Asset Allocation Focus in Summer 2023

Communications

We have seen a faster than expected unwind in digital demand from peak levels reached during COVID-19. Online gaming spend is expected to moderate as player engagement reduces. Digital advertising spend is also contracting. The telecommunications sub-sector may prove more resilient, but represents a small weighting over the overall sector.

Consumer Discretionary

Consumer sentiment is weak. The cost of living crisis is squeezing disposable income, with higher necessary outlays on food and cost of energy hitting discretionary spend. 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

Sector valuations look fair. Whilst the sector faces rising input cost inflation, which has hurt gross margins, we have seen evidence of inflation passing through to customers. Rising bond yields have the potential to hurt valuation multiples, but the deteriorating macroeconomic backdrop is of more concern, so focus is more on the earnings resilience of the sector.

Energy

Investors are focussed on short term supply as Russia faces ongoing constraints on its exports of oil and gas. Economic uncertainty has increased during the year, and with energy prices heavily correlated to GDP, we are now less constructive on the performance of the sector. Capital returns to shareholders should nonetheless remain strong. 

Financials - Banks

The fear of contagion from the succession of bank failures seen earlier this year has diminished, which leaves us once more with the balancing act of understanding the negative drivers of higher credit losses into an economic slowdown versus  the prospect of more persistently high interest margins. Interest rates look to be close to peaking, leaving us with a near-term net positive view for this sector.

We change our stance to neutral in light of higher inflation and interest rates, which we expect to dampen financial assets.

Normally, life insurance performs better with higher interest rates as long-term liabilities are lowered and prospective fixed income investment returns increase. The yield curve is currently inverted, meaning investment returns are lower. General insurance also appears to be benefiting from stronger insurance pricing, leaving us neutral on this sector.

The resilience of global healthcare spend means this sector offers growth and defensive attributes. The sector has outperformed over the past year, and should continue to, as pharmaceutical and medical technology companies exhibit good relative earnings growth at reasonable valuations.

Geopolitical uncertainty has benefited the earnings outlook for defence exposed names. Yet, a higher proportion of companies have more cyclically exposed industrial end markets, and these firms have held up better than expected. Recent earnings results confirm a strong industrial backdrop, resulting in our more positive view on the sector.

Many technology names are increasingly viewed as non-discretionary, however valuation will be the bigger short-term driver of performance. The recent sector rally means valuations are elevated. Higher levels of inflation could persist and many expect to see further interest rate hikes. Given the sensitivity of the sector to interest rates, we believe it prudent to be positioned underweight. 

The short-term outlook is very uncertain, however the markets have rallied on Chinese reopening optimism. At company level, balance sheets remain strong. Longer term, we remain bullish on energy transition metals, e.g. copper, but flag short term weakness. The neutral rating is driven by the expectation of strong dividends.

The rise in interest rates is now feeding through to valuations. As rates rise, so do property yields and this is offsetting any growth in rental income as a result of inflation-linked leases. It seems likely there will be further valuation declines to come, although much of this has already been priced in, hence our neutral stance. 

The sector has inflation protection built into regulatory models, which should protect companies from input cost increases and margin pressure. Yet we are cognizant of the bond proxy nature of the sector and, with the uncertainty surrounding interest rates, remain neutral and would want to see peak rates before becoming more positive. 

UK

The UK market appears cheap. Recent bids and moves to US listings endorse that view. That can be explained by political concerns and higher inflation, together with fundamentals pointing to slower relative growth. A lack of risk capital from pension funds has not helped. But even with those considerations, the UK’s rating makes it attractively valued as sentiment recovers from the Truss discount and perceived Brexit risk. 

North America

The American market looks expensive; added to which it is probably most exposed to a potential risk of a US debt default. Debt ceilings and default aside, the jury is still out on whether a recession is likely. There also remains a lingering bank crisis risk and well publicised concerns surrounding American commercial real estate.

Europe

Europe rebuilt gas reserves to avert a crisis, and so easing energy prices should be economically supportive. Monetary policy is tightening gradually and the labour market has spare capacity, which means that rates should peak at a lower point. This would be helpful for the continent, as should Europe’s relatively benign political environment, its more pronounced exposure to China’s reopening, and reshoring trend in the  manufacturing industry. 

Japan

Japanese equities have rallied and we have downgraded to UW from neutral. Japanese equities would suffer from their higher bank and manufacturing exposures in a global downturn. The suppression of interest rates by the central bank leads us to expect more JPY weakness, although this could change if wage inflation and higher rates surface as a concern. 

Asia Pacific

Companies reevaluating their supply chain exposures and diversifying away from Chinese concentration into other Asian countries should be positive for the region. Longer term, Asia is home to some of the fastest growing economies in the world, such as India, China and Indonesia. 

Emerging Markets

Equity valuations look cheap relative to developed markets. Central banks have tightened policy ahead of developed markets and should be first into a recession. With global growth slowing, corporate earnings could prove more vulnerable. A strong USD (normally associated with economic downturns) would be a headwind for emerging markets.

Conventional

A rising yield environment pushes down bond prices, although we are starting to like the high yields available in short-dated government bonds.  

Corporate

Spreads of corporate bonds over government bond equivalents have stabilised at a point where they are unlikely to discount the effects of an economic slowdown. High yield bonds could do well if inflation drives revenues higher in an environment where central bankers show a weak response to higher inflation. 

Index Linked

With a positive real return, linkers are once more a valid protection against inflation. If inflation proves stickier over the medium term, shorter dated inflation-linked bonds should do well. 

Cash

Cash could be deployed to increase UK equity exposure and reduce government bond and corporate bond allocation to reflect the rising yields available on those fixed income instruments.

Property

There are concerns that high levels of inflation could push up the need for higher interest rates, hurting near term capital values of property assets as financing become more expensive. 

Alternatives

Less correlated opportunities and more market neutral hedge fund investments could be sought after, such as gold. We allocate to gold as a diversifier, inflation hedge and way to reduce currency debasement risk.