In our latest Asset Allocation Monthly report, we discuss five key changes to our multi-asset portfolios. First, we are now underweight European duration to capture valuation dislocations. Second, we have taken partial profits on our overweight in European investment-grade credit to benefit from market rallies. Third, we cleaned up our ‘dry powder’ in US equities, allocating instead to emerging market equities. Fourth, we shifted the funding leg of our long Japanese yen (JPY) to Swiss franc (CHF). And fifth and finally, as a result of these changes, we moved our overall risk taking into the neutral risk quintile for the first time since April 2022.
Fat tails to the distribution of expected growth outcomes have fattened further. Over the first quarter of 2023, markets swung through all four quadrants of the investment clock in a few short months, rather than over a period of several years.
As concerns around the financial health of regional US banks have mounted, with tremors in European banks, too, after the collapse of Credit Suisse, the narrative in the markets now seems to have settled on global economic recession as being the most probable outcome. We are less convinced.
We do not entirely disagree – regional banks are hugely important in the US economy and a further tightening of lending is a real and tangible downside risk to growth. But it is less clear for emerging Asia or Europe, where growth, inflation, policy and banking sector dynamics are different.
We also have greater confidence in other areas. For example,
- The stickiness of inflation in Europe and the need for the European Central Bank (ECB) to continue to raise interest rates
- The prospect of regional decoupling, with emerging Asia particularly well placed compared with developed markets
- The investment opportunity in areas such as European investment-grade credit and commodities, where we remain overweight.
In recent weeks, we have made five key changes to multi-asset portfolios:
First, on ‘Black Monday’ (13 March), after sharp 5 to 12 standard deviation moves in bond markets on the news of the Silicon Valley Bank and Signature Bank failures, we went underweight European duration by 0.45 years. We subsequently deepened the position to 0.75 years. We are seeking to capture valuation dislocations on market concerns over banking sector contagion that seem overdone, particularly after sizeable policy responses. Also, European regulatory frameworks are much stricter. This crystallised a more cautious evolving view on European duration, in turn driven by:
- The trajectory of inflation, which is sticky and has yet to peak in Europe, a particular concern being rigid labour markets
- A hawkish ECB that is poised to continue to raise interest rates to address this
- The challenge of absorbing a large European bond supply in 2023 with fiscal expansion.
Second, we took profits on around one third of our overweight position in European investment-grade credit in notional terms and around half on a risk basis, seeking to take advantage of market rallies.
While we do not judge the woes of Credit Suisse and its AT1 debt to be systemic, and compensation for default risk remains generous, credit spreads have tightened meaningfully from when we were building positions at 230bp last autumn. We remain overweight euro IG, fully hedged – just less so than before.
Third, we see downside risks to US growth and earnings, in an economy where regional banks are particularly important and where tighter regulation and balance sheet issues will add to already tight credit conditions.
Consequently, we cleaned up our ‘dry powder’ from when we downgraded the US as a region in mid-February. We allocated instead to emerging market equities, which we continue to favour on valuation and fundamental grounds. We remain neutral equities overall, with our underweight concentrated in Europe.
Fourth, we reset the funding leg of our long JPY, shifting it from EUR to CHF, while also deepening our positions. We still favour being overweight JPY on both fundamental and valuation grounds. The currency should benefit meaningfully from:
- An expected shift in Bank of Japan (BoJ) policy and an end to its yield curve control approach
- Good liquidity, for example, against Japanese government bonds
- Being a helpful risk hedge for portfolios.
We believe the yen is attractively valued across a range of metrics and with ‘favourable’ positioning (shorts). Our EUR funding leg, however, has been challenged by rates moves, and we have hit levels previously set for review. On balance, there are four key supports for switching to CHF:
- Better risk-reward: CHF/JPY and EUR/JPY are highly correlated (0.8), but the cost of carry is meaningfully lower with CHF: it is 37bp over three months compared with 85bp for the euro. As far as we are seeking to capture Bank of Japan policy shifts, both pairs have shown similar price action after the recent BoJ meetings. This included December’s surprise move and January’s decisions, which were seen as non-events.
- Portfolio construction benefits: CHF/JPY involves two safe-haven currencies; the pair also has a low(er) beta to oil and equity. The shift also removes the inverse link with our short core European rates position. Both are a benefit to portfolio construction and are net neutral on overall risk.
- Policy preferences and timing: The Swiss National Bank (SNB) and the ECB are both expected to raise rates further, but the SNB holds its next policy meeting only on 22 June. That is six weeks after any BoJ adjustments under its new leadership are expected to occur and after the wage negotiations period in Japan. The SNB may have a higher tolerance than the ECB for currency depreciation (notably given the franc’s strength). CHF deposit/bond holdings have surged to 20% of external liabilities since the Global Financial Crisis.
- Valuations: The franc is at historically high levels and CHF/JPY has been higher only three times in the last 50 years (based on quarterly data).
Fifth, because of these adjustments, our overall risk-taking moves into the neutral risk quintile for the first time since last April. Specifically, risk appetite can be thought of as the steepness of the line of best fit between expected risk and return across asset classes: the steeper the line, the more return expected per unit of risk and the greater our risk appetite.
For target allocation funds, risk quintiles are calibrated between zero and the max tracking error of the portfolio; for flexible funds, the low point is the maximum allocation to the least volatile asset and the high watermark is the maximum allocation to the most volatile asset class.
It is important to note that this is not directional to market risk as risk can be consumed by both positive and negative views. Today, our underweight European duration position consumes the highest proportion of tactical asset allocation risk-taking.
What is going on in Europe?
We have been underweight European equities for nearly a year, holding the position today as a relative value trade against emerging Asia. It has, admittedly, been a pain trade for multi-asset portfolios but we are sticking to our guns. Of the four factors that led us to be underweight, most still hold:
1. Downside to European earnings
Looking at valuations, analyst expectations for European earnings are high. This is the case when assessing the current estimates relative to the historical trend, considering where Europe is in the economic cycle, and comparing Europe with other regions. By contrast, expectations for emerging Asia have already fallen, discounting significant downside risk and hence leaving room for a bounce.
2. Upside risks to discount rates
In terms of the outlook for monetary policy and hence interest rates, we believe that stickier inflation (and notably its impact on wages), as well as a more expansionary fiscal policy, mean that there are upside risks for rates. By contrast, the outlook is for central bank rates in emerging Asia – and China – to be eased.
3. High cyclical gearing/operating leverage in Europe
We believe Europe is more exposed to the weaker global cycle than emerging Asia. Indeed, Asia stands to benefit from its links to a reopening Chinese economy. F u r t h e r m o r e , European earnings estimates are now at their highs, while forecasts for emerging market earnings are 15% below their highs. EM stocks are trading at 12x expected (and reset) earnings versus 13x for Europe – at peak forecasts.
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