2 / Outlook and changes

“Data-dependent” will be the guiding principle of the Fed for the months to come, as it told investors after its May 3rd meeting. And when the central bank isn’t so sure any more about what is likely to happen next to inflation, labor markets and the economy, investors might be forgiven for taking a similar approach. For portfolios this means: remain prudent, prepared for various potential outcomes and don’t commit to strong single bets. Our baseline view remains that there will be a mild recession in the U.S. and no recession in Europe and that inflation will recede and yet remain quite high, especially in Europe. The earnings reporting season has not helped to give a clear direction, so that we believe markets will go from data point to data point, assessing their inflation, recession and U.S. banking fears – as well as the noisy debt ceiling debate in the U.S. Central banks will be doing the same.

2.1 Fixed Income

Government bonds

The Federal Reserve (Fed) delivered the 25 basis points (bps) hike expected on May 3rd. In line with our assumptions, the Fed indicated that its pause in rate rises was a “hawkish” one – ready to do more. The slope of the U.S. Treasury yield curve is expected to remain unchanged but renewed stress in the banking system might cause it to steepen. The European Central Bank (ECB) followed the Fed with a 25bps hike but indicated that this was certainly not the last step. Sentiment in Bunds swung between cyclical dampening data, continued worries about regional banks in the U.S. and positive sentiment on the Eurozone; and the market also kept a close eye on the central banks. Volatility declined. We remain neutral on 10-year German Bunds but recently reduced 2-year Bunds to underweight (-1). Yields have declined since mid-April but the ECB has reiterated that it has “more ground to cover”, and that “this is a journey, we haven’t arrived yet”^[3] We moved to +1 on 10-year Italian government bonds (BTP) as the government keeps on surprising positively in its economic policy. The BTP-Bund spread shows low volatility. Higher yields offer good carry but also reduce debt sustainability long term. On Spain’s 10-year bond spread we remain +1. Spreads have been relatively stable, with the support of Eurozone and ECB mechanisms making government bonds more robust in general. In Japan, the outcome of the 3rd round of pay negotiations (known as the “Shunto” spring wage talks) suggests that total wages will rise by around 3.7% and that base pay will rise by around 2% year over year – the highest outcomes for around 30 years. Kazuo Ueda’s new leadership of the Bank of Japan has so far been more dovish than expected. The BoJ will undertake a “broad-perspective review” of its monetary policy – but will take one to one and a half years to carry it out.

Investment-grade (IG) credit

Euro Investment Grade (EUR IG) remains overweight (+1). Primary market activity was seasonally low in April, which helped the secondary market. Earnings from banks and the first quarter earnings season overall were solid and support an overweight recommendation on EUR IG. We remain neutral on U.S. IG. Recent market activity has begun to price in several different scenarios going forward. A good first quarter earnings season from banks but a mild recession as a base case in the U.S. is concerning, as is the debt ceiling brinkmanship.

High-yield credit

We are overweight Euro high yield as the economy remains broadly solid. We remain neutral on U.S. HY.

Emerging markets

We have upgraded Asian Credit back to +1, as Asian credit market sentiment has improved along with the macro-outlook. China aggregate financing remains strong with new Yuan loans in March exceeding estimates, and March export data also came in stronger than expected. Liquidity in the region remains ample and with a lack of new supply, demand for bonds issued by good quality IG and HY issuers remains strong. We expect new supply to come soon as the outlook for Fed rates has stabilized.

Foreign Exchange

On Euro (EUR) vs. Dollar (USD) we are positioned EUR long (+1) because the USD has been weak across the board. Next to the economic momentum that speaks for the Eurozone, the latest central bank action also favors the euro. Market sentiment toward the British pound sterling (GBP) has improved remarkably. On the back of relatively good performance from the UK economy and the hawkish stance of the Bank of England (BoE) we are long the pound vs the dollar, but not versus the euro. The Japanese yen (JPY) weakened after the disappointing BoJ meeting; we are thus short (-1) on USD vs. JPY.

2.2 Equities

In the first quarter of 2023 the global banking industry lost two iconic brands. Yet global equity markets closed +6% up. Since outflows from deposit accounts into money market funds have slowed significantly now, we believe that a systemic crisis has been avoided. Our general view remains that European and U.S. bank balance-sheets have sufficient capital and liquidity. Given the turmoil, we expect somewhat tighter lending conditions in the second quarter. This is likely to hurt most of all the construction sector, labor market and capex plans.

The U.S. economy shows signs of slowing, pointing to a moderate recession in 2023 – allowing the Fed to conclude its hiking cycle as soon as May. Furthermore, muted growth prospects have led to a significant drop in U.S. 10-year yields, supporting broad equity market valuations, especially for long duration stocks mostly found in the IT-sector (neutral) and communication sector (outperform).

Beyond this, we see no upside for U.S. equities at current levels. Instead, we see potential downside to our 0% earnings per share (EPS) growth assumption for 2023. We confirm our unchanged relative preference for markets outside the U.S. – Europe, EM, Asia – and for the very attractive valuations of European small and mid-caps.

The MSCI AC Real Estate index includes quite a diverse set of market segments. In aggregate, current valuation levels are just in line with historical levels, but not yet below. In addition, refinancing needs at interest rates that have doubled are still not fully reflected in analysts’ estimates. We remain underweight on the global listed real estate sector.

On a more positive note, we are still convinced that generative artificial intelligence (GAI) is more than just hype and expect this new technology to shape sectors and companies for a long time. The first-quarter reporting season has seen many companies mention GAI when it comes to their growth prospects.

U.S. Market

The U.S. market remains historically rather expensive and therefore interest rates matter a lot in this market. In this regard the “hawkish pause” by the Fed was not a major relief. Furthermore, while the reporting season was okay, the outlook given by many companies was uninspiring. We remain neutral.

European Markets

Markets were positive till March but appear to be more positioned for negative revisions in Europe – against high expectations – than they are in other regions. China’s reopening remains supportive for European equities. Valuations have rebounded somewhat from all-time lows but remain at a steep discount to U.S. equities. We remain overweight for the time being.

German Markets

Solid first quarter reporting and economic growth have helped the market, assisted by reaccelerating exports and increased automobile production. Recession risk in the U.S. has created short-term uncertainty and geopolitical risks remain in place. Our view remains neutral.

Emerging Markets

Global headwinds are easing for emerging markets (EM). The dollar is weaker relative to last year and there is more visibility on the end game for the Fed’s rate hike cycle. Global export weakness remains a headwind, but a lot of that has been priced in. EM valuations are now reasonable. A cyclical pick up is possible in the second half of 2023 if the forecasted U.S. recession is indeed shallow and not severe. Patience is needed. We are overweight on EM.

2.3 Alternatives

While gold came close to achieving a new historic high in early May and oil kept easing lower, another alternative asset class came to the fore. Investors have been focusing on U.S. commercial real estate (CRE) as it relies to a great extent on funding from regional banks, some of which are under heavy strain right now. We would like to stress a couple of important points with respect to U.S. CRE. One of the most troubled areas, much talked about these days, is the office sector, but it represents only a fraction (around a sixth) of the total value of real estate in the U.S. While it is the sector on which we are most negative, as we certainly prefer residential and logistics, we expect we have seen the worst of the downside in its valuation in part because we believe 10-year U.S. Treasury yields, the chief benchmark for this sector, have only limited upside potential from here (though more than the market is pricing in, according to our forecasts).

Gold

Gold remains an attractive safe haven given the recent banking turmoil and the continuing battle between elevated inflation and slowing economic growth. In fact, its price has also remained relatively stable after the Fed took rates up. While higher interest rates could remain a headwind near-term, we remain positive as several central banks are increasing their gold inventory. Furthermore, we expect more investor participation should global central banks slow the pace of rate hikes in 2023. In the medium to long term, the fundamental case for the metal remains intact as global economic uncertainty remains high. Additionally, gold could benefit should the U.S. dollar continue to weaken over the next 12-months, as we expect. As our target price is only set once per quarter we expect that the current target will be lifted during the next scheduled review.

Oil

There is a good chance that oil will recover its mid-April highs as energy commodities suffered a significant correction last week. However, this might take time to play out as the markets are primarily focused on the possibility of a U.S. recession which would offset positive demand trends out of Asia. Additional supply, from Nigeria and possibly Iraq, might cap any potential rebound in prices in the near-term.

3 / Past performance of major financial assets

Total return of major financial assets year-to-date and past month

4 / Tactical and strategic signals

The following exhibit depicts our short-term and long-term positioning.

4.4 Legend