Do we go more defensive, or do we hold what we have in the portfolios? That is a question which has been on our minds since I returned from holiday at the end of June. The markets have an uncanny habit of giving you hope and then being cruel, especially in uncertain times.
This year there have been many false dawns, but the trend has been for equity and bond markets to fall in unison. They won’t continue to do this and at long last we are seeing signs of a decoupling which means that bonds are more likely to play an effective part in a portfolio. The expected softening of inflation is offering encouragement for this asset class.
If we were isolating the numbers from sentiment, regarding stock market valuations across most sectors and indices, then we would not only be holding but most likely increasing our exposure to pure equities. However, we can’t ignore sentiment which sadly is deteriorating on many fronts and is now likely to feed into corporate earnings.
Some companies have seen this as a signal to buy now (Coutts) whereas others are holding existing assets, and some have increased their cash holdings (LGT Wealth) and firmed up their defensive positions.
No hiding place!
The problem is that there has been no hiding place. A statement in Investment Week said, “for the first time in over a decade, listed stocks and bonds are positively correlated”, something we have alluded to in our previous commentaries. “Combined with geopolitical tensions, record inflation and monetary policy shifts, investors have sought alternative assets to achieve returns”.
The problem with alternative assets is they can be volatile too, commodities being a case in point. Infrastructure, one of the very few assets to have a positive return since the Ukraine invasion, whilst offering some inflation protection, is not immune from sudden pull backs in price.
Then, of course, there is ‘cash’. Conventional wisdom suggests that holding cash during times of extremely high inflation is nonsensical but at least cash is not volatile.
So many different views!
Xavier Baraton, the Global Chief Investment Officer at HSBC Asset Management, in a piece in Investment Week, explained that we are now entering a new ‘macro economic environment’ of persistent inflation, higher interest rates and volatile economic cycles. He went onto say “the positive correlation of stocks and bonds marks a significant paradigm shift which is impacting the approach to diversification, shining a spotlight on alternatives and defensive assets. This situation supports the case for real assets and other ‘new diversifiers’ that can continue to deliver solid diversification while increasing portfolio resilience”.
On the other hand, whilst recognising the challenges to the global economy, Coutts in their mid-year outlook, stated that opportunistically they increased their equity weightings. From a long-term perspective, they were of the belief that the sell-off looked advanced and pessimism had become consensual. Basically meaning that much of the damage was in the price. It’s not quite worked out in the short-term but is likely to be beneficial over the long-term.
Turkeys voting for Christmas!
From the start of the year, metrics and sentiment have accelerated, albeit with pockets of optimism. Even since my return from holiday the cycle has shifted quickly with fears over inflation now being transitioned to fears over the economy, earnings, and consumer sentiment.
Yet, in the face of these fears we see Central Banks ramping up interest rates determined to dampen inflation but at the same time damaging their economies and increasing the possibilities of recession. Very strange but necessary!
The Bank of England (BoE) Governor, Andrew Bailey reinforced that policy makers are prepared to move borrowing costs higher in bigger steps to control inflation. The aim is to bring inflation back to the 2% target and there are no ‘ifs and buts’ about that goal. He went onto say “we want people to see that there are more options on the table than another 25 basis points”, referring to likely interest rate increases.
Bloomberg commented that Bailey’s speech reinforces a growing view that the BoE is prepared to risk growth, or even spark a recession to bring price gains under control. The BoE has already increased interest rates in the last five Monetary Policy meetings.
In the US, the same is happening but with a more vibrant economy, the rate hikes are likely to be more aggressive with the next increase likely to be 0.75% according to the market.
What is the outlook?
Clearly consumer confidence will weaken but if measures form Central Banks go too far, there will be a need to add stimulus back into the economy and reduce interest rates dramatically. A very difficult balancing act.
There are clearly strong warning signs, not just for consumers but also from companies. A Federal Reserve Bank of Chicago survey on the outlook for the US economy decreased to minus 60 in June, the worst reading in data since 2013. The average has been a reading of 25 and last summer it was at the 83 level.
In the survey, Bloomberg reported that just 17% of respondents expected an increase in economic activity over the next 12 months. It’s clear that sentiment has tumbled.
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