investment funds, and that makes it difficult to benefit from trends based on a very small number of stocks. 

We are at the beginning of a multi-year period of innovations based on generative AI, given its ability to reduce costs, expand capabilities and enhance customer experiences. As a result, there is a massive AI spending boom in almost every sector. In addition to the mega-cap companies that are now most directly involved, we see three layers of future opportunities.

First are the companies providing the essential AI infrastructure, such as cloud-services providers, semiconductor companies and the manufacturers of semiconductor equipment. Second are cyber-security companies, where we expect an increase in demand, given how AI can be used to create malware, viruses and false information. And finally, there are the consulting firms and software vendors enabling the implementation of AI. Within this group, we prefer companies that are already tightly integrated with their corporate clients and their IT systems. We currently have an overweight in the IT sector (as well as the health care sector), as these are the areas where we see the most opportunities, despite a challenging economic environment.

Your analysis is again correct, but we do not agree with the conclusion. Our view is that ESG investing over the longer term will certainly not perform worse than traditional investments. Companies that have strong ESG policies are well managed companies and that will also lead to good performance. However, there can be periods when ESG investing lags. For example, what you explained over 2022 with the energy sector doing so well.

This year, it is a more complex story. The energy sector is actually one of the least performing sectors so that has helped. As explained in question three, the exposure to the financials sector was, in general, not positive, as our screening criteria led to a larger focus on US regional banks. And then there is the impact of the “magnificent seven.” Due to different ESG reasons (for example related to controversies), we are not investing in four out of these seven stocks. That is not related to AI, but more to company-specific ESG-related factors.

That is the key question to answer and one we very frequently discuss with our team of investment specialists as well. Our conclusion is that it is still better to be patient and stay cautious about increasing exposure to equities. So what are our main concerns that has led to this conclusion?

First, our expectations regarding economic growth are below market consensus for the US. The table below shows the ABN AMRO expectations and those priced-in to the markets. As you can see, there is quite a gap. We still forecast a mild recession in the US.

Our scenario is based on the consideration that a large part of the impact of the rate hikes carried out by the Fed is still to come. The impact of rate hikes in general takes four to six quarters, and even though we have seen the first impact (for example, rising mortgage costs), there is still more to come. Moreover, the US yield curve is still in very negative territory. In the past, the inverted yield curve has been a strong indicator for a recession. Of course, this time it can be different, but we would be uncomfortable betting against the yield curve. 

Furthemore, some indicators partly derived from the yield curve, are starting to flash warning signals. For example, a model from the Fed, measuring the probability of US recession within the next 12 months, is now above 70%.

Second, a recession always coincides with lower corporate earnings. We also have a divergent view from the market here. The market is expecting earnings to start increasing again, which for us does not match a scenario of much lower growth (consensus view) or even a recession (ABN AMRO view). As shown in the graph below, history tells us that economic recession leads to earnings recession.

Third, even though valuations are no longer stretched as was the case at the end of 2021, which is good news, valuation remains close to its long-term average and does not offer a buffer in case of recession. That implies that if our scenario of recession unfolds in the second half of 2023, volatility will again increase in financial markets.

As you can see, we continue to have high conviction that the recession is still coming. The most difficult element, however, remains the timing. We are carefully watching developments in the economy, for example, through confidence surveys, leading macro-economic indicators (such as surveys of purchasing managers) and, of course, developments in the labour markets. 

Yes, we fully agree. There is now far more return for lower risk allocations, such as bonds. The higher expected returns has led to renewed interest in the asset class from investors. Bonds offer an alternative to lower savings rates, but perhaps also as an alternative for equity markets. That is good news after the very difficult year of 2022 for fixed-income investors.

Central bank policies play an important role here. Even though we believe there might be a few rate hikes to come, we believe that the end of the rates hikes is very close. The valuation of bonds moves in the opposite direction of rate hikes, so that is good news for fixed income investors. During the year, we have therefore increased our allocation to bonds. We recommend focusing on higher quality bonds (governments, strong corporates) due to our macro-economic forecasts. 

Again a good question. It is good to have a base-case scenario, but you should also reflect and ask the ‘what if’ questions. Our base-case scenario is a continued recession in Europe and a mild recession in the US starting as of the fourth quarter. This will lead to higher unemployment and lower core inflation, and thereby allow the Federal Reserve to start cutting interest rates by the end of the first quarter of 2024. This scenario is therefore better for fixed income investors and less positive for equity investors for the next nine months.

The alternative scenario is a higher inflation scenario. Here, inflation, particularly core inflation, will be more difficult to contain, pushing interest rates to increase further or at least staying higher for longer. This implies the economy will stay stronger for longer, but might ultimately lead to a deeper recession in the future. Recession is not eliminated, just starting at a later moment. This scenario will in the short term be better for equity markets, but the longer-term impact will be more negative. For fixed income, it will be negative in the short term due to higher inflation, but more positive in the long term as the recession could be deeper.

The last scenario is the one we call the no-landing scenario (as opposed to a soft or hard landing). Here, core inflation will go down quickly towards the 2% target without causing serious damage to the economy. A recession will be avoided and unemployment will remain very low. Central banks will be able to reduce rates given that inflation is coming down quickly. In that case, investors will enjoy a “Goldilocks” environment, as it will be positive both for equity and bonds.

Looking at probabilities, it is always difficult to quantify, but we assign the largest probability to the base-case scenario. The higher inflation scenario is quickly following in terms of likeliness to happen. The no-landing scenario is, in our view, not likely and we therefore assign a small probability to its occurrence.

We continually evaluate our positioning, through our monthly (or more often) investment committee meetings and the daily monitoring by our investment specialists. From these evaluations, we continue to believe that following our base-case is the best course -- while also considering how alternative scenarios might play out. Against this ongoing analysis, we are also convinced that our underweight equity position remains the best alternative for clients, with a healthy (neutral) allocation to high-quality bonds. Regarding our missed forecast on the US recession – it is baffling to many economists how the US economy  continues to perform – with a stronger than expected labour market supporting consumer spending. The unprecedented effects of coming out of a worldwide pandemic no doubt plays a role here. And, of course, everyone hopes for a no-landing scenario, but the economic analysis that underlies our investment strategy does not support it. 

Global Investment Centre - Richard de Groot - Head Global Investment Centre