Multi-Asset

Multi-Asset Strategy Quarterly – April 2023

Iain Cunningham and Michael Spinks outline their cyclical growth view, and suggest that two primary forces remain underappreciated by financial markets; Sahil Mahtani takes a closer look at the semi-conductor industry, vital to modern civilisation, and yet facing a tumultuous period of growth; Russell Silbertson unpacks the latest thinking from leading central banks. Finally, we close with a succinct summary of our higher conviction asset class views, beginning with equities, moving on to fixed income, currency and closing out with commodities.

19 Apr 2023

20 minutes

Multi-Asset team

Chapters

01
Market observations
02
Thematic viewpoint
03
Policy review
04
Summary of high conviction asset class views
05
Equities
06
Fixed Income views
07
Currency views
08
Commodity views
01

Market observations

Close-up view of beautiful curved glass building
Financial markets are being pushed and pulled by headwinds on the one hand and tailwinds on the other – forces that are not fully appreciated by markets. The authors unpack these, and discuss how these influence their investment strategy.

The two forces influencing markets

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

We continue to believe that two primary forces remain underappreciated by financial markets. The first being the extent of the coming slowdown in the US and Europe as these economies look set to suffer the consequences of one of the largest and most rapid hiking cycles in many decades. The second is the prospect for recovery in China after the country experienced recessionary conditions last year.

History does not support a soft landing

On the former, financial markets appear to be discounting a high probability of a soft landing in developed economies, supported by expectations that the Federal Reserve will pivot and ease policy later this year to support softer growth. Our outlook remains more cautious for two reasons: One, inflation is likely to remain stickier than expected due to ongoing tightness in the labour market. Wage growth remains inconsistent with inflation returning to central bank targets.

The figure below demonstrates the unusual situation of a significantly higher number of job openings than there are unemployed people available to fill them. The ratio of these datapoints is nearly two to one.

The inflation dynamic reduces the likelihood that the Federal Reserve will be able to pre-emptively ease policy in response to signs of weakening growth.

Will the Fed give the market the easing it wants?

Figure 1: US job openings vs. unemployed people

US job openings vs. Unemployed people

Source: Ninety One, US Bureau of Labour Statistics. March 2023.

And two, soft landings have historically been associated with long and shallow hiking cycles, where economic participants have more time to adjust to higher interest rates. The type of hiking cycle experienced in the US over the past year, from 0-0.25% to 4.75-5.0% for the Federal Fund’s rate, has historically been associated with deeper recessions.

US Economy: soft landing? History implies the odds are low

Figure 2: Historic Fed cycles (% over months)

Historic Fed hiking cycles (% over months)

Source: Ninety One, US Federal Reserve. March 2023.

We believe it is also important to remember that this aggressive rate cycle has taken place after one of the longest periods of easy money in history, where capital will have likely been misallocated, and that policy has notable lags until its effects are felt. We expect the full effects of this hiking cycle to be felt in the second half of this year.

The promise of China’s new up-cycle

On China, financial markets have moved to discount a reopening of the economy over the past six months, but investors remain sceptical about the prospect for a sustained recovery in growth and corporate earnings. We would highlight that China’s credit cycle troughed over a year ago and appears to be entering a new up-cycle, while the regulatory cycle peaked a year ago and new initiatives on this front will likely remain quiet until the economy has shown notable improvement. At the same time, there appears to be material pent-up demand and close to 10% of GDP in excess savings, while policy makers continue to add stimulus. This will be important to offset developed market economic dynamics over the next 12 months which are the primary headwind to assets in Asia, in our view.

A bias towards Chinese equities

As a result of these views our strategies remain underweight equities, with a bias towards the Hong Kong and Chinese markets. In fixed income, we remain overweight defensive duration – focused specifically on high grade markets where low interest rates have encouraged households to build up leverage over the past decade, such as in South Korea, Australia, New Zealand, Sweden & Canada. In currency, our strategies maintain a defensive stance and are long reserve currencies (JPY, USD & CHF) vs. the currencies of more economically vulnerable countries (CAD, GBP, SEK, AUD & NZD).

02

Thematic viewpoint

Shanghai city in the mist
The microchip industry has evolved over the last three decades and now underpins modern civilisation. However, it is facing significant change, both from geopolitical forces and technical limitations, as maintaining Moore’s Law becomes more difficult and expensive. The author unpacks what this may mean for the industry as well as investors.

The semiconductor industry faces new challenges, but a multi-year growth cycle continues

Sahil Mahtani – Head of Macro Research at the Investment Institute

Microchips underpin 21st century civilisation. They are now embedded into everything from cars and washing machines to fighter planes. To the extent that they underpin advances in computing power, they are as central to the modern economy as oil, but their production is even more concentrated and globalised. As Chris Miller, who authored a piece on the Chinese chip industry1 with Ninety One in 2021, has pointed out, OPEC’s 40% share of oil production looks unimpressive when ASML builds 100% of the world’s extreme lithography machines, which are essential to produce the most advanced and powerful semi-conductors.

How should we think about our investments in semiconductors today? Ninety One took a closer look at the issues impacting the semiconductor industry and investigated some key issues, including the future of Moore’s Law, investing in chipmaking cycles, as well as the geopolitics involved. Here we share some key observations from recent internal research and debate.

Moore’s Law is changing but is not dead

One observation to emerge in the thematic research was qualified optimism about the prospects for continued progress in the chip industry. Famously, Moore’s Law is an observed empirical regularity based on a prescient forecast made by Intel co-founder Gordon Moore in the mid-1960s that the number of transistors on a microchip double roughly every two years. That possibility of regular progress in turn drives and is driven by ever larger research and development budgets, which pushes up the cost of designing and validating a chip exponentially. Because the industry advances so quickly, those left behind find it harder to catch up.

Why is Moore’s Law important to investors? Moore’s Law is the foundation behind the extreme specialisation and consolidation of firms in the industry, and therefore excess profits. The top five companies with the largest average annual profit – Samsung, Intel, Taiwan Semiconductor Manufacturing, Qualcomm, and Apple – had a larger combined average annual profit (US$35.5 billion) between 2015-19 than the other 249 companies2 in the market (US$27.7 billion).

The figure below shows the number of companies operating at the leading edge. There are currently just three companies producing sub 5 nanometer chips, because of the technological and manufacturing complexity and high capital requirements involved.

Figure 3: Chip companies at the leading edge

Chip companies at the leading edge

Source: Data drawn from JP Morgan; “Strong growth in Leading Edge Foundry, powered by High Performance Computing” June 2022 Needham Presentation at Design Automation Conference 2022; compiled by Ninety One.

Is Moore’s Law dead? It is certainly getting harder to build chips that are denser, faster, and use less power. Moore's Law should be thought of less as a mechanical law of nature in which chip capacities double every two or so years. However, there is good reason to think that progress will continue in a different form. Instead of transistor level scaling, the way forward will see innovation across the entire system – from manufacturing to packaging - to ensure that scaling continues.

First, at the manufacturing level the technology roadmap for EUV (extreme ultraviolet) lithography patterning - the most advanced technique used to ‘draw’ the various structures that make up a chip - and the introduction of novel device architectures will enable the industry to continue making more powerful chips for another decade at least.

While EUV was optional at 16/14nm3, at 7nm and below it is considered essential. That said, chip sizes are getting smaller, and there are challenges with deploying EUV beyond 5nm. While EUV will remain critical it becomes prohibitively expensive to deploy on more critical layers and requires “multiple patterning,” or the need to act multiple times. Therefore, new architectures and materials are necessary. Leading edge foundries — Samsung, Intel, TSMC — are looking to high-NA (numerical aperture4) EUV and beyond. This would enable scaling down to the Angstrom level (a metric unit of length equal to a hundred-millionth of a centimetre), setting the stage for chips with even higher transistor counts and a whole new wave of tools, materials, and system architectures. While there is some uncertainty as to how it will be applied, the technology supports the shift to 1nm in the future, a gigantic technical leap that will unleash a quantum increase in computing power.

Second, apart from advancements in EUV lithography, Moore’s Law cannot continue without innovations in the front-end-of-line device architecture. Again, the likes of Intel, Samsung and TSMC are focused on scaling to 3nm and below but maintaining the same timeline for scaling transistors in the front-end-of-line (FEOL), contacts and interconnects in the middle- (MOL) and back-end-of-line (BEOL) is challenging. All three companies have a clear 2024/25 roadmap (and beyond) for these next generation transistors.

Finally, extending Moore’s Law will also rely on system technology teamwork. Rather than looking at continued improvements in semiconductor processes and design – historically performed by individual companies - this principle aims to integrate front-end design with manufacturing more closely, and in the process drive performance improvements.

Overall, we think the chip industry can continue to evolve for at least the next decade, underpinning specialisation for the key technology leaders. Moore’s Law is changing but it is not dead. Rather than thinking about it as an observed empirical regularity, it is probably fairer to see it as a social compact for the industry that it collectively wrestles to push progress forward. The tools to achieve that are changing but it will continue from a system performance perspective. The importance of system level efficiency entrenches incumbents, especially those that have developed deep design technology ecosystems.

Timing the chip cycle is notoriously tricky

Where are we in the cycle? The industry is expecting declining growth this year as the demand for consumer electronics plateaus and market players try to unwind high inventories, in part driven by slowing growth following two years of extremely high demand in the post-Covid period and supply bottle necks. Technological research and consulting firm Gartner now predicts that industry revenue will decline in 2023.

Yet this cycle is more distinct from previous cycles as the downturn in end-demand appears to be asynchronous. Some sectors are seeing rising demand for specific chips, while demand in others is falling. For instance, 5G, the Internet of Things (IoT) and automotive sectors face increased demand, while consumer-driven end markets, notably PCs and smart phones, are seeing lower demand.

Now, instead of managing shortages in every area, chip suppliers are monitoring and reviewing their inventories to ensure they have the right product mix to meet demand where it is peaking and avoid potential excess of chips from industries where demand is falling. 

The PHLX Semiconductor Sector index reflects these nuances. The index peaked in December 2021, and troughed in September 2022 as the market anticipated a turn in the operating cycle. The price action and EPS contraction puts the current cycle below a mild downcycle, but above a crisis downcycle (such as that witnessed in 2018/19), with a (potential) bottom having occurred in October (4Q22).

Figure 4: SOX - absolute revenue

SOX - Absolute revenue

Source: Bloomberg, March 2023.

Investors intent on trading the cycle will need to accurately anticipate a peak or trough in inventory levels and year on year revenue growth rates. That has never been an easy task and is not straightforward in this unusual macro-economic cycle. Our bottom-up teams rather suggest that it is more prudent to look to the longer term. The earnings power of the industry has improved cycle to cycle—all the charts are up and to the right. Aside from the current bump, this is expected to continue. The industry is underpinned by structural demand as semiconductors and computing power become embedded in every sector in the economy. Stock picking will remain key given the different levels of strength in different end-demand sectors.

Geopolitical fragmentation is a risk for the industry

Chipmaking continues to be a highly sensitive industry subject to geopolitical competition. Countries are increasingly offering subsidies to onshore the semiconductor industry from its concentration in Taiwan (the US Chips and Science Act, and the European Chips Act, in addition to ambitious policies in China, India, Japan, South Korea). In addition, the US has taken a strategic decision to restrict leading chips and chipmaking equipment to China, as evidenced by the US Chips and Science Act, announced in October 2022.

The success of all this remains to be seen. This is an industry that has evolved, unfettered by government intervention, into the world’s most complex and globally integrated industry, spanning dozens of nations with thousands of suppliers – many of which have grown up in ecosystems around or near the big fabrication plants in Asia. Having said that, the giants of the industry including Samsung, Intel and Taiwan Semiconductor, have begun to reconsider their capex spending priorities, with geographic diversification a common theme. Ultimately, unless financially supported by the near host countries, offshoring production is likely to increase capex, lower margins, and lower returns on invested capital for the key players.

In conclusion

Global superpowers have recognised that as far as strategic importance goes, the chip industry could well replace the oil industry as the lifeblood of industrialised nations. As a result, they are now elbowing one another aside in a bid for dominance. Despite these political winds, we believe that the industry has achieved momentum and scale over the past three decades and will continue to advance and deliver returns to countries, companies and shareholders.

1 China’s tech revolution: unprecedented scale, mixed results.
2 S&P, Corporate Performance Analytics by McKinsey.
3 Nanometer - one billionth of a meter.
4 NA - the numerical aperture is a measure of how much light the optical system can collect and focus.

03

Policy review

Aerial view of Shanghai
For months markets have attempted to predict a pause or pivot in the rate hiking cycle – to no avail. However the collapse of Silicon Valley Bank, supported by data that suggests inflation is beginning to moderate, may indicate that a pause is closer than initially imagined.

All eyes on credit conditions

Russell Silberston – Investment Strategist

Our last policy review asked if we were approaching the end of the hiking cycle as monetary policy became restrictive and inflation began to turn. Up until early March, with economies resilient and underlying inflation showing little sign of slowing, the answer to the question would have been a decisive no. However, early in March, stress in the banking market, spurred by rapid deposit flight at Silicon Valley Bank saw a handbrake turn in interest rate expectations and hopes of lower rates by the end of the year. Ironically, for a bank focused on cutting edge tech entrepreneurs, the cause of its downfall would have been recognised by bankers 100 years ago; a concentrated deposit base and huge mismatch between the duration of assets and liabilities.

The Fed’s dilemma

This led the Federal Reserve to an uncomfortable spot, as its most recent meeting came shortly after it had to provide liquidity to those banks suffering deposit outflows, yet economic dataflow and inflation had both recently exceeded expectations. The Fed reconciled this by separating macro prudential and monetary policy, raising rates by 25 basis points to 5% despite the tension, but assuming the turmoil will tighten credit conditions enough to offset the need for much more aggressive hikes in the benchmark Fed Funds rate. The more subtle message of this compromise was, if credit conditions don’t tighten notably, further hikes will be on the agenda.

As we look forward, recent events have reinforced our belief that a recession is looming, as banks tighten credit and the lagged effects of the previous aggressive interest rate hikes bite. This will enable the Fed to hold off further rate hikes from June onwards and wait to see if inflation falls back as far as it hopes. If, however, the US economy maintains enough momentum and the banks keep lending, then the Fed will be forced into further hikes. Ultimately, under this scenario, the destination is the same. But, outside of a major economic downturn, it will not be tempted to reduce rates until it is completely confident that inflation is properly under control. And we see no evidence that it is willing to compromise by accepting inflation settling above target. In practice, for both policy makers and Fed watchers alike, the coming quarter will therefore be one of studying the data closely to determine if recent events are feeding through to the wider economy.

The ECB follows a similar path

Having increased interest rates by 50bps in February and promised that in March ‘a rate hike by 50 basis points is necessary under virtually all plausible scenarios’, the European Central Bank may have communicated itself into a corner as Credit Suisse imploded on its doorstep just as the Governing Council met. However, just like the Fed, it made the distinction between monetary and macroprudential policy and went ahead with the promised hike, leaving its deposit rate at 3.00%. But with economic growth proving more resilient than expected and core inflation sticky, and on condition that banking sector uncertainty subdues, then the Governing Council is clear that its baseline scenario means it has “a lot more ground to cover” on rates, even though it is not confident enough to set out what this means in practice.

Rather it has set out a new reaction function, based on three factors: Staff inflation projections and whether these are converging durably to target; the behaviour of core inflation and finally the transmission of monetary policy to the wider economy, the flow here being from official rates to financial conditions and then on to demand. Expect markets, therefore, to react to each new relevant data point. On balance, we expect the ECB to deliver on Christine Lagarde’s promise to “do whatever is needed to return inflation to 2%” and so expect further rate rises in the coming months before a pause to assess just how tight it has taken monetary policy.

The BOE, resilient growth and sticky inflation

The Bank of England was ahead of the curve in tackling financial instability while continuing to raise interest rates, with its actions in September 2022 rapidly calming frayed nerves in the gilt market. Since the departure of the ill-fated Prime Minister Liz Truss in October last year, the Bank has raised Bank Rate by a further 2.0%, with 0.75% of this in the first quarter of this year. In contrast to many other policymakers, its approach to tackling inflation has been driven by its economic forecasts rather than the ‘shoot first, ask questions later’ approach of the Fed and ECB. But in an environment of genuine uncertainty, this approach has left it hostage to its own outlook, as growth has proved more resilient than expected and domestically generated inflation stickier than hoped, forcing the Bank to modify its guidance. For example, in February, its Chief Economist stated that the “MPC needs to ensure that it does enough to return inflation to target, while guarding against the possibility that it does too much, or for that matter, too little.” By the end of March, the Governor believed that recent economic “evidence has pointed to more resilient activity” and as such “we have to be very alert to any signs of persistent inflationary pressures.” No surprise, therefore, that traders have marked recent news to market and are pricing a further 0.4% increase in Bank Rate over the coming months.

A changing of the guard at the BoJ

With Governor Kuroda’s ten-year tenure at the Bank of Japan ending on 8 April 2023, it feels like a chapter is closing in Japan as the architect of ‘Quantitative and Qualitative Monetary Easing with Yield Curve Control’ steps down just as inflationary behaviour appears to be changing. His replacement - Kazuo Ueda is widely seen as a continuity candidate, but in our view, it is now only a matter of time before the BoJ is forced to begin the exit from its ultra-loose policy stance.

The reasons for this are two-fold. Firstly, it is becoming clear that the financial side-effects of QQE are outweighing the economic benefits, and secondly, there are increasing signs that underlying inflationary pressure in Japan is building, and the disinflationary mindset is fading as core inflation remains at elevated levels. However, it is likely that the BoJ will only take small steps to the exit, starting with another adjustment to yield curve control, perhaps as soon as the second quarter of 2023. This will be implemented as either a higher upper band level or a shift shorter from 10-year bonds to 5-year bonds. Either way, given the nature of this policy, markets are unlikely to receive any advance notice of this change and so will be on high alert as Governor Ueda settles into his new role. If this occurs, perhaps history will conclude Kuroda really was the official that allowed Japan to escape her disinflationary funk?

PBoC faces different challenges

China’s economy is in a very different stage of the cycle to western economies, rallying hard as COVID restrictions are lifted and the widespread policy easing implemented in 2022 begins to support growth. Inflation, however, has remained moribund, likely reflecting the subdued demand stemming from the tight pandemic restrictions and the deflating property market.

The number of policy initiatives from the People’s Bank of China slowed to a trickle in the first quarter of 2023, but it still managed to surprise market participants by announcing a 25bps cut to its Reserve Ratio Requirement, releasing RMB500 billion of long-term liquidity into the economy. While the timing was a surprise, this was consistent with the three goals of the PBoC, as announced in the latest Monetary Policy Report. These goals were stabilising growth, prices, and employment. While the tone of the report was clearly more balanced in the face of the economic rebound, it is very clear that the role of monetary policy is to provide continued and sustainable support for the recovery. As such, the fact that the authorities are no longer firefighting should be seen as a positive development, as it suggests more confidence in the economic outlook over the coming year.

04

Summary of high conviction asset class views

Rockface shaped like skyscrapers
There are attractive investment opportunities across the entire investment universe. The key is knowing where to look across the credit markets, FX, equities – both regional and sector – in addition to commodities.
Defensive bonds

The US curve has repriced aggressively over the last few quarters and with growth momentum showing signs of moderation and breakeven inflation off its highs we have retained nominal yields as single positive. We continue to prefer to express duration exposure within portfolios in areas such as the $ Bloc and Korea which have repriced significantly above medium term fair value and remain attractive considering structural challenges.

View as at 31 Mar 2023 31 Dec 2022 30 Sep 2022
US      
Eurozone      
Japan      
UK      
China      
max positive positive neutral negative max negative

Positive: Australia, Canada, Korea, New Zealand, US 30
Negative: No comments

FX

The outlook for USD vs. major currency blocs has become more uncertain. While macro and policy divergence between the US and China is expected to continue in the short term this has largely been priced by exchange rate markets and we remain neutral on all USD vs. major Bloc FX. We have downgraded $ Bloc given signs that the large structural imbalances within the household leverage and housing markets are beginning to correct which should act as headwinds to growth and central bank tightening vs. the US. The BoJ has made the first moves towards abandoning its very easy policy stance as pressures from inflationary forces and global interest rates grow. Hence, we have upgraded the JPY although remain cognisant that material appreciation will remain reliant on global macro factors.

View as at 31 Mar 2023 31 Dec 2022 30 Sep 2022
USD      
EUR      
JPY      
CNY      
EM      
Gold      
max positive positive neutral negative max negative

Positive: CHF, JPY
Negative: AUD, CAD, GBP, NZD, SEK

Growth bonds

The EM macro score remains negative, while our quality scores have moved deeper into negative reflecting higher inflation which has eroded institutional strength scores, as well as a deterioration in fiscal scores. Valuations remain attractive across the board, in particular real interest rates on a relative basis. We favour those areas that have nominal and real rate advantages to DM, as well as attractive carry dynamics as these should continue to benefit from yield advantages to DM.

View as at 31 Mar 2023 31 Dec 2022 30 Sep 2022
EM HC      
EM LC      
max positive positive neutral negative max negative

Positive: Chile, Colombia, Poland, South Africa
Negative: Peripheral spreads

Credit

Credit spreads are increasingly rich particularly in higher quality names and IG which is back to the tightest levels since May 22. Flows remain strong in US HY however large inflows to IG ETFs were offset by active fund outflows driving a net outflow overall. Given the deteriorating valuations, despite persistence of the weak macro backdrop DM credit spreads have been retained at maximum negative.

View as at 31 Mar 2023 31 Dec 2022 30 Sep 2022
US IG      
US HY      
EU IG      
EU HY      
max positive positive neutral negative max negative

Positive: Asian HY
Negative: No comments

Regional equity

The Asian region has structural tailwinds and is beginning to see earnings dynamics trough as regulatory incursion lessens and macro policy becomes more supportive. By contrast, the need to keep policy tight to meaningfully bring inflation down constrains the growth outlook for the US, where valuations are elevated, as well as for Europe ex UK which faces additional structural headwinds.

View as at 31 Mar 2023 31 Dec 2022 30 Sep 2022
US      
Europe ex UK      
UK      
Japan      
Asia ex Japan      
EM vs. DM      
max positive positive neutral negative max negative

Positive: Asia ex Japan, EM vs DM
Negative: Europe ex UK, Japan, UK, US

Asset heavy equity

We are cautious on cyclical sectors with the highest exposure to consumer goods demand and the manufacturing cycle.

View as at 31 Mar 2023 31 Dec 2022 30 Sep 2022
Energy      
Materials      
Industrials      
Financials      
Consumer goods      
Cyclical technology      
max positive positive neutral negative max negative

Positive: Auto value chain, Electrical equipment, Financial exchanges & data, Steel, Truck OEMs
Negative: Auto OEMs, Japanese banks, Retail goods

Asset light equity

The richest opportunity set can be found across areas which benefit from accelerating structural change in technology and healthcare sectors. Valuations remain most at risk across highest growth areas as real discount rates rise.

View as at 31 Mar 2023 31 Dec 2022 30 Sep 2022
Software      
Media and online retail      
Healthcare technology      
max positive positive neutral negative max negative

Positive: Chinese internet companies; US payment providers, US managed care, Media technology, Environmental services
Negative: No comments

Stable return equity

Higher quality defensive sectors are attractive given the growth outlook. We are positive on parts of the real estate sector on structural tailwinds, such as tower, datacentre and logistics REITs, alongside a more balanced outlook for bond yields. Valuations have also begun to become less stretched in real estate (and utilities) although margin pressures do remain.

View as at 31 Mar 2023 31 Dec 2022 30 Sep 2022
Pharmaceuticals      
Consumer Staples      
Telcos & Utilities      
Real Estate      
max positive positive neutral negative max negative

Positive: Europe; Utilities; US tower, Datacentre, Logistics REITS
Negative: Telecommunication services

05

Equities

Mountain reflecting in placid lake
This is a market for bottom up stock selection as the macro environment remains challenging. Equities are likely to face continued pressure as earnings expectations – which remain high – adjust to a cyclical weakening in demand. We remain negative on US and European stocks and are positive on Asia ex-Japan. At a sector level, there are opportunities within specific sectors.

Equity views

Our outlook on developed market equities remains negative with maximum negative view on US and Europe ex-UK equities given that valuations have returned to expensive levels and we continue to expect that the dramatic tightening of monetary policy and liquidity over the last 12 months will cause a significant slowdown in these economies and a broad-based earnings recession in due course.

Emerging vulnerabilities in the banking sector are driving a further tightening of credit conditions, which will further slow growth and reduces the probability of another large series of interest rate hikes. However, as long as we do not see a major systemic issue develop in US or European banking, policy makers are likely to maintain tight monetary conditions until there are clearer signs that inflation is on a durable path back to target. While the market has become more optimistic on the likelihood of a softer landing, we maintain our central scenario that a harder landing and recession is likely. Markets have not fully digested the impact that slowing growth will have on margins and on earnings and US and European equities are priced on demanding multiples of peak profits.

UK valuations are less stretched and currency weakness may provide some offset for local currency returns but the market remains at risk in a cyclical downturn, and we maintain a single negative view. Structural supply side issues and the risk that the Bank of England falls behind the curve mean that upside risks to UK inflation also remain somewhat more elevated. We downgraded Japan to single negative as we believe that we are in the early stages of a tightening cycle in Japan as the evidence that consumer prices and wages have definitively shifted higher have become impossible for the Bank of Japan to ignore. Tighter domestic policy and slowing global growth are tailwinds for the yen which remains historically cheap, and this constrains the outlook for outward facing Japanese corporates. Holding us back from a more negative view are the facts that valuations are the most attractive globally and Japanese exporters are most directly exposed to the rest of Asia where Chinese policy easing is expected to drive an upturn in the growth cycle.

We remain positive on Asia ex-Japan, which is benefitting from structural tailwinds and is beginning to see earnings dynamics trough as regulatory incursions lessen and the transmission of supportive macro policy to the real economy can take hold. China’s reopening is well underway, with indicators of industrial activity, consumer demand and property transactions all moving higher.

At the sector level, we remain cautious on cyclical sectors with the highest exposure to consumer goods demand and the manufacturing cycle, with unchanged negative views on both sectors. The historic squeeze in real incomes and volatile demand trends provide a very difficult background for producers and retailers of discretionary goods. The broad swing away from goods spending in favour of services, as well as historic supply chain issues and difficulties in predicting demand at a product level have contributed to excessive inventories and, in aggregate, valuations do not sufficiently compensate for these risks.

There are opportunities within cyclical technology given that technology remains a strategic priority in many sectors. An increasingly consolidate conservatively managing supply, has resulted in more durable profitability even with end market demand cyclicality. Stretched valuations remain a challenge across cyclical and asset light technology sectors, in addition we believe that the cyclicality of many software and media & entertainment businesses remains underappreciated and hold negative views on both sectors.

Valuations are reasonable within the defensive telcos and utilities sector. While we are positive on utilities, which are viewed as a key enabler and beneficiary of the energy transition, we remain negative on telcos, which remain structurally challenged by repeated excess investment, high leverage, and failure to generate returns that meet the cost of capital.

There are opportunities in select areas. We see opportunity in companies that help to accelerate decarbonisation by shifting how we generate electricity or enable increased electrification and more efficient use of resources. Within real estate structural changes in consumer and business activity, accelerated by the pandemic, have created a radical shift in demand for traditional retail and office properties and a step up in requirements for supply chain logistics and digital infrastructure assets. Tower, datacentre and logistics REITs are structurally attractive as a result of their high quality assets with wide and durable moats. We are also positive on the pharmaceutical industry where demand remains steady and uncorrelated to the cycle, driven primarily by medical needs which have structural rather than cyclical drivers.

Overall, we believe equities will face continued pressure as earnings expectations – which remain high – adjust to a cyclical weakening in demand.

06

Fixed Income views

Top view of skyscrapers
With inflation showing signs of moderating, and stresses emerging in the banking sector, the discussion has switched to when the rate hiking cycle will pause, and what the terminal rate will be.

As discussed in the policy review chapter, central bankers around the developed world continue to hike rates in their bid to tame inflation. However, with a year of tightening behind us, there are signs that higher rates are starting to have an impact in slowing growth and inflation. The discussion for central banks has shifted from the pace of hiking to what the terminal rate will be, when this will be reached and for how long to hold at this level. The issue is the continued strength in data and there remains a significant risk that if labour markets do not show signs of softening, core inflation may remain sticky and as a result central banks will be forced to keep policy tight, which is not currently in market expectations.

Government bonds

We have retained US government bonds as single positive. Even though policy tightening has not yet brought inflation back into the target range, policy is now restrictive and credit conditions are tightening, which is slowing growth and supporting a moderation in inflation. As a result the Fed is getting closer to pausing rate hikes. To increase our positive view on US fixed income further we would need to have a high conviction that policy was set to move to an easing phase imminently. This would give us confidence that real rates were likely to fall versus our current expectation of stability. Although our positive view is focused on US fixed income, we continue to see the most attractive opportunities in highly leveraged economies (Australia, Canada, New Zealand, South Korea) which have followed the US in tightening policy aggressively and are likely to experience weaker growth given these economies’ have the highest sensitivity to interest rates. We have upgraded our view on the Eurozone from neutral to positive given more attractive valuations and clarity from the ECB, notably that the central bank has indicated a terminal rate at 3.5% which it expects to reach in the coming months. We have moved negative on Japan given the BOJ’s confidence that pricing behaviour is changing and is therefore likely to lead to further changes in their monetary policy stance, including an eventual move away from the ultra-loose policy that has become the norm, and abandonment of its policy of yield curve control.

Emerging markets

Valuations in much of Asia are reasonable and Emerging Markets ex Asia continue to offer attractive valuations and are beneficiaries of the strength in commodity prices and demand. Significant long term opportunities remain across emerging markets, focusing on areas with robust structural underpinning from domestic consumption growth. We continue to find opportunities in those economies that have experienced significant hiking cycles and are seeing moderation in their inflation rates, notably Latin American and CEE economies. Despite this we continue to express caution, notably due to the tightening liquidity backdrop from major central banks which is likely to remain a headwind. A catalyst to become more positive would be a view that we have reached the peak in developed market tightening, with a move towards easing. Although we are getting closer to this point, we believe that the conditions are not yet in place to express an overall positive view.

Credit

We maintain a maximum negative view on developed market credit given the likely future impact on corporate earnings of prior policy tightening and subsequent increase in default risk. Neither of these outcomes are adequately compensated for by the level of spreads on credit instruments. This is true despite the recent meaningful moves, which have seen synthetics underperform cash bonds, IG underperform high yield, and financials take a significant hit following the collapse of SVB and write-down of Credit Suisse AT1s ahead of equity. It is likely that lending standards in the US will tighten further given the recent damage done to regional banks through deposit flights and higher costs of capital, while it will take a few months to see whether this is the case, recent survey evidence suggests banks have reined in credit supply, this is a negative for borrowers and symptomatic of the monetary policy environment. We expect these dynamics to pressure credit spreads wider and to become more positive on credit would require a reversal in central bank policy or a reacceleration in growth.

07

Currency views

Chinese tea plantation
The outlook for major currencies looks uncertain and we are neutral on the USD and negative on sterling. However, we have recently upgraded our views on the Japanese yen given indications that the cycle of loose monetary policy may be coming to an end.

After a year of rate hikes, the Fed has indicated that the pace of rate hiking is likely to slow, however we are still not at the endpoint. Despite increased evidence of a slowing in US growth momentum there are risks that we continue to see labour market strength, which shows little sign of weakening and continues to drive a hawkish policy outlook. Overall, we remain neutral on the US dollar (USD) as a result with the weakening economic backdrop expected to reduce upward pressure on the currency despite hawkish policy. We believe the time to shift underweight will be when we have conviction in a deterioration in the US macro backdrop, which is ultimately likely to put the Fed on hold.

Meanwhile, we continue to expect policy divergence between the US and ‘dollar bloc’ economies (Australia, New Zealand and Canada) given the large structural imbalances and associated weaker growth outlook that they face. This is expected to drive these countries to loosen policy sooner than the US, which is structurally stronger following a significant period of deleveraging since the Global Financial Crisis. Hence, we have maintained positions in USD versus the New Zealand dollar (NZD), Australian dollar (AUD), Canadian dollar (CAD) although remain cognisant that the AUD and NZD will benefit from a reacceleration in the Chinese cycle.

We continue to believe that the latent impacts of policy tightening are yet to be seen in the Eurozone and thus we remain neutral on the area. One important consideration for European growth will be the impact of China improvement, a fact we are monitoring. Despite our neutral view we continue to express a negative view on Swedish krona (SEK) vs Swiss franc (CHF). Elevated household debt levels and associated systemic risks from a highly inflated housing market act as headwinds to growth and inflation within Sweden. At the same time there is increasing evidence that the Swiss authorities are speeding up policy normalization and may utilize FX intervention to strengthen the currency. We also remain negative on sterling (GBP).

We have upgraded our position on the Japanese yen (JPY) following the shift in Bank of Japan yield curve control (YCC) policy in late December. Domestic inflationary pressures have been building within the Japanese economy and are increasingly being passed through into wage considerations. With global interest rates elevated there is increasing pressure on the central bank to move away from their super easy policy stance which would support currency appreciation. In addition, slowing US growth will provide a tailwind for the yen, and could spur a shift in policy.

The more challenging backdrop for growth, and the continue hawkish stance from the Fed, notably the balance sheet policy, means we remain cautious on EMFX. However, the outlook for the Fed and China may shift this view in the coming months, given the increased evidence of a growth improvement.

Finally, we have retained our neutral position on the Chinese renminbi (CNY) given diminishing macro divergence with other major regions. The credit impulse is now positive and is expected to become more supportive as authorities use this channel as their main source of support for economic growth and means of aiding a recovery. Growth momentum is beginning to pick up while emerging evidence in the rest of the world is of slowing suggesting a move towards macro convergence and a less clear outlook for relative currency performance.

08

Commodity views

Engineer supervising machinery
The past year was an extraordinarily volatile one for commodities across the board, however there are sectors that look promising in the year ahead. Oil and natural gas is an example, agricultural commodities may be another. Metals could swing either way.
Mixed views for oil

Oil prices weakened over the quarter, with Brent falling from US$85 per barrel to US$73 per barrel by mid-March, before rallying back up into the high US$70’s by the end of the quarter. The supply and demand fundamentals were mixed; while global oil demand growth forecasts for 2023 remain strong, driven by China, they are also weighted to the second half of the year. In the near-term, OECD oil inventory levels are increasing, and Russian supply is making its way to market, albeit to Asia rather than Europe. The sell-off in March was precipitated by the turmoil in the banking sector and fears of broader contagion. The near-term outlook for oil is mixed, but we would not be surprised to see a stronger price environment as we move through the year.

Weather and China key to gas demand

Natural gas prices weakened substantially in both Europe and the US. Mild winter temperatures in NW Europe, combined with efficiency gains and demand reductions, have caused inventory levels of natural gas in Europe to increase towards the upper end of the 5-year range, a remarkable turnaround given the fears around gas shortages in the second half of 2022. Weather remains a key determinant in this equation, as does the role of China as an importer of international LNG cargoes; we expect China to be a more active buyer in 2023 which will reduce the supply of LNG cargoes into Europe. US natural gas prices have fallen right back to around US$2 per MMBtu, driven by benign winter temperatures across the US, a delay to the restart of the Freeport LNG terminal, and equivalence with international prices.

Grain prices keep farmers planting

Within agriculture, grain prices and farmer economics have weakened somewhat during the first quarter of 2023 but remain well above historical levels. With the Northern Hemisphere planting season coming up very soon we expect a healthy incentive for summer crop producers to try and maximise their output. This should support demand for inputs such as seeds and fertiliser. Protein markets are more nuanced with European salmon and Chinese pork prices rising while the chicken and beef industries across the Americas remain in surplus.

Mixed outlook for metals

Demand indicators for metals have been mixed year-to-date. China’s re-opening after COVID continues in a stop-start fashion but momentum is building in our view. This has benefitted copper and iron ore so far in 2023 and we expect prices to rise more into the second half. Even though consensus expects surpluses in some markets, supply disruptions are often underestimated, and we have seen various examples in recent months. Steel markets are more regional than global, and we expect pricing power for US and European producers to continue to be better than China and other emerging markets. Rising prices have driven modest earnings upgrades over the quarter and this should continue into Q2. Gold prices rose 8% during Q1 as safe haven characteristics and the nearing peak in interest rates enjoyed the market’s attention. Demand from central banks has also been good in 2022 and year-to-date and we expect gold to hold on to its gains as we progress towards H2 2023.

General risks. All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.

Specific risks. Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems. Commodity related investment: Commodity prices can be extremely volatile and significant losses may be made. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company.

Multi-Asset team

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