UIC retains neutral risk positioning
Corporate bonds strongly overweighted
- Economic growth continues to slow while upward pressure on prices eases
Inflation remains the central banks’ top priority as the turning point approaches
Overweight exposure to fixed-income assets with emphasis on corporate bonds
Creation of a new position based on the transatlantic spread
Underweight position in equities and commodities confirmed
Outcome and justification
The Union Investment Committee (UIC) confirmed its neutral risk positioning (RoRo meter at level 3) at its regular meeting on 22 November. In addition, an overweight position in US Treasuries was established along with an underweight position in government bonds from core eurozone countries (transatlantic spread). Around the middle of the month, the committee had already shifted investment-grade corporate bonds to a substantial overweight. As part of this adjustment, it had also raised the risk positioning from level 2 to level 3 on the RoRo meter. The strategic portfolio is therefore now overweight in fixed income assets and absolute return investments while equities and commodities are underweighted.
The shift to a slightly more bullish positioning was mainly driven by current macroeconomic trends. In recent months, the markets have been dominated by extremely unfavourable economic conditions in the form of rising inflation and falling growth rates. However, there are signs that this exceptionally challenging environment for opportunity-oriented assets is now starting to improve. Economic growth remains sluggish and looks set to weaken further. But on the inflation front, indications are mounting that the persistent upward pressure on prices may abate in the foreseeable future. This hypothesis is supported by metrics such as US consumer prices for October. The UIC believes that inflation rates are now close to peaking and potentially already past their peak in the US. Consequently, central banks – above all the US Federal Reserve – may soon slow down, or even pause, their cycle of interest rate increases. In the capital markets, the moment when the end of this cycle comes within realistic reach will mark a turning point for investment prospects.
However, the UIC takes the view that this point has not yet been reached. The outlook for economic growth, inflation and monetary policy is still shrouded in too much uncertainty, although trends in certain key areas have recently improved. In the US midterm elections, the Republican Party was unable to bring home the sweeping wins that the markets had anticipated. Most notably, supporters of former US President Donald Trump tended to perform poorly. President Joe Biden’s Democratic Party lost its majority in the House of Representatives but managed to retain control of the Senate. This outcome is not expected to have any immediate impact on the capital markets but turmoil will probably increase going forward as certain draft bills will require agreement between both parties in order to be passed. This applies, for example, to the plan to raise the national debt ceiling, which is expected to be addressed in the third quarter of 2023. All in all, the next two years will likely be characterised by gridlock on the legislative front – conditions that typically sit well with the capital markets.
By contrast, the situation in eastern Europe still constitutes a largely unquantifiable risk factor. The missile strike on Polish territory in November recently acted as a stark reminder of how quickly this conflict can escalate. However, all parties clearly tried to respond calmly to the incident and avert escalation. The situation thus remains fragile and there is currently no path to peace in sight. But, at the same time, an escalation or widening of the conflict does not seem imminent either.
Economy, growth, inflation
Global economic growth recently continued to weaken. Union Investment’s leading indicators suggest that the pace of growth is slowing in the US, the eurozone and China. However, consumer spending continues to prop up the US economy. US retail sales for October unexpectedly showed a 1.3 per cent uptick. But around the same time, higher interest rates started to take their toll in the real estate market, causing property prices to dip and transactions to slow down. The labour market, which had shown signs of overheating for a prolonged period, recently also seemed to calm down a little. The unemployment rate edged up by 0.2 percentage points to 3.7 per cent and at 261,000, the number of newly created jobs was slightly lower in October than in previous months. Union Investment’s economists expect that the rapid tightening of monetary policy will cause the US economy to slip into a mild recession in the first half of 2023 in spite of the recent upturn in consumer spending. In the second half of the year, there should then be a much healthier balance between growth and inflation.
Inflation data for October already offered a first glimpse of what might lie ahead. The upward trend in consumer prices slowed to a rate of 7.7 per cent year on year, the lowest figure since January. The most significant signal came from core inflation, which was once again up year on year, but had slowed down compared with the previous month. On balance, this probably means that inflation is now past its peak in the US.
China’s economy continues to struggle under Beijing’s zero-COVID policy. After some of the very tight restrictions were recently eased by the Chinese government, there had been increased speculation in the markets as to whether this policy, which has proven to be a serious drag on growth, might be abandoned. However, a renewed rise in infections and coronavirus outbreaks in large cities such as Guangzhou have thwarted any plans in this direction for the time being. Moreover, economic growth no longer seems to be the Chinese government’s number one priority. The recent National Congress of the Chinese Communist Party sent clear signals to this effect. Union Investment’s economists believe that the country will start to open up again from March 2023 and are thus taking a relatively muted view of the country’s economic outlook for now.
Growth in Europe is also slowing and a recession seems very likely for the coming months. Consumers are feeling the impact of soaring costs of living while their wages are rising at a much slower rate. Companies across the board are struggling with cost pressures that are pushing their business models to – and sometimes over – the limit. These conditions are having an adverse effect on value creation and investment. However, inflationary pressures should start to ease in the eurozone too. The recently published German producer prices for October, for example, showed a month-on-month decline for the first time in two years.
Monetary policy: turning point not (yet) reached
Falling inflation rates are reducing the pressure on central banks to act, making it more likely that they will rein in or stop the tightening of monetary policy next year. However, they have probably not got to this point yet, as inflation is still running high. Moreover, the central banks want to avoid repeating the mistakes of the 1970s, when – for example – the US Federal Reserve (Fed) stopped tightening monetary policy too soon because it wanted to stimulate growth. The central banks do not want to take this risk and will therefore not ease off just yet. However, the turning point for monetary policy is drawing closer.
Specifically, the European Central Bank (ECB) is expected to hike interest rates by a further 75 basis points at its next monetary policy meeting in December. The UIC anticipates that the ECB will implement a smaller rise of 50 basis points in the first quarter of 2023 before taking a break. Central banks will then turn their attention to trimming down their balance sheets, which will reduce the overall level of liquidity in the financial system. This will also be the case for the Fed, which is now closer to the end of its cycle of interest-rate increases. The UIC expects a further rise of 50 basis points at the Fed’s meeting in December 2022. The US central bank may possibly raise interest rates again next year, but not by much.
Attractive yields now available again on the lower rungs of the risk ladder
Yields on investment-grade bonds above the high-yield level reached in 2021
Fixed income: preference for corporate bonds
Hopes that the cycle of interest-rate hikes will soon be paused have resulted in a slower increase in yields at the short end of the yield curve for US Treasuries and German Bunds in recent weeks. Longer-dated paper has already seen yields start to fall again. A partial inversion of the German yield curve has thus set in. The corresponding trend in the US has intensified, with yields on two-year US government bond yields currently around 70 basis points higher than those on ten-year paper. As inflation peaked in the US sooner than in the eurozone, upward pressure on US Treasury yields is likely to be significantly lower than that on government bonds from core eurozone countries going forward. The UIC is therefore opening a relative position in favour of US paper over core eurozone bonds. The consolidation of safe-haven government bonds also led to a fall in spreads. This opened up a window of opportunity in the primary market that was – and is being – seized by issuers, particularly of corporate bonds. Attractive valuation levels and upside potential mean that demand from investors is high, especially for investment-grade paper, and fixed-income investors can climb down the risk ladder. In the current environment, the UIC therefore continues to favour investment-grade corporate bonds because it believes that environmental factors are adequately reflected in prices. However, the committee remains cautious about bonds from the eurozone’s periphery as it still anticipates tensions between the new Italian government and the European Union (EU). For now, Italy’s ability to service its debts is assured, although the UIC believes there is a risk of a substantial widening of spreads in 2023 should there be a sharp rise in government spending. Turning to bonds from the emerging markets, the growing divergence between countries with an investment-grade credit rating and those in the high-yield segment has been halted. Nonetheless, the committee is taking a wait-and-see approach for now.
Equities: recovery, but no trend reversal
As pressure from the interest-rate markets eased, the stock markets were able to stage a strong rally in recent weeks. Consequently, Europe benefited from its higher proportion of value stocks, whereas the US markets were held back by the weaker performance of growth stocks. US technology firms, in particular, reported profits that were lower than equity analysts had expected, frequently followed by announcements of restructuring and job losses. This is a clear sign that the post-pandemic boom is over. By contrast, the shares of financial, energy and mining companies benefited from the higher interest rates and commodity prices. Given the negative factors, however, Union Investment’s experts do not believe that the recovery represents a major trend reversal in the equity markets. Growth is continuing to decline and, in some regions, will soon turn negative. Inflation is still high and remains the central banks’ main priority. It is likely to come down only slowly in 2023. Against this backdrop, any scope for higher revenue and profits – i.e. for growth – will remain limited initially but will increase in the medium term. The situation in China continues to be an important factor for shares from the emerging markets. Nascent hopes that the zero-COVID policy will be eased resulted in sharp share price rises in the stock markets in Hong Kong and China. However, the strict measures imposed in response to the latest coronavirus outbreaks confirm the view of Union Investment’s economists that Beijing is unlikely to change its mind before spring 2023 at the earliest.
Commodities: few fundamental changes
Speculation about the easing of China’s COVID-19 policy, combined with the general recovery of the capital markets, caused a jump in industrial metal prices in the first half of November. The price of nickel – one of the key materials in the emerging transition to a green economy – shot up by almost 40 per cent during this period, for example. Diminishing upward pressure on interest rates and a weakening US dollar also helped to push up precious metal prices. However, the sideways trend that took hold at the midway point of 2023 remains intact. Demand continues to falter in the energy market, and OPEC’s decision to reduce output failed to stabilise prices. Europe’s gas inventories are still at a good level and the longer that temperatures stay above the seasonal average, the less likely it is that this winter will see supply shortages. Reflecting this situation, natural gas prices in Europe have fallen sharply in recent weeks and months. Commodity roll yields remain high. Geopolitical risks continue to be the main influence on both upward and downward price movements.
Currencies: correction for the US dollar
After continually appreciating for almost one and a half years, the US dollar has undergone a correction in recent weeks owing to hopes that the Fed will soon stop raising interest rates. The US central bank was among the first to embark on a cycle of interest-rate hikes, which played a significant part in the greenback’s strengthening against other currencies. And the Fed will now be one of the first central banks to suspend or end the cycle. As a result, the interest-rate differential will shift towards other currencies, such as the euro or pound sterling, as inflation is still rising in Europe and neither the ECB nor the Bank of England can follow in the Fed’s footsteps at this time. This meant that the US dollar was very weak against virtually all other major currencies in the first half of November. The ongoing ultra-expansionary monetary policy of the Bank of Japan (BoJ) has put significant downward pressure on the Japanese yen in the year to date, but it has now been able to stage a recovery, as has the euro. The latter had fallen well below parity with the US dollar at the end of September. However, the exchange rate has now risen to comfortably over one again. The ECB’s continued tightening of monetary policy, bringing it closer to that of the US, should help the euro to maintain its value against the US dollar going forward. For now, however, the UIC is refraining from opening a position in the currency segment.
Convertible bonds: looking strong
Compared with that of the equity markets, the performance of convertible bonds has been particularly robust in recent weeks. One of the main drivers of this uptrend was the recovery of the underlying shares from the technology sector. Another factor was the narrowing of convertible bond spreads owing to the stability of the credit markets. Average equity market sensitivity increased to around 45 per cent. Valuations remained at a fair to attractive level. And issuance activity picked up markedly, with some new issues even reaching as much as US$ 1 billion.
Unless otherwise noted, all information and illustrations are as at 22 November 2022.