Multi-Asset Strategy Quarterly – January 2023

Caution is the watchword

Iain Cunningham – Co-head of Multi-Asset Growth, Michael Spinks – Co-head of Multi-Asset Growth

Our cyclical growth view is more cautious than the consensus with sticky core inflation requiring more tightening and a meaningful recession to bring inflation down. We also expect this slowdown to happen earlier than the consensus expectation. As we enter 2023 there is continuing evidence of slower macro data, particularly in leading indicators and we do not see an imminent change in this trend given tighter fiscal policy, contracting central bank balance sheets and a weaker monetary impulse.

This is already the fifth sharpest Federal Reserve (Fed) tightening cycle in history and this level of tightening has never not led to recession, let alone a soft landing (as occurred in 1966, 1984 and 1995). The effects of increasing interest rates work out with a long lag, and the impact has yet to broaden from the moderate declines in house prices and new orders to profits and employment. We expect macro data to deteriorate sharply, with increased momentum from the declines already seen in late 2022. While lending and credit activity continue to look robust there are tentative signs that it is turning over. This is a factor to watch closely as it will have a critical impact on the extent of a recession.

Inflation remains key

Inflation fighting remains the primary objective of central banks, and the Fed in particular. It has highlighted that the risk of doing too little is greater than the risk of doing too much and growth will therefore likely be sacrificed to get inflation fully back under control. We continue to believe that tightness in the US labour market and the level of wage growth is inconsistent with the Fed being able to return inflation to target without a notable slowdown in the economy. Our central case, therefore, is that the Fed maintains tight policy over 2023, through a combination of rates and quantitative tightening, while both growth and earnings begin to weaken. This may disappoint a consensus which is expecting cuts to interest rates in the second half of 2023.

China moves away from the herd

The one area where policy dynamics are now firmly moving in the opposite direction is in China, where authorities have signalled an exit from their zero-COVID policy and are ramping up stimulus to support the real estate market and the broader economy. Chinese growth is therefore likely to strengthen heading through 2023 with policy makers having moved decisively towards easing, notably through credit channels and the property market. We remain encouraged by the prospect of further easing and the moving away from policies that hampered Asian markets (regulation, deleveraging and zero-COVID) over the past two years.

Tightening liquidity will be a headwind to risk assets

As we look to the year ahead, we believe investors should continue to focus on tightening liquidity dynamics in the developed world and the weakening of growth and earnings, while valuations in the US remain extended when factoring in likely earnings downgrades. We remain cautiously positioned in growth assets reflecting our anticipated declines in margins from elevated levels, an earnings reset driven by the expected recession, and still elevated valuations. Margins are strongly tied to the growth cycle and have started to decline as companies’ ability to pass through price increases fades, while costs, particularly wages, will take time to roll over. We expect double-digit declines in earnings vs. mid-single digit consensus growth in both markets. Meanwhile, valuations look expensive for the US and Europe, as optimism has begun to creep into market earnings expectations.

Within equities we are overweight China and Hong Kong, as a function of the policy dynamics, quite different cycle positioning and attractive valuations given the underlying growth rates. We continue to watch the evolution of Chinese policy, the direction of developed market liquidity, growth, and corporate earnings, believing that these are the primary forces driving financial markets from here.

Rising real yields have made defensive government bonds much more attractive against the backdrop of slower macro data. From the current overweight position our intention is to increase exposure if yields reprice further, or we gain conviction that economic growth and inflation metrics are deteriorating. We continue to heavily bias duration exposure towards economies with housing market and household leverage imbalances, which risk deflationary shocks in 2023.

All eyes on the US dollar

In currency, a reacceleration in Chinese growth and a tightening cycle from the Bank of Japan present notable headwinds to the US dollar through 2023. However, the US economy remains structurally more healthy than European countries and nations like Canada, Australia, and New Zealand, in our view, and can therefore likely tolerate higher rates for longer. This presents a more mixed outlook for the US dollar over the next year. In our portfolios the active currency overlay is currently structured to take advantage of the above noted country level vulnerabilities and remains defensive but more diversified than last year; being long the US dollar, Swiss franc and Japanese yen versus the Swedish krona, Canadian dollar, Australian dollar and New Zealand dollar.