Asset allocation and Sector Focus in Autumn 2024

Communications

The telecoms sector has benefitted from above-inflation price rises as many contracts are structured with Consumer Price Index + % increases, yet this will abate now as global inflation rates are falling. Rising debt costs remain a headwind as companies are forced to refinance at higher levels. Parts of the sector such as advertising are more cyclically exposed and would likely struggle if the economy slows into recession.

Consumer Discretionary

Inflation has been falling, but the performance of the sector is likely to continue to be driven by macro considerations, as it remains pinned to the economic cycle. The non-essential element of products/services makes them less resilient to a downswing. Because of the pandemic, businesses have been supported by excess consumer savings. With savings depleted, the risk of higher rates for longer looms over the sector, underpinning our underweight stance. 

Consumer Staples

Input costs have been a headwind for the sector; however, given abating inflation this should start to reduce. Pricing power has been resilient, while volumes are flat to negative. As consumers are more wary of budgets, growth will likely be suppressed as firms will be not able to rely on price as much. 2025 could provide a rebound in growth and it would remain wise to focus on the longer term.

Energy

Brent crude started the year at US$77 a barrel and saw prices rise to a peak of US$91 a barrel. Since then, prices have fallen back to near their beginning of the year level. The performance of the oil companies has broadly tracked this, and with oil prices back down from their mid-year highs we are less concerned with demand destruction now, therefore we retain our neutral recommendation. 

Financials - Banks

The prospects for US banks are muted by expectations that the US economy is about to cool off and that rates will fall. Lower interest rates put pressure on banks' net interest margins. Rate declines for UK banks are expected to be lower than in the US. With buoyant non-life insurance rates and the prospect of a soft landing, we retain a neutral on this sector.

Biopharma has performed better recently as the sector has proved resilient. Med tech performance has been more mixed, but procedures growth remains resilient as the sector continues to recover. Valuations have increased recently but we still see long-term value in the sector. Longer-term demand remains resilient, and the structural drivers associated with an ageing population are unchanged. The non-discretionary nature of healthcare means it typically proves defensive in downturns. 

Recently released first half results from industrial businesses were a little disappointing, demonstrating weak earnings delivery. Prior management guidance had suggested a recovery in demand weakness and destocking in the second half of 2024 in manufacturing, automation and life sciences, but recent management commentary pushed back these expectations largely into 2025. More generally we are seeing declining cyclical momentum in the global economy and so move industrials from overweight to neutral.

The artificial intelligence (AI)-driven performance of the sector in the first half of the year seems to be abating. Investors are beginning to question the immediacy of the AI tailwind. Valuations still look rich compared to historical multiples, and the sector is still driven by a handful of very large companies. The lack of margin for error provided by valuations and the increasing capital intensity of AI players drives our rating, yet we remain attracted to the sector longer term.

China is still the largest medium-term influence, although the press would have us believe that speculators are the strongest influence in the very short term. We don't think that China will support prices going forward. Longer term, the dynamics of the copper market and a possible bull move in the commodity super cycle remain supportive. 

2023 was a challenging year, due to persistent inflation and a 15-year high in interest rates. Volumes of commercial real estate transactions plummeted, as valuations fell with heightened borrowing costs. Imminent rate reductions should help stimulate activity. The market remains fragile, with risk of inflation reacceleration and delayed rate cuts, but on balance we believe an uptick in the real estate sector is due on the back of easy comparatives and an improving economic landscape. 

The UK water regulator OfWat released its draft determinations in July for the next regulatory period, AMP8. The allowances made fell short of the proposals made by water companies but were better than had been feared by the market. A key component of the UK’s energy transition will be reform of energy infrastructure, which should be supportive of earnings growth for UK power names. For this reason, we continue to have preference for power utilities.

UK

UK economic activity has been relatively strong, with Q2 2024 GDP growth of 0.6% and Purchasing Managers’ Index data better than expected. Elsewhere, conditions in the labour market remain buoyant and inflation continues to moderate. The Bank of England cut its base rate by 25 basis points (bps) to 5% in August and we expect further easing of monetary policy in the coming months. With resilience in the UK economy and relatively attractive valuations, we have a liking for domestically geared UK equities. 

North America

With recent economic data suggesting a downshift in activity in the second half of the year, and US inflation falling, it is likely that the Fed will start to ease monetary policy at its September meeting. Elsewhere there is evidence that the labour market is weakening and this, in conjunction with a downshift in manufacturing, highlights growing private sector caution. Whilst valuations remain elevated, earnings delivery is strong and easing financial conditions should be a tailwind for risk appetite.

Europe

The European Central Bank (ECB) cut its key policy rate by 25bps in June and is addressing the downside risk to growth over the stickiness of inflation. We expect moderate regional growth but are keeping a close eye on the downshift in manufacturing which we expect will support further ECB rate cuts. With European valuations favourable compared to historic averages and the US, we remain overweight. 

Japan

The Bank of Japan raised its key policy rate by 25bps at its July meeting, prompting a sharp rally in the Yen. This fed through to volatility in the Nikkei 225 and broader market contagion as investors who had borrowed cheaply in Yen to fund positions in global equities were forced to liquidate. Notwithstanding recent volatility, we continue to like Japanese equities on strong earnings delivery and corporate governance changes, which should enhance shareholder returns.

Asia Pacific

Asia Pacific revolves mainly around China, where incoming activity data remains disappointing. Whilst the People’s Bank of China (PBoC) has eased monetary policy to support consumer spending, we feel that more monetary and fiscal stimulus will be required. The PBoC has been reluctant to ease more because the Yuan is under pressure against the US dollar. With the Fed easing cycle likely to start in September we feel that easier monetary policy will follow. 

Emerging Markets

The prospect of lower US interest rates and a weaker US dollar have improved investor sentiment in emerging markets. Widening growth differentials with the developed world and the prospect of further monetary easing are the key reasons for our shift from underweight to neutral.