Asset allocation update

Growth (economic)

The macroeconomic outlook is uncertain, with sharp swings in expectations as market participants adjust to new data. The data suggests economies are deteriorating. We see a slowdown in both world GDP and possibly inflation. Economists predict a higher chance of recession in the UK and Europe than in the US, Japan and China. We have been fearful of the situation in China for some time over concerns about the sustainability of its export and domestic property-led recent growth model. The key issue for us is whether it is a hard or soft economic landing in the US as the Federal Reserve tightens policy to reduce inflation.

Interest rate & liquidity environment

Policy hawkishness is the main feature influencing markets. The central case is that inflation is peaking around now, presaging a peak in interest rates by year end or early 2023, which is being reflected in inverted yield curves. Central banks are reducing their balance sheets and market liquidity, which makes policy much more restrictive than headline interest rates imply.

Valuations & earnings outlook

World equity valuations (P/E ratio) have fallen significantly from their highs in 2021. Some areas look cheap, particularly the UK, where valuations are cheaper than they were after the 08/09 financial crisis. European and Japanese equities are also very cheap with, for example, Eurozone equities trading around their Covid lows. There is evidence that US corporate margins and earnings are beginning to come under pressure but are still holding up well. Our expectation is that corporate earnings will fall from here as economies enter recession. That said, earnings in Japan are growing, beginning to drive relative outperformance of this market.

Sentiment / flows

Sentiment is very poor based on survey submissions yet, in our opinion, actual investor positioning seems more ‘risk on’ with big institutional investors maintaining still high equity weightings. Perhaps the resilient earnings season is helping, and the idea that we may be near the peak in interest rates in the US.

Equities

With elevated recession risks, we decided to trim our equities exposure, preferring to increase our cash levels and seek better risk adjusted returns in other asset classes. Despite being cautious on the outlook for economies, equities (asides from the most expensive mega caps) have derated on higher interest rates, and now demonstrate reasonable valuations and the dislocations within indices provide opportunities for good active managers to outperform.

Data in the US shows its continued strength relative to all other major economies. Unemployment is very low. Consumer and company balance sheets remain strong, earnings are holding up better than in many countries, and it has low external energy dependence, reflected in a very strong US dollar. The US remains our largest absolute equity allocation in portfolios.

Within the US, smaller companies have been hit hard and are trading near all-time valuation lows, significantly cheaper than the overall market. We think they could generate excess returns and continue to tilt portfolios in this direction.

The UK stock market is beginning to look interesting in our view. It’s incredibly cheap, and the high dividend yield compelling. Because the pound has fallen, it’s even cheaper for foreign investors. That said, it’s hard to see a catalyst for an improvement in investor sentiment and inflows, so we reconfirmed our low exposure to the UK stock market relative to other UK wealth managers, but we are watching for signs of a reversal of fortune.

Japan has very low unemployment (2.5%), and its economy is strengthening. These factors, coupled with a significant fall in the yen, have resulted in large increases in reported earnings for Japanese companies, yet its stock market continues to trade at depressed levels. We have reconfirmed our overweight to Japan, and may add more pending increased clarity on valuations, assessment of forward margins, sentiment, and investor positioning, and above all an identification of clear catalysts for a real pick up in investor (both domestic and foreign) interest.

With the business cycle turning down, costs increasing, and earnings beginning to come under pressure, last year we tilted our portfolios towards companies scoring high in quality metrics such as strong balance sheets, low financial leverage, high returns on equity, and the ability to pass on price increases to consumers. These companies are less likely to suffer earnings downgrades. Because of the outlook, we maintained our tilt towards quality factors in equities.

Government bonds

We decided to maintain our US Treasury positions, which provide a good yield, and exposure to the US dollar. They should continue to provide protection against adverse movements in other parts of our portfolios.

Having avoided most of the pain within UK government bonds this year, we discussed whether now may be a good entry point, since we can now invest at more attractive levels. We decided the outlook is too uncertain and decided to maintain our low exposure for now.

Corporate bonds

Yields on US bonds have increased to attractive levels, and we decided to increase our exposure to US investment grade bonds. We decided to fund this by reducing both equities and emerging market bonds. At this stage in the cycle, we see this as a safer way to take risk, we prefer to collect a good rate of interest lending money to creditworthy US companies than having that capital invested in stocks or emerging market bonds.

Alternatives

Alternative asset classes can provide protection during market falls, with returns not correlated to the rest of the portfolio. For this reason, we maintain our strongly positive view on the asset class.

We are positive on selective macro hedge funds with an established record of doing well in volatile environments.

We invested in broad commodity exposure to benefit from rising commodity prices, then took profits earlier in the year. We recently decided to sell this position, fearful of falling demand from slowing economies. We expect demand for copper to increase dramatically due to the energy transition and limited supply. Whilst it could be painful to hold it through a recession, we decided to maintain this strategic long-term investment.

Within low-risk portfolios we reduced some low-risk alternatives (an absolute return fund and a property fund), in favour of short-dated US Treasuries, since the yield on the latter is now so attractive.

Overall, the environment is characterised by high uncertainty and rising recession risk, so we remain cautiously positioned, but prepared to take advantage of opportunities that present themselves.