Asset Allocation Focus in Spring 2023

Communications

We have seen a faster than expected unwind in digital demand from peak levels reached in Covid.  Competition in online media appears to be intensifying with high content spend set against a consumer that is seeking to trim expenditure. Online gaming spend is expected to moderate as player engagement reduces. Digital advertising spend is also contracting as advertisers are reducing ad budgets on macroeconomic slowdown concerns. The telecommunications sub-sector may prove more resilient, helped by inflation-linked contract price rises, but represents a small weighting overall.

Consumer Discretionary

Consumers still have excess savings built up but these appear to be shrinking as high levels of inflation have undermined spending power. Consumer sentiment is weak by historic standards and recent noise of corporate cost cutting, including job cuts, is expected to weaken confidence ahead. The cost of living crisis is squeezing disposable income  with higher necessary outlays on food and energy taking a bite out of consumer discretionary spend. Additionally, higher interest rates are pushing up mortgage and rental costs in addition to the cost of unsecured borrowing which is discouraging credit card spend.

Consumer Staples

Consumer Staples businesses tend to be of high quality and are less sensitive to the economic cycle, given the necessity of their goods. Sector valuations look fair and whilst the sector faces rising cost inflation, we have seen evidence of inflation pass-through to customers. The deteriorating macroeconomic backdrop is of concern, so focus more on the earnings resilience of the sector.

Energy

Longer term environmental considerations have dissipated as the geopolitical situation has forced investors to focus on short term supply in a world where Russia faces constraints on its exports of oil and gas. Economic uncertainty has increased and with energy prices heavily correlated to GDP, we are less positive on the sector. Capital returns to shareholders should nonetheless remain strong.

Financials - Banks

The balancing act with banks is to understand the negative driver of higher credit losses into a recession vs. the prospect of greater net interest margin expansion. The former, credit losses, are to a degree budgeted for with more than generous provisions. And whilst interest rates look to be peaking, there are likely to be a few more hikes in store, leaving us with a net positive view for this sector, within the near-term.

This sector includes a very broad range of stocks and is generally geared to the investment markets. On balance we are positively disposed to this sector so long as a recession continues to be avoided.

We are positive on life insurance as higher rates drive long term liabilities lower and increase prospective returns. General insurance does better on higher rates helping cash deposits perform better, but also appears to be benefitting from stronger insurance pricing.

Demographic tailwinds and the relative resilience of global healthcare spend mean this is a sector that offers growth and defensive attributes. We distinguish between biotech, life sciences, medical technology and pharma sub-sectors. We continue to think pharmaceutical and medical technology companies can exhibit good relative earnings growth at undemanding valuations.

Geopolitical uncertainty has benefitted the earnings outlook for defence exposed names yet a higher proportion of companies have more economically sensitive industrial end-markets. We are cognisant that industrial demand can turn quickly, particularly with order book visibility typically less than a year. 

We take some confidence from the relative economic resilience of many technology names, whose products/services are increasingly viewed as non-discretionary by consumers and businesses alike.  We do however believe the valuation will be the bigger driver of performance within the near-term. We remain concerned that higher inflation will persist given the sensitivity of the sector to interest rates, we believe it prudent to be underweight.

The short term outlook is uncertain as backward looking Chinese data is still weak however the markets have rallied on Chinese reopening optimism. Balance sheets remain strong so any weakness could be weathered better than previously. Longer term we remain bullish on energy transition metals but flag short term weakness.

The rise in interest rates is now feeding through to valuations so yields are rising which is offsetting any growth in rental income, as a result of inflation-linked leases. 

The sector is typically defensive and has inflation protection built into regulatory models, which should protect companies from input cost increases and margin pressure. 

UK

UK equities offer greater valuation opportunities versus overseas equities and seem historically undervalued in the context of higher interest rates; a contrast to US equities. The UK is more exposed to Financials that benefit from rising rates because of widening differentials between lending and deposit rates and, Energy & Materials, which are viewed as better insulators during inflationary times. Political risks have reduced and markets have appreciated the more fiscally responsible approach. We expect headline inflation to fall as UK consumers are rate sensitive due to shorter term fixed rate mortgages.

North America

Equities look relatively expensive and higher interest rates could place greater strain on valuations.  We remain concerned by the overvaluation of the dollar which, if weakened, could prove painful for UK investors. The US consumer has proved resilient and employment has been strong.  Good news for the economy is bad news for the Federal Reserve, who might be required to hike interest rates, which could place greater strain on the growth orientated US market.

Europe

Sentiment has been weak for a prolonged period and equities are under-owned. This might ease: Europe rebuilt gas reserves to avert a crisis and with energy security a key political priority, easing energy prices should prove economically supportive. Monetary policy is tightening gradually and the labour market has spare capacity. Rates should peak at a lower point to reflect Europe’s softer growth trajectory.

Japan

We hoped weakness in the Yen would revive exporters yet Japanese manufacturing output has shifted into contractionary territory making us more cautious ahead. Moreover, the Bank of Japan has eased up on their yield curve control policy and their appetite to continue such accommodative conditions looks to be moderating.

Asia Pacific

Geopolitical flashpoints between the West and East remain high. Western military support for Ukraine continues to expand and tensions between the US and China have re-flared. We view companies having to re-evaluate their supply chain exposures as a multi-year theme and expect diversification of supply chains outside of China into Asia Pacific, which should be a net positive for the region. 

Emerging Markets

Equity valuations look cheap relative to developed markets but central banks have tightened policy ahead of developed markets and, with global growth slowing corporate earnings could prove more vulnerable.

Conventional

A rising yield environment tends to push down bond prices but we are adding to short dated government bonds as yields rise because newly issued bonds have to offer up higher coupons to encourage investors in. 

Corporate

With spreads on government bonds having moved tighter we think the risk/reward trade-off has become less favourable as firms have indicated they are finding it more challenging to access credit.

Index Linked

With a positive real return they are necessary protection against inflation. If inflation proves stickier over the medium term, inflation-linked bonds should receive higher inflation returns.

Cash

We have been deploying cash to expand our UK equity overweight and reduce our government bond and corporate bond underweights to reflect the rising yields available on those fixed income instruments.

Property

Moved to underweight on concerns that high levels of inflation push up the need for higher interest rates, hurting near term capital values of property assets as financing becomes more expensive. 

Alternatives

We are seeking less correlated opportunities and more market neutral hedge fund investments. We allocate to gold as a diversifier, inflation hedge and as a way to reduce currency debasement risk.