2023 Mid-Year Outlook
Prashant BHAYANI, Chief Investment Officer Asia, BNP Paribas Wealth Management & Grace TAM, Chief Investment Adviser Hong Kong, BNP Paribas Wealth Management & Dannel LOW, Investment Specialist, Asia, BNP Paribas Wealth Management
Summary
- At the start of the year, we viewed “known” risks of an impending recession as an opportunity given price dislocations last year. As a result, our multi-asset allocation calls have worked year-to-date. Consensus expected a tough first half and better second half for equities, while we had the opposite view: overweight global equities since last November. In addition, our overweight to investment grade credit and gold, while forecasting a weaker dollar also boosted returns.
- However, risks remain. Interest rates continue to rise as central banks globally continue their fight against inflation. Additionally, geopolitical uncertainty remains, with the ongoing Russia-Ukraine war, as well as worsening US-China tensions.
- Looking ahead, the key focus is on the depth and timing of a possible recession, as well as the central banks’ actions. Will we see recession in 2023 or 2024? If so, will it be a hard landing? Crucially, how should we navigate through this uncertain period and stay invested in the second half of the year?
Strong first half for multi-asset returns
It is the best start to a 60/40 equity-bond portfolio since 1995. Many declared the 60/40 equity-bond portfolio dead after the bear market in bonds and equities in 2022. We highlighted how economists by the end of 2022 had already forecasted a US recession at the highest probability since the 1980s. In that regard, always look at what is priced in. We had turned overweight global equities based off this notion and after equity markets bottomed last November. In addition, we were also positive on investment grade credit and gold, while forecasting a weaker dollar, further boosting returns.
No landing, soft landing, or hard landing?
The recent unemployment rates in the US and Europe continue to remain near all-time lows. However, the June US non-farm payrolls missed for the first time in 15 months. Revisions to prior months were also lower. Will this finally be the start of a softer labour market? Central banks still face the challenge of calming core inflation, while also having to deal with this current resilient labour market.
Nonetheless, the fact is employment and inflation are lagging indicators. In fact, the timing may be appropriate, and we may start to see the effects of interest rate hikes given it typically takes 12-24 months on average to work its way into the economy. Important to note, the US Federal Reserve only started raising rates in March 2022.
This cycle is slightly different with labour hoarding and a persistently tight employment markets. However, advance indicators like job openings or temporary hires still show only moderate weakness. Overall, our base case is for a moderate recession in the US in 2024. We currently forecast one more rate hike from the Federal Reserve, two more from the ECB, and three more from the Bank of England.
Recession Proof the Portfolio:
1) Diversify cash exposure via extending duration with investment grade bonds
Cash is Not King!
As mentioned, our forecast is for one more rate hike in the US, with the Fed Funds ending at the terminal range of 5.25% - 5.5%. Nonetheless, the market has already started pricing this additional rate hike in. The current rate hike cycle is one of the fastest in history, and it is important to remember that monetary policy acts with a lag. We don’t expect any rate cuts until after March 2024.
As investors have been observing the uncertainty on interest rates as well as the economy, many have been sitting in hefty cash positions. Some were earning reasonable yields in the form of money market funds, while others in the form of deposits, and that meant missed opportunities after the strong performance of equities and bonds. Given our outlook, holding too much cash can indeed be costly going forward.
Shorter-term yields are sensitive to interest rate expectations. The bond market is already in the process of pricing in another rate hike and a pause. Nevertheless, long-term investors will eventually need to shift into bonds as there could be an opportunity cost to having too much cash. Additionally, investment grade yields are the highest in a decade. Meanwhile, we remain neutral on high yield bonds given expectations of rising default rates. Importantly, trying to time the peak in yields will be difficult and could be proved costly. Given there is reinvestment risk on any longer-term deposit, investors should start to examine their cash allocation and gradually over time extend duration to high quality bond allocation.
Read Investment Navigator, Asia June 2023: Home Sweet Home: Diversification Through Asian Sustainable Bonds
It is crucial to highlight that historically since 1990, as the Federal Reserve approaches being on hold and/or begins to cut rates, high quality long-term and short-term debt have outperformed cash. This is the environment we believe the market could enter in the coming months. Additionally, the recent rise in yields also provides a good opportunity to moderately extending bond allocation across the curve.
2) Diversify dollar exposure
Overall we went underweight the greenback just as treasury yields peaked in the fourth quarter 2022. While the USD may need to consolidate recent weakness, we still see further moderate weakness on a 12-month basis. This view is predicted on peaking yield differentials, reserve diversification, and flows to non-US equities. However, the dollar view is not across all currency pairs. Given central banks are raising rates at different paces to deal with contrasting levels of inflation, this creates trading opportunities in different currency pairs. Hence, it is important to look at individual currency pairs rather than just the dollar overall.
3) Monetise volatility and hedge?
The average investor this year is more likely than not to have missed our contrarian call on the equity rally. One way to ensure participation at this juncture is to monetise the volatility via structured solutions in favoured names, allowing better entry points and income. In short, volatility creates opportunity.
If one is already overweight equities, they can take advantage of the low index volatility (S&P 500 volatility below 15) to hedge market risk while maintaining portfolio exposure.
In addition, uncertainty about interest rate forecasts, as well as when rates will peak and for how long, creates opportunities in foreign exchange and fixed income structured solutions pricing.
Conclusion
Our favoured allocations include:
(1) Quality income via investment grade bonds which remain an attractive allocation to gradually extend duration.
(2) Dollar diversification while expecting some short-term consolidation. However, we are not bearish on the dollar versus every currency pairs, as different central banks are moving at a different pace.
(3) Gold remains the ideal diversifier; accumulate on pullbacks.
(4) Structured solutions allow for more portfolio flexibility and to tailor positions for better entry points, income as well as hedging.
(5) We remain overweight global equities, preferring non-US equities such as Japan, Europe and China. For sectors, we prefer healthcare, financial, materials, and continue to overweight semi-conductors based off long-term AI growth narrative.
CIO Asset Allocation
