- Financial markets continued to oscillate between concerns about growth and inflation. We took advantage of market volatility to neutralize our short duration views. This was a high-conviction view held in multi-asset portfolios for much of 2022.
- With US yields close to 4% – some distance from the 1.75% where the portfolios were building positions earlier this year – the risk/reward of going short in sovereign bonds is significantly reduced. It’s a valorization movement rather than a change in our fundamental valuation.
- Within fixed income, we remain well-rated longs, defensive in EUR corporate bonds which are priced for defects that are several multiples of what we anticipate. Positions are mainly duration hedged.
- Stock premiums have risen recently, but are still significantly below their June level or, indeed, where recession growth might imply they should be. While stock prices have fallen, earnings expectations have remained (surprisingly) flat.
- We have reduced our allocation to Japanese stocks, which held up remarkably well this year. We remain long on Japan and China, fully offset by caution on European equities. We share a deep dive on Chinese stocks below. The portfolios are globally neutral in equities.
- Globally risky drinking is conservative, at just under a third of the allowed ranges for asset allocation.
With US yields close to 4% – some distance from the 1.75% where the Investment Committee (CI) had built positions earlier this year (see Exhibit 1) – we took profits on our view of the short duration in the United States, bringing government bonds and US bonds to neutral in our asset allocation grid (see table at the end).
This is a move driven primarily by valuation, with the risk/reward of short duration at these levels being less clear to us. Despite the political paradigm shift underway (and felt intensely in the UK), financial conditions have tightened considerably. As concerns about the growth outlook resurface, this should limit the upside in yields.
Within fixed income, we remain long defensive high rated EUR corporate bonds, mostly duration hedged. We have reduced our allocation to Japanese equities, which have held up remarkably well this year, so that they are at par with Chinese equities.
We cling to China as strong stimulus comes late. Both of these positions are fully offset by the cautious position on European equities, leaving us broadly neutral on equities. Overall, our risk consumption remains cautious and is in the “dislike” quintile.
Stay constructive on China
Financial market reaction to the higher-than-expected US inflation data has been intense, with outsized falls in equities, including leveraged exchange-traded funds. Earnings warnings amplified the moves.
Although investors are cautious, with higher short-term volatility (see Chart 2) and elevated put-call ratios, we still see significant risk of a steeper decline in equities, driven by earnings adjustments . For example, a return to trend earnings for US equities would indicate a 20% decline in total returns; a move halfway up the trend would suggest around 12%. With European equities facing the biggest decline in earnings, this remains our preferred short position.
By contrast, Chinese (and Japanese) equities have already shown some caution. The investment committee has been long on Chinese stocks since the nadir in March – a stance that has stalled against global stocks after an initial rally.
To the extent that each of the five main supports for Chinese equities remains firm or has strengthened somewhat, especially relative to the rest of the world, we remain constructive.
Going through these supports in turn:
• Policy relaxation, as monetary policy in the rest of the world tightens, has arrived. While housing market metrics may have disappointed expectations, the action is now just around the corner and our core macro research team has become more constructive lately.
• A step back regulation: this was particularly important for the MSCI indexes with a strong technological component. The easing may have exceeded market expectations. For example, gaming licenses are now being approved after a long pause amid a more business-friendly stance from regulators and cybersecurity bodies. Most US-listed American Certificates of Deposit (ADR) are now fungible.
• Decent earnings forecast remained in place, with earnings growth estimates at 9.5% for this year and 15.5% for next year. Earnings expectations for Chinese companies have outpaced those of the rest of the world and are now rising much earlier, with significant caution built into buy-side estimates. Our macro-research colleagues are constructive.
• Attractive valuations: After a torrid 2021, the MSCI China forward price-to-earnings ratio against the broad ACWI had fallen to a six-year low in March. Valuations have since rallied as Chinese earnings momentum has been weaker, but reasonable, and investor positioning is still significantly underweight.
• A strong bottom-up picture: our bottom-up analysts reaffirmed their April optimism. China’s zero Covid policy has been the wildcard. The signs are now positive with the recent reopening of Hong Kong and President Xi’s new trip abroad. Here, too, our research colleagues are becoming more and more positive.
IG credit in EUR – growing conviction
Year-to-date, European Investment Grade (IG) credit yields have been – by many multiples – the worst in recent history (see Chart 3), providing portfolios with attractive valuation opportunities to deepen positions favorable. Certainly, the fundamentals are stronger than they have been for many years and the European IG has long been where our conviction grows.
Since July, we have seen four main supports for European investment grade corporate credit. All remain in place or strengthened slightly in September (notably valuations):
- Fundamentals: Leverage is generally down, interest coverage is high and corporate balance sheets are strong, even in the most vulnerable sectors such as chemicals and autos. Our research colleagues are predicting a mild 2001-style recession, which could suit IG European bonds.
- Ratings: Spreads are close to 2020 crisis levels: European IG has an implied default level of 9% (40% recovery). This is twice the worst rate over 5 years and 10 times the average rate. This seems extreme to us. Expected European high yield defaults are below 2%. We believe European IG is attractively valued relative to equities.
- Techniques: The outflows have stabilized, and there are indeed the first signs of inflows (see chart 4). Many companies have extended their debt maturities. It is possible that governments and the European Central Bank (ECB) will provide support (for example in sectors such as utilities), notwithstanding any withdrawal of monetary support.
- Macroeconomic cycle: Maybe this cycle should be different. Leverage is declining and cash balances are high as we enter the downturn, so any deleveraging pressure, which tends to weigh on credit, is conspicuously absent.
Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. All opinions expressed herein are those of the author as of the date of publication, are based on available information and are subject to change without notice. Individual portfolio management teams may have different views and make different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income from them can go down as well as up and investors may not get back their initial investment. Past performance does not guarantee future returns. Investing in emerging markets, or in specialized or restricted sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of developed international markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds investing in emerging markets may involve greater risk.