Bracing for volatility

Welcome to the October edition of InView: Monthly Global House View. In this publication we consider significant developments in the world’s markets, and discuss our key convictions and themes for the coming months.

Following a brief correction at the start of the month, many global stock markets hit new all-time highs at the end of September. The MSCI All Country Index rose 2.4% for the month, bringing its year-to-date gain to 19.1%. Government bond yields remained close to their lowest levels in 15 months on the prospect of easier monetary policy.

Commodity prices, except for oil, rose on a mix of elevated geopolitical tensions (gold) and the announcement of measures to support the Chinese economy (industrial metals). In currency markets, the yen, sterling and renminbi led the recovery of major exchange rates against the US dollar.

Several important economic policy steps were taken in September. First, the Federal Reserve began its latest easing cycle with a 0.50% cut – which was more than markets had expected - signalling a shift in focus from fighting inflation to supporting the labour market and economic growth. In addition, Chinese authorities announced a broad package of fiscal and monetary measures aimed at supporting the real estate market and domestic demand.

Another factor that helped support markets was the decline in oil prices. Despite worsening crises in the Middle East and Ukraine, crude oil supply remains more than sufficient to meet demand, which remains moderate. Furthermore, the growing availability of energy from renewable sources is helping to limit oil price gains. The prospect of lower inflation is fuelling hope of a prolonged period of interest rate cuts and moderate bond yields.

In this overall favourable context for risky assets, it should be remembered that the weeks before US presidential elections have historically often seen an increase in volatility. Therefore, a balanced portfolio allocation should avoid too much active risk in the coming weeks, maintaining more cash than normal to take advantage of any correction. That said, within equity markets our preference is for European equities, including the United Kingdom. Among fixed income assets, our preference is for high quality government and corporate bonds focusing on maturities of less than 5 years.

Asset Allocation

Global Allocation

Having reduced both equity and fixed income exposure back to neutral last month following recent strong performance, we see it as appropriate to maintain this positioning for now. We expect seasonal volatility to kick in from October, compounded by volatility around the US election, augmented by ongoing geopolitical risks and some inflexion point in the macroeconomic cycle. Alternatives are held at an underweight position while cash levels are above the benchmark.

Should there be a 5-10% intra-month correction in markets, we would look for opportunities to deploy cash into risk assets. Even if there is no market correction, if the US election passes without much noise, which is not our base case, we would still see it as appropriate to increase our equity allocation later in the year. A worsening of economic data is one of the key downside risks to our asset allocation. However, the tightness of credit spreads suggests this is not what markets are anticipating.

Based on a balanced mandate, the matrix below shows our 6-12 month view on investment strategy.

Fixed Income

Expectations are currently that the fed funds rate will end next year at 3.00%-3.25%. The big risk currently is that of a surprise downside in economic data. However, our expectation is that the US yield curve will continue to steepen and will increasingly focus on the terminal fed funds rate. With this in mind, we now see it as appropriate to further reduce portfolio duration. Previously it was in line with the benchmark at 4 years but should now be lowered to 3.5 years. For Swiss franc-based portfolios, duration reduction should be more aggressive in our view, close to 2 years. Last month we upgraded hybrid bonds to neutral to reflect improved conditions for financials, with banks seeing a better environment due to a steeper yield curve. This was funded by a reduction in the allocation to local currency emerging market bonds, bringing it back to a neutral position. EM local currency technicals remain subdued and we are taking profits following a recent strong rally.

Equities

No significant changes are being made to the equity allocation this month. In the US we remain underweight, reflecting idiosyncratic risk around the upcoming presidential election, as well as observing that earnings expectations have started to come down during the month. In contrast Asian earnings expectations look solid. The overall Asia ex-Japan allocation is left unchanged but with some country weighting adjustments. Our equity valuation model shows Europe and UK markets as the cheapest and we continue to favour these regions.

Equity Sectors

Equity Sector Views

UK

We continue to see an opportunity for the outperformance of UK midcaps over the coming quarters, reversing a multi-year period of underperformance as high inflation and interest rates return to more normalised levels. Information technology has been a sector in which we have initiated several new positions recently that fit this theme and for which we have found specialist UK companies trading on attractive valuations in our view, backed by strong structural growth tailwinds.

This year we have also increased our weighting towards consumer discretionary given our more constructive outlook for a domestic UK recovery and improving real incomes for UK consumers. Within this sector, UK housebuilders remain a key component as they will be supported by falling rates, which will help strengthen demand, and potential political support from the new Labour government which aims to reform the planning permission system to boost economic growth.

Falling rates have also been a significant contributory factor to our decision to increase our exposure to utilities, given our view that declining bond yields will provide support for the sector. Furthermore, regulatory uncertainty has recently taken a back seat with clarity provided over windfall taxes, and earnings will be further supported by the large amount of capex required in grid infrastructure over the coming years needed to meet climate targets and increasing electrical generation demands.

US

The information technology sector is starting to look interesting again. Despite high valuations, we believe that the strong momentum being exhibited as well as positive earnings revisions support the case to upgrade the sector to neutral. We continue to like secularly growing segments such as public cloud, digital advertising and life science tools. To balance out the increase in IT positioning, industrials is being reduced to neutral, helping to reduce the cyclicality despite the sector showing both an uptrend and momentum based on our model. Last month we raised REITS exposure to overweight given interest rate expectations, strong technicals and contrarian sentiment.

Europe

In communication services we favour an overweight position versus the benchmark, which saw upwards market drift over the month. Consumer staples exposure should also be overweight in our view, buying into the pullback. We have a constructive view on real estate where we are now overweight as rate cuts start to take effect. Notable underweights include financials and industrials. Notable overweights include communication services and materials.

Alternatives

No changes are being made to our alternatives exposure. We hold an underweight commodity position, with gold accounting for our only exposure as we still view it as too early to invest in more cyclical commodities. Hedge funds are overall neutral. However, within the segment we prefer commodity trading advisor (CTA) strategies owing to defensive attributes as well as discretionary macro managers, while being more neutral on both equity and credit long-short managers. Insurance positioning remains overweight versus the benchmark, with our exposure being a useful portfolio component given its uncorrelated nature.

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