August 07, 2023
August 07, 2023
Managing assets through higher rates
August 07, 2023
Global equities continued to rally in July as fears of a hard landing seem to have dissipated amid persistent inflation and rising interest rates. The S&P 500 Index returned 3.2%1 (USD) while the MSCI Europe (EUR) Index was up 2.0%1and MSCI Japan Index (JPY) gained 1.3%1. However, the top performers this month were emerging markets, with the MSCI EM Index gaining 6.3% (USD). China soared and held onto early gains with the MSCI China Index returning 10.7% (USD), after the country’s policymakers signalled a ramping up of stimulus measures without providing details. While most analysts do not anticipate the kind of massive support measures seen in previous crisis situations, the risk of instability has decreased. The US 10-Year Treasury yield rose, ending July at 3.95%2 after reaching a high of 4.06%3 during the month, after the Federal Reserve decided to raise rates and economic data surprised to the upside. The VIX index remained subdued, ending the month at 13.92.
As we head into the final weeks of summer and the heatwave seems to grip most of the world, inflation finally shows signs of cooling. The U.S. Consumer Price Index (CPI) and core CPI (except food and energy) both increased at a monthly rate of 0.2% and annual rates of 3.0%4 and 4.8%4 respectively, the latter being the lowest since October 2021. The Federal Reserve (Fed) raised interest rates by 0.25% in July for the eleventh time in the past 17 months, in an effort to contain inflation, but offered little insight into when or even if it might raise rates again. As a result, the benchmark Fed Funds Rate rose to a new high ranging between 5.25% and 5.5%, the highest level since January 2001. The expectation for a recession, if any, has shifted to 2024. With persistent labour market strength and the economy continuing to grow, inflation remains higher than the Fed's 2% target. While they remain noncommittal about their next steps, the Fed implied their readiness to jump into action, if needed.
On 27 July, the European Central Bank (ECB) also announced an interest rate hike of 0.25% indicating that inflation, while slowing, was still too high to be comfortable. They indicated keeping rates restrictive, for as long as it takes to bring inflation closer to the 2% target. Meanwhile the Bank of Japan (BoJ) announced a unanimous decision to keep the short-term policy interest rate unchanged. However, in order to enhance the sustainability of its stimulus policy, the BoJ adopted a decision to expand the scope of yield curve control policy.
As central banks around the globe remain data-dependent, it may very well be the beginning of the end of the hiking cycle, as inflation continues to ease. However, we remain nimble and well-positioned to manage both of the fat tail risks. We increased risk for risk-targeting portfolios. Portfolio realised volatility has increased modestly and the adjustment allowed us to keep broad asset allocations unchanged, while implementing the following tactical changes in July:
We moved from neutral to overweight US equities, owing to a strong labour market, while corporate profit margin weakness is troughing and rebounding. Fundamental momentum is shifting in favour of US equities and away from Eurozone equities.
US small cap equities
We moved further positive on US small cap equities as we believe they are best valued for our non-hard landing view. Small caps represent higher beta amidst the growth resilience in the economy.
We move from neutral to underweight European equities, as the European economy is showing signs of weakness and peak corporate profit margins risk reversing eurozone equities.
We moved from positive to neutral eurozone banks, as economic growth has been disappointing in the region and the ECB policy increases weigh on demand.
Greek Government Bonds
We moved from neutral to positive on Greek government bonds, as the Greek growth outlook looks more favourable than its European peers, due to its dependence on services and tourism. Greek bonds also have fair cross-sectional valuations.
EM Local Currency Sovereign Debt
We moved from neutral to positive on EM Local Currency Sovereign Bonds, as they provide diversification benefits and less interest rate sensitivity, along with higher yields than traditional safe fixed income investment grade allocations in the current environment. At the same time, we took profits by reducing the overweight to front-end Mexican bonds.
The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions.