The Fixed income addition was split evenly between short-term US Treasuries and short-term US Investment Grade Corporate Bonds. To fund the shift, we eliminated our overweight in global natural resources equities. This reduced our Global Equity position from neutral to underweight 2% (excluding commodity-related industries, the equities position remains unchanged at 2% underweight).
Our Global Fixed Income weighting was raised from -1% to +1%. Our US Fixed Income overweight rose from +10.2% to +12.2%. Gold remains 2% overweight, with cash at 1% underweight.
With the Fed and other developed market central banks continuing to tighten, we see very weak GDP growth or recession ahead in 2023. In the US, this should result in modest employment declines and, at minimum, a small drop in corporate profits. Weaker inflation should help real incomes stabilize. However, there is low probability that the US economy can reaccelerate unless the Fed pivots quickly toward policies to preserve the expansion.
The severe price shocks in Europe and the likely central bank policy path in both the EU and UK point to a contraction there after a strong start for economic growth in early 2022. China is suffering from the aftermath of sharp policy tightening last year, but is now in the process of easing. While a growth recovery may be slower to gain traction, we look for a stronger gain for China’s economy in 2023.
Equity markets have changed course in the past two months with strong gains coming on the back of more stable bond yields and slightly weaker inflation. The communication of rapid central bank tightening – particularly from the Fed – had caused investors to expect recession in the first half 2022. However, the likelier timeframe for economic weakening has always been 2023 rather than this year. The now-inverted US yield curve has on average led US economic peaks by 10 months. For now, continued employment gains reflect rebounding production and inventory accumulation. However, these gains, along with a drop in housing, will weigh on economic growth in 2023.
The Fed has now raised short-duration yields high enough to suppress longer-term yields, giving us reason to add short-term bonds in portfolios. Prior to the yield rise at the front end of the curve, we had kept overweight bond weightings at intermediate- and long durations only, adding sharply over the past year. With short-term US Treasury yields at 3.2% and short-duration IG corporate yields near 4%, this low-volatility asset offers opportunity at very low risk.
To fund the addition, we removed our thematic overweight to global natural resources equities. While we see attractive dividends across industry segments, with shares also representing a valuable hedge against supply shocks, our risk posture no longer favors an outright overweight. These equities continue to be fully weighted in global benchmarks. We would prefer to maintain opportunistic overweight positions in narrow industry groups such as LNG and EV materials rather than petroleum.
Last month, we eliminated a position in Oilfield Services, which we also considered an inflation hedge. While the supply issues surrounding Russia and Ukraine have not been resolved, over the last four recessions, the energy and materials sectors (combined) posted an average peak-to-trough EPS decline of 86%. This was the largest decline among industry sectors.
Gold may also come under downward pressure as the Fed raises policy rates further, inflation decelerates, and the US dollar remains a beneficiary of global safe-haven flows. However, gold may benefit if and when the Fed pivots to easing. While this may take many months, the first signs of a US employment contraction could boost expectations of such a shift, benefiting safer bonds and gold.
We have maintained a focus on defensive, income-oriented equities through most of 2022, including both the sharp correction and the rebound of the past two months. In the year-to-date, these equities have outperformed. The severe weakening of US small cap shares (-32% at the low point) boosted our tactical returns as we are underweight. However, as small and mid-cap shares have bounced back, this has recently detracted from our performance.
Investor sentiment readings in the past few months have been acutely bearish. This is typically a contrarian positive indicator, suggesting defensive positioning. As we have always believed the lag between the Fed’s tightening and the impact on US economic growth would be sizable, the immediate panic over recession can fade. The world economy, however, cannot avoid an economic slowdown in the year ahead. As such, we believe it is premature for investors to discount an economic reacceleration before the full impact of economic slowing can be gauged.
That said, we do not suggest
market timing or wholesale liquidation of equities positions. The 17% rise in US large cap equities in the last 2 months (a GIC overweight) shows why. With our return outlook now dimmer over the 12-18 month tactical period ahead, we have simply shifted holdings to incorporate safer bond and dividend yield components while maintaining market exposure.
The period of rapid central bank tightening may generate a recession in the year ahead. It has already resulted in double-digit declines in both global equities and bonds for the first time in observable history during 1H 2022. While costly, these actions are also likely to set inflation on a decelerating path. Though we are concerned that US monetary policy actions will generate greater-than-necessary market volatility, containing inflation will yield economic benefits for long-term investors and the public. While too early for immediate action, we would expect to see greater potential opportunities in equities during the coming year.