One of the key challenges for asset allocators at the moment is balancing the relatively strong current environment in developed markets with various medium-term risks. Sentiment has been supported in recent weeks by the fact that a 2008-style financial crisis looks much less likely than it did when Silicon Valley Bank collapsed. However, the hit to confidence in the financial sector will reverberate through the rest of the US economy and adds to a growing number of macro headwinds.
Eugene Philalithis, Head of Multi Asset Investment Management, Europe, Fidelity International comments: “Inflation might still be too high and too sticky for policymakers to relax, but the near-term growth picture continues to look robust. However, further into the future things start to look a little more concerning. We still expect a recession in the US and Europe within the next 12 months. Both the Fed and the ECB have tightened monetary policy significantly, the effects of which are still yet to be fully realised. The jitters in the banking sector have accelerated financial tightening, and we are watching closely to understand the impact of this across markets.”
Philalithis goes on to discuss three themes currently driving markets, and how the team are allocating accordingly.
1. No ‘Goldilocks’ scenario: the inflation battle will continue but with growing divergence
“Inflation remains far too high in developed markets, and this leaves central banks unable to fully support slowing economies and at risk of worsening the inflation problem. Conversely, some Emerging Markets have subdued inflation and growing divergence between central banks may present opportunities.
“We remain neutral on fixed income overall for now as inflation is sticky and we are scepticalthat the near-term rate cuts the markets expect will materialize. Within fixed income, we prefer to allocate towards higher quality and more defensive government and investment grade bonds and away from riskier high yield debt.
“We are allocating away from corporate credit, as credit conditions continue to tighten in the aftermath of banking sector stress and loan markets are seeing rising rates of distress. We prefer UK Gilts over Bunds and JGBs as inflation dynamics soften as opposed to the more hawkish ECB.
2. US banking stress: crisis averted but tighter financial standards will bite
“The stress seen in US regional banks further accelerates the tightening in credit conditions we saw throughout 2022. While this is unlikely to be the start of a full-blown financial crisis, it clearly increases the risk of a ‘hard landing’ – and blunts economic momentum, particularly in the US.
“Lending standards are tightening further as a result of the banking sector jitters. It is becoming harder for businesses, especially the small firms that are crucial for jobs and growth in the US, to secure the loans they need. Furthermore, the S&P 500 remains expensive, especially compared to Emerging Markets so we remain cautious on US equities. Instead, we are moving into higher quality areas of equities and credit, keeping exposure to the current positive momentum but increasing protection should data start to turn. In the small cap sector, European companies are at a large discount to those in the US despite being higher quality and having a better macroeconomic outlook.
3. China is resurgent
“China is emerging from Zero Covid far faster than expected, accompanied by a broadening package of growth-positive policy announcements. Many other Emerging Markets are benefitting from falling inflation, peak monetary tightening, and attractive valuations. This may prove a potent mix, despite global headwinds.
“We think the recent pause in China’s reopening rally is temporary, and improving corporate earnings are likely to take over from cheap valuations as the main driver in the next stage of the rebound. China A shares are one of the purest ways to play the China reopening theme because A shares are less impacted by geopolitical events and more driven by domestic idiosyncrasies. Global luxury behaves more like consumer staples, so it should provide relatively good downside protection as growth slows. The sector also benefits from China’s rapid reopening.”