Newsletter | March 2023
MARKETS WERE IMPACTED BY A REPRICING OF POLICY RATES IN FEBRUARY
4% THE EXPECTED PEAK LEVEL OF THE ECB’S KEY RATE
Investment perspective
The early-year optimism in financial markets gave way to renewed concerns over inflation and even tighter monetary policies, triggering a significant drop of bond markets. As often observed in 2022, the volatility in bond markets rose noticeably and impacted the momentum of other asset classes. The yields of 10-year Treasuries ended the month 41bps higher at 3.92% with those of Bunds with a similar maturity climbing by 37bps to 2.65%. While European equity markets proved to be resilient, as the Euro Stoxx 50 Index edged 1.8% higher, emerging market and US ones gave back a large portion of their January gains; the MSCI EM Index fell by 6.5% and the S&P 500 Index lost 2.6%. In this context, the US dollar benefited from the widening of the interest rate differential between Treasuries and Bunds, and from its safe haven status, to record a solid performance against other major currencies. A strong dollar and higher real interest rates meant that gold saw its early-year gains being erased, while other commodity prices also dropped.
Early-year market confidence over the decline of inflation appears to have been replaced by concerns that it will be more sticky and remain higher for longer than previously anticipated. This change of outlook was triggered by the publication of inflation data which was above forecasts, on both sides of the Atlantic, and was reflected by the steep rise of inflation expectations. The correction of bond markets in February means that they are more closely aligned now with the outlooks of the Federal Reserve and the ECB, with an implicit admission that policy rates will end up at much higher peak levels than previously expected. Markets are now pricing in peak policy rates of 5.5% in the US and 4% in the Eurozone, compared to January 2023 lows for peak rates of 4.7% and 3.05% respectively.
Investment strategy
We maintained our defensive asset allocation in February. Thanks to an underweight allocation towards equities and a low duration of the fixed income exposure, the drawdown of portfolios was not too deep. In last month’s newsletter, we had reiterated our scepticism about the markets’ optimistic outlook over a pivot by the Fed in the second half of 2023 and were therefore not surprised by the retreat of equity markets in view of rising bond yields. We believe that equity risk premiums are not attractive at this stage, leading us to remain cautious, especially in view of concerns over profit margins and the path of earnings.
We are closely observing the level of European bond yields as we are approaching a point where we would likely increase the duration of the portfolios. The latest developments in bond markets also mean that the recent appreciation of the US dollar has stalled. As we did not reach our first target on the EUR/USD parity, we have not yet reduced our dollar exposure for non-USD denominated portfolios.
INVESTORS HAVE BACKTRACKED FROM THEIR OPTIMISTIC STANCE OVER TERMINAL RATES
Portfolio Activity/ News
February was a negative month for the portfolios as both the equity and fixed income asset classes were detractors, while hedge funds produced only a marginal positive contribution. For non-USD denominated portfolios, the appreciation of the dollar provided a welcome positive contribution. Some of January’s best performing funds fared the worst during the month under review; the metal mining fund and Chinese equities were the largest equity detractors, whereas emerging market corporate bonds and the long duration investment-grade fund were the biggest fixed income ones. European Value and cyclical equities provided the best contributions within the equity asset class and the short duration European high yield fund generated the only positive fixed income contribution.
In February two new funds were approved by our investment committee. The first one runs a systematic Global Macro strategy based on fundamental and price-based indicators. The fund combines carry, fundamental, trend-following and value/reversion strategies, and displays a remarkable track-record over an extended number of years. The second fund is a concentrated US Value fund, which seeks to invest into great businesses trading at a “bargain”. Since its inception in 2008, the strategy has outperformed both its Value bench-mark and the broader S&P 500 Index.
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Newsletter | February 2023
MARKETS MAKE A STRONG START TO THE NEW YEAR
+ 10.7% THE JANUARY RISE OF THE NASDAQ COMPOSITE INDEX
Investment perspective
Financial markets got off to a very positive start in 2023 as investors took the view that the likelihood of a soft landing was rising despite the hawkish tone from the Federal Reserve and the European Central Bank. In this risk-on environment, the vast majority of equity markets posted above-average monthly gains, long-term bond yields decreased, credit spreads tightened, and the US dollar continued to depreciate. The MSCI World index in local currencies climbed by 6.4%, with the Euro Stoxx 50 index rising by 9.7% and the Hang Seng index by 10.4%. The yield on the 10-year Treasury note dropped by 36bps to 3.51%, with US and European high yield credit spreads contracting by 49bps and 68bps respectively. Other strong gains were also observed on industrial metals, as a result of the anticipation of renewed demand from China, and on the price of gold. Maybe a little surprisingly, oil prices ended the month lower, despite the boost from the reopening of China, while gas prices continued to slide at a fast pace.
At the time of writing, the Federal Reserve has just hiked its Fed fund rate by 0.25%, as fully anticipated. The more relevant outcome of the FOMC meeting were the comments by the Fed’s chair, Jerome Powell, on the future path of the Fed’s policy. Powell repeated that more rate increases were needed and that rate cuts in the second half of the year were unlikely. This goes against markets’ expectations for two rate cuts by the end of 2023. What was more surprising was that Powell did not push back more against the recent easing of financial conditions, leading markets to extend their early-year rally, with equities ending the trading session higher and bond yields declining. The ECB and the Bank of England also matched market expectations by hiking interest rates by 0.5%. The ECB signaled its intention to raise interest rates by another 0.5% in March and will then evaluate its policy depending on data. As was the case after the Fed’s decision, markets are continuing to rally, with bond yields dropping quite noticeably.
Investment strategy
At the onset of 2023, our asset allocation is composed of an underweight equity exposure, an allocation to fixed income which is close to neutral and an overweight exposure to hedge funds. Taking account of the strong performance of equities in January, we are sticking to this asset mix for the time being. We fear that markets could be overconfident in their dovish outlook relative to monetary policies and to the path of earnings. With bonds offering positive yields once again, we believe that it makes sense to hold more balanced portfolios and no longer to rely just on the equity asset class to generate portfolio performance. It is also reassuring that the current valuations of some of the traditional assets offer a better starting point for future portfolio returns than a year ago, when only a few of them could be considered cheap. Global value stocks, emerging and European equities, as well as investment grade credit are some of the assets that offer attractive valuations.
For non-USD denominated portfolios, our allocation to the US dollar remains underweight but we prefer to wait before reducing it further. From a medium to long-term perspective we would expect the dollar to depreciate but it continues to offer defensive qualities were markets to turn.
MARKETS INCREASINGLY POSITIONING FOR A SOFT LANDING SCENARIO
Portfolio Activity/ News
January was a strong month for the portfolios. With both bond and equity markets rising simultaneously, the majority of funds contributed to the performance, as to be expected. European Value equities, the metal mining fund, the global technology fund, Chinese equities, and the US Value fund provided the best contributions within the equity asset class. The only equity detractor was the healthcare fund, as the more defensive sectors such as healthcare, consumer staples and utilities ended the month lower. The best performers in the fixed income asset class were emerging market corporate bonds and the long duration investment-grade fund. In the alternative space, the Global Macro fund provided the best contribution, whereas one of the long/short equity funds, with a barely positive net exposure currently, ended the month with a small loss. The other hedge funds provided only marginal contributions.
Following a tough year for many strategies, we are confident that active managers will be able to generate more alpha in 2023. We would expect market dispersion to be high and to represent a favourable environment for good stock pickers. This extensive dispersion should also be helpful for hedge fund managers, and we are comfortable with our overweight exposure to these alternative strategies.
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Investment Perspectives 2023
Executive Summary
2022 was one of the most challenging years ever for investors
The past year was a brutal one for investors. The tightening of monetary policies was not a surprise, but it proved to be far more pronounced and damaging than anticipated for many asset classes. This fast-paced tightening of monetary policies, due to ongoing inflation pressures, and the war in Ukraine were the main drivers for the significant weakness of markets. China’s zero-COVID policy provided another headwind as its economy fared much worse than forecast. In a risk-off environment, there was hardly anywhere to hide, and this was reflected by the dreadful performance of US Treasuries, considered to be amongst the safest of assets. Volatility in the bond markets reached crisis levels and remained very elevated for most of the year. This stress spilled over to the other asset classes, and the high level of correlation between equities and bonds meant that diversification failed to protect well against portfolio losses.
The breath-taking speed of the Federal Reserve’s monetary policy tightening
2022 will be remembered as the year when the era of extremely accommodative monetary policies finally came to an end. Since the great financial crisis, the major central banks had lowered interest rates to zero, or even into negative territory. Investors had been expecting interest rates to rise and central banks’ balance sheets to contract in 2022, but they were not prepared for what took place effectively. The Federal Reserve’s shift from a very accommodative monetary policy to a very restrictive one took place in a matter of months only, as the size of rate increases quickly rose from 0.25% in March to 0.75% at four consecutive FOMC meetings between June and November. The US central bank hiked its rates by a total of 4.25% in 2022 to a range of 4.25% to 4.50%, with other major central banks taking a similar path, even if not at the same pace. The latest interest rate decisions and communications from the main central banks have confirmed their hawkish stance and determination to bring down inflation.
Investors will remain focused on inflation trends and geopolitics
GDP growth is expected to slow in 2023, with a high risk that the global economy could slide into recession as growth expectations for the United States and Europe are very low or negative. Much will depend on the pace of deceleration of inflation and the trajectory of interest rate increases. The task of central banks around the world is extremely challenging and the risks of a damaging policy mistake are much higher than average. Economic prospects could be boosted if China finally manages to reopen its economy successfully. Geopolitical threats remain elevated. There are many sources of tensions across the world, but one cannot exclude the possibility of some unexpected positive developments even if we are not holding our breath.
Amid elevated uncertainty we maintain a cautious asset allocation
The tightening of monetary policies has erased some of the markets’ distortions and excesses of the previous years, meaning that fundamentals should matter more now that the era of easy money has come to an end. Valuations have improved for most asset classes, but uncertainty remains prevalent on many issues. Despite last year’s derating, equities still face headwinds. That largely explains why we have maintained our overweight allocation to alternative strategies and have increased our fixed income exposure recently in view of its improved risk/return profile.
Table of contents
- EXECUTIVE SUMMARY
- 2022: REVIEW OF OUR INVESTMENT THEMES
- 2022: ECONOMIC & POLITICAL DEVELOPMENTS
- 2022: THE FINANCIAL MARKETS
- 2023: ECONOMIC OUTLOOK
- 2023: FINANCIAL MARKETS' OUTLOOK
- 2023: ASSET ALLOCATION
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Newsletter | December 2022
THE DOLLAR INDEX HAD ITS WORST MONTH SINCE 2010
+ 26.6% THE REBOUND OF THE HANG SENG INDEX IN NOVEMBER
Investment perspective
November was a strong month for capital markets, as both equities and bonds performed well. For once, emerging markets’ equities outperformed those of developed ones; Chinese equities rallied massively due to a dramatic shift of investor sentiment in the wake of the end of October selloff. The MSCI EM index climbed by 14.6%, compared to a 5.5% gain for the MSCI World index in local currencies, whereas the Euro Stoxx 50 index gained 9.6%. These equity gains were accompanied by another negative month for the US dollar; the 5% monthly drop of the dollar index was effectively its worst since September 2010, and this move contributed significantly to the overall improved market sentiment. The decline of long-term bond yields was another supporting factor for risk assets; the yields of 10-year Treasuries and Bunds declined by 44bps and 21bps to 3.61% and 1.93%, respectively, resulting in increasingly inverted yield curves. Credit and emerging market debt spreads continued to contract at a fast pace. Significant moves were observed in the commodity space also, with the price of gold rising strongly whereas oil prices dropped by more than 6% on concerns about weaker demand.
As in October, one of the drivers for the stronger markets was the narrative that the Federal Reserve was likely to slow the pace of its interest rate hikes. The US central bank is widely expected to rise rates by 50bps at its December meeting following a string of 75bps increases. The fact that the latest inflation data in the US have been below expectations has contributed to the market’s optimism relative to the path of the Fed’s policy. The market could, however, be at risk of underestimating the terminal Fed fund rate in view of the very resilient job markets, and the fact that the Fed will want to avoid making a mistake by ending its hiking cycle prematurely.
Investment strategy
The recent rebound of equity markets has obviously been most welcome for the portfolios, but we are reluctant to add to our current equity allocation and we maintain our modest underweight positioning. In our opinion, markets could be overconfident that central banks will soon be ending their hiking cycle. The upcoming economic slowdown could also be accompanied by a declining growth of earnings, as margins contract from record highs, hence our caution.
On the other hand, we think that bond markets offer a more attractive risk/reward at present, and we will be increasing some of our exposures. Investment-grade credit, and funds having the flexibility to manage both duration and credit quality are our current top picks. These funds can allocate to some of the more attractive segments of the bond markets, in areas such as subordinated bonds of investment-grade companies, corporate credit and financials, and corporate hybrids.
MARKETS ARE AT RISK OF UNDERESTIMATING THE TERMINAL FED FUND RATE
Portfolio Activity/ News
November was a positive month for the portfolios thanks to the strong returns of equities and also of bond markets. The best contributions were provided by Chinese and emerging equities, metal mining companies, the European value fund, emerging market corporate bonds, the technology fund and long duration investment-grade bonds. For portfolios with an exposure into gold, it proved to be a rewarding month as the precious metal climbed by 8.3%, as it benefited from lower real bond yields and the weaker dollar. The number of detractors was low. The depreciation of the dollar hurt portfolios not denominated in USD, as did the drop of the trend following CTA strategy, US small caps and the multi-thematic fund.
We were pleased to observe the massive rebound of our Chinese equity fund in November. In last month’s newsletter, we had highlighted why we believed it still made sense to be exposed to Chinese equities, and the recent upside move just shows how difficult it can be to predict trends. It also shows how sentiment is continuing to drive the markets, with the shift in China’s Covid stance towards a loosening of some restrictions contributing to boost market sentiment.
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Newsletter | November 2022
DEVELOPED MARKETS’ EQUITIES REBOUND BUT INVESTORS DUMP CHINESE EQUITIES
+ 7.1% THE PERFORMANCE OF THE MSCI WORLD IN OCTOBER
Investment perspective
Following a dreadful September, the month of October provided much welcome relief for investors thanks to a rebound of developed markets’ equities. One of the main drivers for this rally was the perception that key central banks might be getting closer to slowing the pace of their rate hikes following the decisions by the Bank of Canada and the Reserve Bank of Australia to raise interest rates by less than expected. The rise of equities was accompanied by a pause of the US dollar rally, tighter credit spreads, and an upwards move of the US yield curve. A significant underperformance of emerging market equities was also observed, as they recorded a monthly drop, largely as a result of Chinese equities plunging further from already depressed levels. In terms of investment style, Value outperformed Growth, and energy was the best performing sector, supported by rising oil prices. October also provided a much needed return to calm for UK assets after the replacement of Liz Truss, who became the shortest serving UK prime minister, by the former chancellor Rishi Sunak. The UK yield curve shifted down materially, with 2-year and 10-year Gilt yields dropping by 95bps and 58bps, respectively, whereas the pound recovered some of its recent losses.
With more than 80% of the S&P 500’s market cap having reported, earnings have beaten estimates by 3.6%, with 66% of companies topping projections. Earnings per share growth is on pace for 5.9%, assuming the current beat rate for the rest of the season. Even if the beat rate was inferior to those of the previous quarters, amid lowered earnings’ expectations, companies’ results proved to be supportive for equity markets overall. What was quite striking was that equity markets continued to rise even if the share prices of some of the US mega-caps, including Amazon, Alphabet, Microsoft and Meta, were badly hit by a set of disappointing reportings.
Investment strategy
At the time of writing this newsletter, the Federal Reserve has just announced another 75bps rate hike, as expected by the markets. What was less anticipated was the tone of Jay Powell’s press conference; equity markets had been rallying on the assumption that the Fed could be approaching the end of its hiking cycle and could even cut rates next year. Fed chair Powell made it clear that the US central bank still had work to do, and that real interest rates had to turn positive, implying that markets’ expectations were too optimistic in relation to future Fed fund rates. We were not in the camp expecting the Fed to turn more dovish, and this explains why we had not increased our equity exposure. In reason of the deterioration of the global economy, restrictive monetary policies, and a risk of further earnings’ downgrades, we have maintained our equity underweight.
It has been a disappointing month for Chinese equities, but we continue to believe that an exposure to the country still makes sense despite the ongoing headwinds. Overly cheap valuations, a significantly underweight positioning by foreign investors, and the prospect of some policy support are just some of the main reasons why we remain invested.
MARKETS HAD PINNED THEIR HOPES ON MORE DOVISH CENTRAL BANKS ONCE AGAIN
Portfolio Activity/ News
October was a positive month for the portfolios thanks to the rebound of developed markets’ equities. US and European Value funds, metal mining equities, the Healthcare fund, and US small caps provided the best contributions. The positive return of portfolios was, however, dented severely by the exposure to Chinese equities, and to those of emerging and frontier markets. The overall contribution of fixed-income was negative due to the declines of emerging market debt and the long duration investment-grade fund, even if convertible bonds did provide some positive returns. The overall contribution of the alternative exposure was neutral, with the recently added L/S US small cap fund continuing to perform well. For portfolios not denominated in USD, the depreciation of the US dollar was a detractor.
In October, we added a high yield bond fund to our list of approved funds. The particularity of this fund is that it is managed based on a fixed maturity approach, with the fund ending at the end of 2026. This means that all the underlying bonds will have maturities with a maximum of six months longer than the end of 2026.This approach is more defensive than a traditional bond fund, as risk factors such as credit risk, duration and volatility, decrease over time. We believe that the next months could provide a good entry point for the strategy, if credit spreads were to widen more.
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Newsletter | October 2022
MARKETS BATTERED BY INFLATION AND HAWKISH CENTRAL BANKS
1.033 THE BRITISH POUND PLUNGES TO A RECORD LOW AGAINST THE DOLLAR
Investment perspective
The early-month optimism of investors in September quickly gave way to severe market angst due to higher-than-expected inflation data and hawkish central banks. In a scenario often observed this year, yield curves moved up materially and equity markets tanked. The Local Currency MSCI World Index plunged by 8.5%, with US and EM equities underperforming and European ones faring somewhat better. The rise of bond yields was steep, and key bond indices dropped between 3% and 5%; 2-year Treasury yields climbed by 76bps to end September at 4.2%, with 10-year ones rising by 64bps to 3.8% after briefly breaching 4%. The moves on UK sovereign debt proved to be even more dramatic; 2-year and 10-year Gilt yields jumped by 122bps and 129bps, respectively, as markets reacted poorly to new UK government tax policies. The appreciation of the US dollar accelerated during the month, with the Japanese yen and the British pound finding themselves under particularly acute selling pressure; for the first time since 1998, Japan intervened in the currency market to support its currency, and it took an emergency statement by the Bank of England to help the pound to recover some of its losses.
As expected, the Federal Reserve hiked interest rates by 75bps in September to a 3%-3.25% range. The bank’s Chair Jerome Powell also delivered a more hawkish message, leaving little doubt that more outsized hikes would be announced at the upcoming meetings, leading to an end-2022 rate of 4.5%. The ECB also increased rates by 75bps last month, at the high end of market forecasts. The ECB is currently widely expected to rise rates by another 1.25% by the end of the year to a level of 2%. Markets are now anticipating the ECB’s policy rate to be increased to around 3% in 2023, a significant ramp up of expectations compared to only a few weeks ago.
Investment strategy
Following the reduction of our equity positioning last month, we did not change our asset allocation in September, with both equity and fixed-income asset classes remaining under-weight. In contrast, the exposure to alternative strategies is overweight and has contributed to limit some of the market volatility, and to preserve capital in these challenging market conditions. Our assessment is that markets are still struggling to correctly price in the path of monetary tightening, and the instability of bond markets continues to negatively impact all the other asset classes. The ongoing strength of the US dollar is another factor which is preventing any significant rebound of equity markets. In view of the extreme level of uncertainty on key issues, including geopolitical risks, rising interest rates, inflation, currencies and Chinese economic growth, visibility is extremely low, and forecasts are of little help.
In this environment, we try to filter out the short-term noise and prefer to invest over the long term, and not attempt to time the market. We continue to believe that well-diversified portfolios are the best way to navigate in the current market environment.
MARKET VOLATILITY IS LIKELY TO REMAIN HIGH IN THE NEAR TERM
Portfolio Activity/ News
September was a brutal month for portfolios as both bonds and equities recorded steep losses. Alternative strategies outperformed long-only exposures significantly and, for portfolios not denominated in USD, the US dollar exposure was a positive contributor. The trend-following CTA strategy provided the unique positive contribution while other hedge funds were either flat or only marginally negative. The main detractors were the real assets fund, badly hurt by higher bond yields, Chinese and EM equities, the global technology fund, as well as various Value funds. In the fixed-income space, investment grade sovereign debt funds with a longer duration and EM bonds fared the worst, whereas credit funds with some flexibility managed to outperform their reference benchmarks strongly and to limit the impact of pronounced market drawdowns.
In September, we cut one of our Japanese exposures due to a risk management measure in view of the fund’s declining assets. For some portfolios, we replaced this position by a newly-approved long/short fund focused on US small and mid caps. This fund has a very limited net long exposure and has low levels of beta and correlation with the market. At a time when equity markets are very volatile, and dispersion is wide, this kind of strategy offers a differentiated source of performance and diversification within the portfolios.
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Newsletter | September 2022
FED CHAIR POWELL CUTS HOPES FOR AN EARLY PIVOT TO RATE CUTS
3.9% THE EXPECTED PEAK LEVEL OF THE FED’S POLICY RATE HAS CLIMBED AGAIN
Investment perspective
The positive sentiment observed in markets since mid-June ended in the middle of August. Equity markets were resilient to rising bond yields intially, but then gave back all of their gains to end the month much lower; the MSCI World Index in local currencies dropped by 3.6%, with European equities underperforming and EM ones holding up better. The rise of bond yields was steep, with European sovereign debt being the most negatively impacted; 2-year Bund yields climbed by 92bps to end August at 1.18%, with 10-year ones rising by 72bps. The size of these moves was reflected by the 4.9% monthly drop of the Euro Broad Investment-Grade Index, dragging it down to a year-to-date decline of 12.9%. The high correlation between bond and equity markets remains entrenched and the comments by Jerome Powell at Jackson Hole only reinforced this relationship. The month of August also saw the US dollar appreciate strongly, as investors turned to one of the only remaining safe haven assets.
Jerome Powell’s Jackson Hole speech was eagerly awaited by investors. The Fed chair spoke for less than ten minutes but that was long enough to trigger a significant fall of equity markets as the S&P 500 Index lost 3.4%. Powell emphasised the central bank’s resolve to hike interest rates to curb inflation. He said that the Fed “must keep at it until the job is done” and that this would bring “some pain to households and businesses”. He pushed back against the notion of raising rates and cutting them soon afterwards. Investors are also bracing themselves for a more hawkish European Central Bank. The ECB is widely expected to raise rates by a half percentage point at its next policy meeting on September 8, with some policymakers even pushing for a more aggressive move to raise rates by 0.75%.
Investment strategy
During our last investment committee, we decided to reduce our equity allocation to underweight. The strong summer rally of equities provided an opportunity to exit some of our positions at higher prices, with the objective to raise the level of cash and to contain some of the portfolios’ volatility. We have mostly, but not exclusively, acted on European positions as Europe remains the most fragile region. The energy crisis, inflation pressures and the increasing risk of a recession have led us to turn more cautious, especially as the recent rally was quickly losing momentum. The level of uncertainty on many issues remains high and, in certain cases, represents too much of a binary risk. The higher level of liquidity will provide more flexibility to rebuild positions if equity markets were to correct in the upcoming months.
Bond markets also still need to find an equilibrium level. The message sent by Jerome Powell means that yields are more likely to keep on rising and at risk of further hurting the prices of equities. As long as bond markets remain as volatile, it will be difficult for other asset classes to stabilise.
WE HAVE REDUCED OUR EQUITY ALLOCATION FOLLOWING THE SUMMER REBOUND
Portfolio Activity/ News
Following a good start, August ended up by being a negative month for the portfolios. With both equity and bond markets posting negative returns, there were only a limited number of positions ending August in positive territory. The best contributions were provided by frontiers markets’ equities, the metal mining fund, the trend-following CTA strategy, emerging markets bonds and equities, as well as high-yield bond funds. European Small Caps and other European equity funds, the global technology fund, and the European sovereign debt fund, due to its long duration, were the portfolios’ main detractors. For portfolios not denominated in USD, the US dollar exposure was a positive contributor.
Despite the negative performance observed in most markets in August, it was somewhat reassuring to note that emerging and frontier markets produced positive returns. At a time when it is challenging to find assets which are less correlated, the broad diversification within the portfolios enables to benefit from these different trends. The fact that Chinese authorities are attempting to stimulate their economy when developed markets are facing more restrictive conditions explains this contrast in terms of market performance.
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Newsletter | August 2022
GLOBAL EQUITIES REBOUND AS BOND YIELDS DECLINE
3.4% THE EXPECTED PEAK LEVEL OF THE FED’S POLICY RATE
Investment perspective
Following a painful month of June for both equity and bond markets, July looked much like a mirror month as both asset classes performed strongly. In fact, the rebound of markets had started in June already, when expectations relative to the Federal Reserve’s terminal fund rate and bond yields peaked. The decline of yields, combined with an overall reassuring reporting of 2Q earnings, helped equity markets to generate outsized gains, with the MSCI World Index in local currencies climbing by 7.9%. US equities outperformed, especially growth stocks, whereas emerging markets underperformed, largely due to the weakness of Chinese equities. The retreat of bond yields continued at a quick pace; 10-year Treasury yields dropped by 0.36% to end the month at 2.65%, with the equivalent Bund yields falling by 0.52% to 0.81%. Credit spreads also tightened significantly, whereas the US dollar’s appreciation came to a halt, at least temporarily, around the middle of the month.
With more than 75% of the S&P 500’s market cap having reported, earnings have beaten estimates by 4.7%, with 71% of companies topping projections. Earnings per share growth is on pace for 9.8%, assuming the current beat rate for the rest of the season. Even if the beat rate was a little lower than that of the previous quarters, companies’ results can be qualified as solid overall, and guidance has tended to be constructive. Investors reacted positively to the publication of the results of mega-caps such as Apple, Amazon, Alphabet and Microsoft, further boosting the ongoing rally of equity markets. The FED press conference following the July 26-27 FOMC meeting was another supportive factor for equities; Chair Jerome Powell suggested that US rates were near their neutral level so that it was an appropriate time for the Fed to move to a strategy of data dependency.
Investment strategy
In our recent mid-year review, we wrote “Our assessment is that a lot of negative news has already been priced in, and market sentiment has become overly depressed”. While we will not pretend to have been anticipating such a strong rally of risky assets in July, it just goes to show how fickle markets have become, and how quickly they can turn around. It also shows that the cutting of exposures when market sentiment is at extreme lows can prove to be very costly. Historical data suggests that equity returns following bear markets, defined as a 20% drop, tend to be well above average over the next two years. That largely explains why we invest over the long term and do not attempt to time the market. We continue to believe that a well-diversified portfolio is the best way to navigate current market conditions, hence our positioning.
Like many we have been astounded by the speed at which some market trends have shifted this year. This reflects an extreme level of uncertainty which has resulted in prices overshooting and undershooting massively. It is still too early to believe we have reached a point of equilibrium following these violent swings so further volatility is to be expected in the months ahead.
MARKETS HAVE REGAINED SOME COMPOSURE WITH CORPORATE EARNINGS PROVIDING REASSURANCE
Portfolio Activity/ News
July was a very positive month for the portfolios, with the vast majority of strategies producing monthly gains. The best contributions were provided by the global technology and multi-thematic funds, European Small Caps, US Value and US Growth, the Medtech & Services fund, as well as European and Japanese equities. The fixed-income asset class also contributed positively, thanks to declining risk-free bond yields and tighter credit spreads. Chinese equities, the trend-following strategy and L/S equities were the portfolios’ main detractors; the negative return recorded by the trend-following CTA strategy in July was to be expected considering the inversion of some well-entrenched trends. For non-USD denominated portfolios, the US dollar exposure was also a contributor.
In July we cut one of our more growth-orientated strategies in favour of more defensive ones. We effectively increased the allocation to the real assets and to the stable equity strategies. The objective of these moves is to reduce some of the portfolio’s volatility and to increase the exposure to less cyclical businesses and to assets offering a higher level of protection against inflation.
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Investment Perspectives 2022 | Mid Year review & Outlook
Executive Summary
The economy is facing a sharp slowdown, and visibility is poor
The world economy is slowing down, and early-year GDP growth forecasts have been downgraded materially. The war in Ukraine, lockdowns in China, supply-chain disruptions, and restrictive monetary policies have hurt economic activity severely and hopes for the extension of a strong post-COVID recovery period have been crushed. Russia’s invasion of Ukraine has exacerbated ongoing strains from the pandemic, such as supply chain bottlenecks and significant increases in the price of many commodities. Inflation pressures have also proved to be much more persistent than those forecasted by central banks. The World Bank now expects global growth to reach only 2.9% for the whole of 2022, from a 4.1% projection six months ago. The economy has had to face even more headwinds than expected so far this year and recession risks have kept on rising.
Financial conditions will continue to tighten
The recent period has seen a most dramatic hawkish shift from central banks. Markets are now anticipating the most aggressive and synchronised tightening cycle since the Volcker era of the early 1980s. It has taken some time for central banks to realize how wrong their inflation forecasts had been, and they are now in catch-up mode. The yields of G-7 sovereign bonds have increased at an unprecedented pace. A rise of yields had been anticipated but the speed at which central banks, especially the Fed, have shifted their monetary policies has shocked the markets. In January, markets were expecting three 0.25% rate hikes only by the Fed in 2022 to a level of 0.75%. A month later, five hikes had been discounted, to a level of 1.25%, and by March this expected level had moved up to 2.5%! Current expectations are for the Fed funds rate to end 2022 close to 3.5% and for the terminal rate to reach 4% in 2023. Rate hike expectations from the ECB have also increased significantly, from none expected in January to five at the time of writing to an end-2022 level of around 1%.
The second half will likely remain volatile for financial markets
The first half of 2022 has been brutal for global equity and bond markets. Despite solid 1Q corporate earnings and, so far at least, an overall positive outlook on future profits, equities have dropped significantly because of the rising hawkishness of the major central banks. The combination of higher earnings and lower equity prices means that the derating of valuations, a trend observed since the end of 2020, has continued throughout 2022. Sovereign debt yields have risen at an accelerated pace and credit spreads have widened significantly. Key broad bond indices are down by around 15%, a staggering drop for the asset class. Investors have had to continuously adjust their expectations relative to the policies of the major central banks, which has triggered outsized volatility. In view of the elevated level of uncertainty, due to economic and geopolitical headwinds, we expect financial markets to remain volatile in the near term.
The positioning of the portfolios has become more defensive
Our portfolio positioning has become more defensive, with a neutral allocation towards equities, an overweight in alternative strategies and a fixed-income allocation which is underweight and has a low level of duration. For non-USD denominated portfolios, the US dollar position was also increased, a defensive move. Our equity exposure remains well diversified and some growth equity strategies have been replaced by more defensive ones, a switch that has worked well so far. Our assessment is that a lot of negative news has already been priced in, and market sentiment has become overly depressed. In the current market conditions, the more defensive strategies, including the less cyclically exposed companies, real assets, healthcare, value equities, and quality growth businesses, are likely to continue outperforming. We also like the decorrelation offered by equities of frontier markets, especially as their valuations remain very compelling. In the next section of the document, we will evaluate the macro environment and the prevailing financial conditions by highlighting several key indicators that we observe. Following a brief overview of the first half returns of the different asset classes, we will outline our current market outlook and asset allocation.
Table of contents
- EXECUTIVE SUMMARY
- THE MACRO ENVIRONMENT
- FINANCIAL CONDITIONS
- FINANCIAL MARKETS
- MARKETS' OUTLOOK
- ASSET ALLOCATION 2nd HALF 2022
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Newsletter | June 2022
GLOBAL EQUITIES REBOUND AMID EXTEMELY DEPRESSED MARKET SENTIMENT
$600 bn THE EXPECTED LEVEL OF EQUITY BUYBACKS IN THE FIRST HALF OF 2022
Investment perspective
May was an archetypal month of two halves for most asset classes. Global equities extended their early-year decline initially before staging a spectacular rebound. This helped the main indices to record flat monthly performances, even if growth and small cap indices were not able to make up all of their early-month losses. The yields of US Treasuries continued to rise fast until May 6 when they began to climb down from a peak level of 3.2% to end the month at 2.84%. It took longer for credit spreads to start contracting but, then again, the movement was swift, for US high yield bonds in particular. The US dollar ended May on a much weaker note after reaching a multi-year high. The trend that continued to be persistent was the appreciation of the prices of most commodities. With the EU’s agreement of new sanctions against Russia in the form of a partial oil embargo, oil prices climbed by close to 10% in May; low expectations for any further increase of OPEC production and the anticipation of a recovery in demand in China also contributed to this rise.
The high level of uncertainty on many issues continues to weigh on markets and on market sentiment. This has led certain well-followed indicators such as the Fear & Greed Index and the AAII Bull/Bear Index to drop to extremely negative readings. From a contrarian viewpoint, such depressed levels often precede equity rebounds and this proved to effectively be the case in May. Amidst all the doom and gloom hovering over the markets, the corporate sector appears to be a brighter spot. This has been reflected by the significant insider buying of shares by companies’ directors as well as an increase of equity buybacks from record levels observed the previous years. US business sentiment remains optimistic regarding demand even if supply chain and pricing issues remain the biggest concerns.
Investment strategy
Some of the latest market movements could be signalling that markets have already priced in a lot of negative news and maybe become too bearish. When looking at historical average stock drawdowns for US equities, the current trough has gone beyond the average non-recession selloff, according to JPMorgan’s quant team. When compared to the average selloffs during recessions, the current drawdown represents around 75% of prior recession bottoms. Were a recession to be avoided, the current market positioning might well prove to be overly defensive. This is reflected by the near record premium of US defensive sectors versus cyclicals. Rather than adopting such a lopsided defensive position, our allocation to equities continues to be well diversified across investment styles, regions, sectors, and market caps.
The past month saw a pause in the rise of US bond yields as well as a decline from peak expectations relative to the end-2022 implied Fed Fund rate. Were these expectations to be anchored around the current levels, this could provide some support for markets.
MARKETS REMAIN VOLATILE AS RECESSION RISKS AND HIGH INFLATION DOMINATE INVESTORS’ MINDS
Portfolio Activity/ News
May was a negative month for the portfolios. Even if many global equity indices recorded flat monthly performances, several of our growth-orientated strategies finished in negative territory. Japanese equities, the multi-thematic fund, US small caps and equities of frontier markets were amongst the portfolios’ main detractors. Positive contributions were provided by the European and US Value funds, Chinese equities, the L/S equity strategy, as well as the global technology fund. Most of the bond positions ended with limited losses as US rates started to stabilize and credit spreads contracted towards the end of May. For non-USD denominated portfolios, the US dollar exposure was a detractor in view of the decline of the US currency from its May multi-year high.
We recently attended an event where many fund managers presented their strategies. Whereas equity managers tended to remain unsure about the next move in equity markets, bond managers proved to be more optimistic. Following extensive spread widening, the consensus was that the market now offers decent opportunities in view of much higher carry and solid fundamentals. They also highlighted the fact that refinancing needs remain very low as most companies have taken advantage of record low yields the past years to boost their balance sheets.
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