The sustainable investor for a changing world

Over the last 30 years, broad asset market returns have rarely been weaker: So far this year, the losses for a 60:40 portfolio of equities and bonds have approached those incurred during the 2008 global financial crisis. Financial markets are increasingly pricing in ‘stagflation’ – soggy growth and rising inflation. What does this mean for asset allocations?

First a view on the outlook for US interest rates. Expectations for the fed funds in a year’s time have dropped by about 40bp amid signs of weakening economic growth and worries about a recession. Growth needs to slow if inflation is to fall towards the US Federal Reserve’s long-run inflation target. Already, retail sales growth is waning and purchasing managers’ indices (PMIs) are falling. Investors worry that the deceleration will go too far.

A key indicator to watch will be US wage growth. Recent wage gains have been incompatible with the Fed’s inflation target. Wage growth will need to begin falling by autumn for the markets to continue to believe that 200bp of additional increases in the funds rate – as currently priced in – will be enough to manage inflation.

There is little comfort from consensus estimates for GDP growth. These suggest that growth will remain steady at around 2% each quarter through 2023. The most negative forecasts, which might signal a recession, suggest it might happen towards the end of next year. While our view is more pessimistic than the consensus, we expect a recession to be avoided.

Earnings estimates  

Earnings forecasts have mostly flatlined as analysts factor in waning demand due to inflation and lower margins due to higher costs (see Exhibit 1). Even so, we believe forecasts for Europe ex-UK are too optimistic and see meaningful downgrades ahead. The boost to earnings growth in the commodities sector is likely to be only temporary. European energy sector earnings could almost double in 2022 before falling for the next two years.

To be sure, in asset allocation portfolios, we would rather just be long commodities – a position that has worked well for us and in which we maintain a clear overweight, re-established in mid-April.

After a period of strong outperformance, we deepened our short in Europe. Cyclically geared European equities face headwinds from slowing growth and rising inflation; an ECB that is clearly focused on inflation; geopolitical risks; and over-optimistic analyst earnings forecasts. Our long exposures are focused on Asia. We see Japan as offering quality value, with a supportive domestic policy backdrop and upside risks to consensus earnings forecasts. In China, policy is also supportive amid deeply attractive valuations, particularly in the tech sector (see below).

China challenges and opportunities

Markets now appear to be looking past the near-term challenges, assuming that the Covid-related lockdowns will eventually be lifted and activity recovers. Beijing has recently sought to follow through on its promise to do ‘whatever it takes’ to support growth and we have seen better relative performance from Chinese stocks.

We see three supports for a tactical allocation to China:   

  • First, valuations. Chinese equites remain nearly one standard deviation cheaper than global equities on forward price/earnings multiples. The discount is particularly clear in the tech sector.
  • Second, a more favourable outlook. We expect good earnings growth: in consumer discretionary, for instance, the consensus and BNPP AM research foresee 40% gains in earnings. Also, the positive market timing signals have remained in place. We note the resilience of tech names now that the drive to regulate the sector looks to be behind us.
  • Third, the turn in China’s credit impulse as policy is tightened elsewhere. This should create a supportive setting for Chinese businesses. 

The drive for higher yields

Nominal 10-year US Treasury yields breached the significant threshold of 3% in May for the first time since July 2018. The increase was driven by sharply rising real yields as expectations of yet more aggressive tightening by the Fed to dampen inflation pressures was priced in. Five-year/five-year forward real yields have risen towards the post GFC ‘new normal’ associated with secular stagnation.

While a new regime of higher inflation should bring with it higher policy rates and higher long-dated yields, immediate market moves have been intense. Accordingly, we have progressively reduced our underweight in duration.

There is room in our view for inflation expectations to rise – it’s a long way down still for core personal consumption expenditures (the Fed’s preferred inflation measure) and inflation may not decelerate that quickly. We also believe term premia could rise further as the central bank steps up its inflation-busting policy action, including quantitative tightening (QT).

For valuation reasons, we clipped back our short positions in the US and Europe, while maintaining our short in Japanese sovereign bonds. Fundamentally, however, we remain cautious on long duration assets.

Asset class views

   Strongly dislike  Dislike  Neutral  Favour  Strongly favour
  Risk appetite*     X         
  Asset allocation     Government bonds  Credit Real estate Cash  Equities Commodities   
  Equity regions     Europe ex-UK  US    Japan GEM   
  Equity style/size        EU large cap EU small cap US large cap US small cap      
  Sovereign bonds     US Europe Japan  EM local Australia UK Linkers      
  Credit        US investment-grade US high-yield Emerging markets    EU IG EU HY     
  Commodities        Precious metals  Energy Base metals   
  FX        USD, AUD, GBP, EUR, EM currencies  JPY   

* Risk appetite/return to risk – Data as at 27 May 2022. The views reflect those of the Investment Committee of the Multi-Asset team at MAQS. Other specific/tactical trades may be implemented in addition.


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