February 02, 2023
Window of Opportunity
February 02, 2023
In January markets rebounded, providing a window of opportunity to capture returns. Towards the end of December, we began increasing risk to take advantage of this, and continued to add to risk assets during January. We see 2023 as a year of transition, with a number of opportunities in the first half, but also fat-tail risks to be managed.
A Year of Transtion
Though US inflation is moderating, the greatest risk we see is the potential for inflation to re-emerge in 2H2023, which could happen if the Federal Reserve stops hiking too early. In the meantime, we anticipate the reduction of macro events with negative tail risk including key factors such as moderating inflation, and a strong labour market supporting consumption. In many ways factors driving markets in 2023 appear to be behaving in the opposite direction to last year. Inflation peaking and falling (for now), central banks ending their tightening cycle, the US dollar stabilising or even weakening and China reopening, indicate it is time to act whilst markets are favourable.
We are therefore more constructive on both the global and US macro view. Supported by labour markets, we see a rising probability of the US Federal Reserve achieving a soft-landing. On the upside there is even the possibility of runaway markets. However, we are monitoring the labour market closely, as any deterioration could signal a re-emergence of negative tail risk.
Against this positive backdrop, with the downside risk having diminished for now, as mentioned we have been increasing our exposure to risk assets since the end of December and throughout January. We remain positive global equities ex-US and have incorporated opportunities in credit and higher beta fixed income, such as emerging markets and high yield, which do well in a risk-on environment.
However, we are managing the tail risks through some partial offsets, cognisant that the environment could turn, should inflation pick up again. We have increased exposure to commodities, as a hedge against inflation. Whilst we have increased exposure to equities, recognising equities’ interest rate sensitivity, we are reducing fixed income duration. We have also been seeking higher yields, to offset the increased capital risk from equities, so have been emphasising high carry assets in fixed income and in equities, such as banks and energy.
This is reflected in the tactical changes we made over January:
European Banks Equities
We moved further overweight European banks, which have continued to benefit from higher rates in the eurozone, boosting net interest margins and benign asset quality trends, after a recession has been averted. Valuations slightly above recession trough levels are still discounting a lot of risks and we believe do not appropriately reflect the earnings growth over the coming year, nor the capital return to shareholders.
We moved underweight Japanese equities since we expect the yen to strengthen on general dollar weakness and on the expectation that the Bank of Japan will give up its yield curve control framework later in 2023, due to increasing inflationary pressures. The FX translation tailwind for Japanese earnings from a weaker yen in 2022 is thus likely to turn into a headwind.
We moved further overweight Chinese equities given China’s reopening, easing regulatory headwinds and a reprioritisation of growth, which we believe is likely to drive outperformance. Accumulated household savings are supporting consumption and growth in a post-lockdown China.
US Long Duration
We neutralised our US long duration exposure as disinflationary trends gain momentum in the short-term, which reduces upside risks to the Fed terminal rate. We expect long duration yields to remain range bound if recession risks do not materialise.
Italian Government Bonds Duration
We neutralised Italian Government Bonds from our previous underweight stance. After a strong rise in 2022, yields are now at levels that offer significant carry compared to German Bunds. At the same time, spreads could compress further as GDP growth in the eurozone should re-accelerate over 1H 2023, after the significant decline in energy prices.
USD High Yield
We moved from underweight to neutral in USD High Yield. Near-term recession risks have diminished on a sustained strong labour market and a more pragmatic approach by the Fed, which signalled a pause to rate hikes some time in 1H 2023 and which supports some risk taking. However, USD High Yield still screens expensive compared to EUR High Yield.
EUR High Yield
We moved overweight European High Yield, to take advantage of spread valuations that still incorporated a “gas premium” compared to USD High Yield, given the European energy crisis of 2022. Spreads should continue to tighten as European GDP growth troughs in the winter, reducing credit risks and encouraging risk taking by investors. The asset class saw significant fund outflows over 2022 and we expect market participants will want to re-build positions over the coming months.
Emerging Markets Hard Currency Debt
We moved further overweight Emerging Markets Hard Currency Debt (EM HC), given emerging market economies are ahead of developed markets in terms of their rate hiking efforts to control inflation. EM HC still offers attractive carry and spreads could compress, as global growth stabilises on China re-opening and Europe emerging from its energy crisis. A more benign outlook for US duration supports EM HC further.
Mexican 10-Year Yields
We moved from neutral to overweight Mexican 10-Year Bonds, given elevated real yields, accelerating inflows into EM Debt and easing Mexican inflation driven by slowing food inflation, as indicated by already declining fertiliser prices.
Brent Crude Oil
We moved overweight brent crude oil at the end of December and increased this overweight during January. The recent selloff appeared excessive in light of a likely tight market throughout 2023. Fundamentals are positive, as we see upside risks to oil demand from the reopening of the Chinese economy. At the same time there are downside risks to Russian supply, as sanctions fully come into force in 2023.
We initiated an overweight in copper, given low inventory levels and structural headwinds to supply, yet increased demand from China reopening and long-term “green” demand.
We moved even further overweight the euro against the US dollar. We expect rate differentials are to support EUR/USD as the Fed is likely to pause hiking before the European Central Bank. Further, China’s reopening should support the Euro area’s economy.
We increased our underweight to the US dollar relative to the Japanese yen, given the Bank of Japan’s surprise yield curve control adjustment in November and our expectation of a complete abandonment later in 2023, which should support rate differentials in favour of the yen. China’s reopening should also be supportive.
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.
There is no assurance that the Strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this strategy may be subject to certain additional risks. There is the risk that the Adviser’s asset allocation methodology and assumptions regarding the Underlying Portfolios may be incorrect in light of actual market conditions and the Portfolio may not achieve its investment objective. Share prices also tend to be volatile and there is a significant possibility of loss. The portfolio’s investments in commodity-linked notes involve substantial risks, including risk of loss of a significant portion of their principal value. In addition to commodity risk, they may be subject to additional special risks, such as risk of loss of interest and principal, lack of secondary market and risk of greater volatility, that do not affect traditional equity and debt securities. Currency fluctuations could erase investment gains or add to investment losses. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Equity and foreign securities are generally more volatile than fixed income securities and are subject to currency, political, economic and market risks. Equity values fluctuate in response to activities specific to a company. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Exchange traded funds (ETFs) shares have many of the same risks as direct investments in common stocks or bonds and their market value will fluctuate as the value of the underlying index does. By investing in exchange traded funds ETFs and other Investment Funds, the portfolio absorbs both its own expenses and those of the ETFs and Investment Funds it invests in. Supply and demand for ETFs and Investment Funds may not be correlated to that of the underlying securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. A currency forward is a hedging tool that does not involve any upfront payment. The use of leverage may increase volatility in the Portfolio.
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Barbell approach: A strategy of investing on the two opposite ends of risk spectrum at the same time. For example investing in anticipation of a risk-on scenario, but also investing as a hedge, in anticipation of a risk-off scenario.
BTPs: Italian Government Bonds.
Earnings per share (EPS) is a company's net profit divided by the number of common shares it has outstanding.
Fed Funds Rate: The interest rate that banks charge other institutions for lending excess cash to them from their reserve balances on an overnight basis.
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