We became neutral on equities – in line with our long-term positioning. With recession our base case in Europe, we have a preference for the US and emerging markets equities versus euro area and global equities, respectively (see more in the “More on our views” section).

We see US equities as a high-quality asset class for several reasons. The more positive EPS upgrades for euro area vs US equities, coupled with the similar returns year-to-date, is something we believe will be increasingly challenged by investors. Additionally, historical analysis shows that US equities have tended to strongly outperform euro area equities when growth slows.

In Fixed Income, we remain overweight emerging market sovereign hard-currency bonds against low-yielding government bonds, to capture the additional yield on offer.

What we’re watching
Despite equity markets recovering from their June lows, we still think near-term uncertainty remains high. That’s why we are maintaining our overall equity and bond weights in line with what we view to be the best long-term allocation. With emerging markets, particularly China, underperforming in recent weeks, we’ve reviewed our preference for emerging markets over global equities. We remain positive on the asset class given its deep discount both relative to global equities and its own history. Specifically, we see emerging market monetary policy easing, led by China, though we’re mindful of the domestic risks within the Chinese economy.

The ongoing earnings season and company forecasts are likely to continue to provide clues on the near-term outlook for the corporate sector. The next US jobs report, inflation print and round of Fed projections (all throughout September) will likely be critical to gauge how close the central bank really is to slowing the pace of tightening. While one data point doesn’t make a trend, last month’s drop in US inflation, which was more pronounced than expected, is encouraging and supports our view that bond yields have peaked, even if levels stay low. The situation in Taiwan and any possible geopolitical spillover is another risk we’re monitoring.

What’s happening
Recession is our base case for the euro area and the UK, given rising costs and the energy squeeze. Even if economy is slowing, we are more optimistic for the US because we think inflation is already peaking. China’s reopening and stimulus are helpful. However, Covid infections are rising again and so lockdown risks remain.

In the US, core inflation (excluding energy and food) and wage growth have both slowed somewhat and inflation expectations are rolling over. Inflation in the euro area and the UK is still rising on energy and supply strains. We don’t expect consumer prices to fall, but think inflation is likely to moderate while staying higher than the depressed levels of the last 10 to 15 years.

The data the US National Bureau of Economic Research uses to measure the health of the economy suggests things are slowing down. According to these data, the US isn’t in recession, although the risks of one occurring in the next 12 months are rising. There’s also a chance that it can be averted. The Federal Reserve now has more flexibility to slow the pace of its interest rate hikes or even start to bring them back down when inflation is more under control.

Inflation has been as hot as the weather over the summer and central banks have been raising interest rates to cool things down, which has unsettled financial markets. More recently, though, investors have started to look forward to better days ahead as US inflation appears to have peaked and bond yields are declining, even though the chances of recession in Europe seem to have increased, which you can read about in more detail in this month’s update.

Partly because of geopolitical risks, we think markets are in a state of flux right now and we expect conditions to remain volatile for some time, which is why we’re positioned for uncertainty through well-diversified portfolios designed to capture opportunities and weather the risks. As always, we’ll be monitoring the evolving economic and investment environment closely over the rest of the year and adjusting portfolios if things change.

While recession in the euro area and the UK is now our base case and uncertainty remains elevated, equity markets are focusing on the decline in bond yields and the likely US inflation peak. Let’s look at what it all means for portfolios

A fine balance

COUNTERPOINT 
SEPTEMBER 2022