Asset allocation and Sector Focus in Winter 2024

Communications

The communication services sector is broad but many of the large constituents are exposed to ad spend which in turn has exposure to the economic cycle. In the US, the probability of a recession seems lower now. Valuations in this sector look more stretched and the increased threat from AI technologies could exacerbate this.

Consumer Discretionary

Inflation has been falling, but the performance of the sector is likely to continue to be driven by sluggish macroeconomic data in Europe and China. The non-essential element of products/services has made them less resilient to a downswing. With consumer savings from the pandemic largely depleted, we nonetheless feel that further policy stimulus in Europe and China should support reasonable consumption growth in 2025 and with more attractive valuations we upgrade our view to neutral.

Consumer Staples

Input costs have been a headwind for the sector; however, given abating inflation, this should start to reduce. Non-discretionary demand provides defensiveness. We are seeing a divergence between over-and underperforming brands due to their ability to push through volume growth, as consumers are still wary of budgets, limiting the sector’s ability to push price increases. 2025 could provide a rebound in growth, and it would remain wise to focus on the longer term.

Energy

Brent started the quarter at U$87 per barrel, but has since fallen throughout the quarter. The UK oil majors broadly followed the oil price downwards whereas the US majors held up better relatively.  Looking forwards from current levels we see both upside and downside risk to supply. Risk to the upside comes from ongoing geopolitical risk in the Middle East; downside risk comes from the ability of supply taps to be turned on elsewhere. We therefore retain our neutral stance.

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 which is the difference between the rate that they lend at and what they pay depositors. 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 view on this sector.

Biopharma valuations have compressed recently. The appointment of RFK Jr as health secretary in the US introduces uncertainty in US policy outlook. Longer-term demand remains resilient, and the structural drivers associated with an ageing population are unchanged. However, considering the uncertainty triggered by the US election, we downgrade to neutral until there is more clarity.

The performance of industrials of late has picked up with some very early signs that demand weakness and destocking will recover in 2025 as has been guided. Nevertheless, earnings delivery remains quite weak relative to other sectors. G7 industrial production and manufacturing PMI data continue to be unimpressive, but with a strongly reflationary stance in the US and UK and further policy stimulus expected in China and Europe this leads us to believe the cycle will turn positive in 2025.

Performance has been choppy, however the election of Donald Trump has injected positive share price performance. Valuations still look rich compared to historical multiples. The sector is interest rate sensitive and remains driven by several very large companies. The lack of margin for error provided by valuations and the increasing capital intensity of AI players drives our shorter-term rating, yet we remain attracted to the sector longer term.

China remains the largest medium-term influence. The country looks set to undershoot prior expectations with regards to stimulus and without a property specific stimulus package, we struggle to see China being a short-term tailwind for the sector. Longer term, we continue to see the attractiveness of the copper market and a possible bull move in the commodity super cycle remains supportive. For the shorter term though, we struggle to see the sector outperforming considering a weak China outlook. 

High interest rates saw volumes of commercial real estate transactions plummet, as valuations fell with heightened borrowing costs. Recent rate reductions help to stimulate activity and investors to reduce their ‘risk off’ position. 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 quarter saw Thames Water's financial condition deteriorate, with its parent Kemble Water Finance defaulting on a bond payment. A key component of the UK’s energy transition will be reform of energy infrastructure, which should be supportive of asset base and earnings growth for UK power names. For this reason, we prefer power utilities, which have a more attractive regulatory and operating environment than water.

UK

The UK economy has been resilient this year, with both the service and manufacturing sectors in growth mode. The labour market has remained healthy and wage growth has been solid. Falling inflation has given the Bank of England ample cover to continue to ease monetary policy and we expect a measured pace of rate cuts next year. The recent budget contained a higher level of borrowing than was expected and a significant front-loaded boost to economic growth.  As a result, near term growth is likely to be firm.

North America

The US consumer has been remarkably resilient this year, supported by strong household balance sheets, strong wage growth and supportive fiscal and monetary policy. There have been periodic concerns about weakness in jobs growth but the pace of lay offs has been moderate and hiring intentions remain steady. Fed policy easing has been aggressive, but we expect the pace of rate cuts to slow in 2025, reflecting a policy adjustment to accommodate Donald Trump’s reflationary fiscal policy.

Europe

The European Central Bank (ECB) has continued its monetary easing policy as incoming activity data remains disappointing. The downshift in Chinese demand has been a particular challenge for the export sector and domestic vehicle production has faced considerable headwinds from Chinese competition. Looking into 2025, the prospect of US tariffs on all imports is a material concern for investors, and there will be increased pressure on the ECB to deliver further monetary policy stimulus. All points considered, we move to underweight for Europe. 

Japan

We expect Japan to sustain a cyclical upswing during 2025. This will be driven by a combination of positive real wage growth, the conclusive end to corrosive disinflation, and ongoing reform of the corporate sector. These are clear tailwinds to the growth outlook. We expect the Bank of Japan to increase interest rates moderately over the next year, in contrast to the other major central banks.

Asia Pacific

Recent monetary policy easing by the People’s Bank of China in addition to liquidity support for highly indebted local authorities are likely to foster a moderate upswing in economic activity as we head into 2025. However, the overhang of unsold inventories continues to put pressure on the broad real estate sector. Elsewhere in Asia Pacific however, with regional growth still solid and scope for central banks to ease policy from currently restrictive levels, we are more optimistic on the growth and earnings outlook ex-China.

Emerging Markets

Recent re-strengthening of the US dollar has been a short-term headwind for emerging markets. Much of the rally in the dollar which one would expect as a result of Trump’s proposed tariffs has already occurred and any disappointment on the sequencing or delivery of his policy agenda is likely to see a reversal of dollar strength.