Summary

1. Europe helped by China’s reopening, lower energy prices: China’s reopening plus sharply lower European energy prices, have inspired a rebound in eurozone economic momentum. We reiterate our positive view on eurozone stocks, with a preference for the Value investment style.

2. Not too late to buy into European, emerging market stocks: most investors remain sceptical of the recent rally in stocks and have not increased equity exposure. We still suggest buying UK, eurozone and Emerging Market Equities on surprisingly robust fundamentals.

3. Euro corporate bonds are attractive today: we upgrade euro investment grade corporate bonds to Positive from Neutral given the near-4% average yields. We prefer short duration as government bond yields are likely to drift higher.

4. Where next for the US dollar? Expect the US dollar to consolidate in the short term around current levels after a sharp move lower to USD1.09 per 1 euro. But the medium-term dollar trend should continue downwards. Increase exposure to gold and other precious metals.

5. Upgrading Base Metals to Positive: China’s reopening plus an accelerated European, US energy transition are positive demand drivers for battery metals such as copper, nickel and lithium. Buy into the base metals producing sector to benefit from effective oligopolies, elevated profitability and improving pricing.

 

After a strong start, now what?

Can Europe, China maintain the momentum?

One month into 2023, investors have already recovered quite a bit of the ground lost last year.

Eurozone and Chinese stocks have led the advance, gaining 10% and 9-12% respectively since the start of the year (as of 30 January). Corporate credit has also participated in this risk rally, gaining 4% year-to-date. Gold has also gained, up 6% over the period.

China reopening, falling energy prices  are key

The surprisingly rapid reverse in Chinese policy from zero COVID towards economic reopening has spurred optimism over Chinese domestic growth, with consensus forecasts rising to over 5% for this year (after 3% or less for 2022), backed by a rebound in domestic retail sales – potentially “revenge consumption” of the sort seen in Europe and the US upon post-lockdown reopening in 2021.

As seen in Europe and the US, Chinese COVID-related  restrictions have resulted in a huge increase in domestic household cash savings, which could fuel a catch-up in household spending in the coming months.

Eurozone defies recession, for now

The indirect benefit to European exports from China’s reopening, combined with the sharp retracement lower in European natural gas and electricity prices, has inspired a sharp improvement in eurozone economic momentum. This is reflected in the rise in both manufacturing and services purchasing manager (PMI) survey readings for January, which rebounded, remaining around the 50 break-even level between expansion (growth) and contraction. 

Hopes for US “Goldilocks” economy seem premature

In the US, continued falls in inflation reinforce our belief that the Federal Reserve will pause on interest rates after raising the Fed Funds rate to around 4.75%-5% at their 1 February meeting.

In spite of diminishing inflation pressures from a number of areas, including goods, rents, energy and food, let’s not forget that the declining US leading economic indicator still points to (at least) a modest recession (comprising two consecutive quarters of negative growth) in mid-2023.

After all, this Fed cycle of monetary tightening via interest rates and balance sheet reduction has been extremely rapid – the fastest rate hike cycle in 40 years. Today, we already have the tightest US monetary policy in over 20 years, according to calculations by the San Francisco Fed, following a long period of zero rates that only ended in March 2022.

However, lower energy prices are a huge help

Ultimately, the biggest support for the global economy and the best hope of avoiding a painful economic recession lie with energy prices. Today, natural gas prices have receded to levels not seen since September 2021 in Europe, and since mid-2021 in the US – levels well below gas prices in early 2022 prior to the Russian invasion of Ukraine.

Similarly, US gasoline prices are back around late-2019/early-2020 levels, thus relieving a lot of pressure on US household spending.

Reviewing our convictions

Value Equities, US IG credit, Gold

How have our key investment conviction calls fared over the last few months?

Recall that we upgraded US investment grade corporate Bonds to Positive in November 2022, while we upgraded Global Equities to Positive in December 2022, with a bias to the Value style and to the World ex-US.

In Alternatives, we have maintained a key Positive call on Gold, together with a Positive sector call on the Mining sector, and also on infrastructure funds.

US investment grade credit (Positive)

Since publishing our upgrade on US IG credit to Positive on 10 November 2022, the Barclays US IG corporate bond index has returned 6.4% in USD and 5.6% in hedged euro terms, helped by falling US CPI prints and a compression in the US investment grade credit spread from 1.5% to 1.2% today.

World ex-US Equities (Positive)

We upgraded Equities overall to Positive on 12 December 2022, with a focus on world ex-US equity exposure (we remain Neutral on US Equities) and on the Value style (low valuation, high dividend yield) within Equities. Since this upgrade, the MSCI World ex-USA index has rebounded 7% in US dollar terms and 4% in euro terms (to 26 January).

Key regional preferences such as UK stocks (FTSE 100) have risen 4% in sterling terms, while the Euro STOXX index has gained 6% in euro terms over this period.

Gold and precious metals (Positive)

Over the last 3 months, thanks to the fall in long-term bond yields and in the US dollar, Gold has returned 17.5% while the Bloomberg basket of precious metals has returned 19.1% in USD. In euro terms, 3-month performance has been positive but less impressive at +7% for Gold and +9% for the precious metals basket.

Precious metals-producing companies have benefited from their high operational leverage to the underlying metals prices. The NYSE Arca Gold Miners index has risen 33% in USD over the last 3 months.

Infrastructure funds (Positive)

Our long-term positive call on infrastructure funds continues to generate steady returns: the Dow Jones/Brookfield global infrastructure index has generated a 7% over the last 12 months in euro terms, of which +5% over the last 3 months.

 

Positive on EU and US IG credit

Upgrading Euro Investment Grade credit

Better momentum: the European economy is improving. The mild winter, coupled with declining natural gas prices and the reopening of the Chinese economy, has reduced the risk of a near-term recession.

Supply risk: we expect high bond supply as companies have rebuilt liquidity buffers (currently at record lows). Spreads have remained tight since the beginning of the year as supply has been well absorbed by investors, but new issue premiums are not as generous. Demand for new issues may diminish and credit spreads may widen modestly.

Yields are high: the average all-in yield is at a 10-year high, at 3.9% (see chart), which would offer compensation in the event of spread widening and/or higher interest rates.

Interest rate risk: we expect bond yields to increase in the near term in the eurozone.

Conclusion: we upgrade EUR IG corporate bonds to Positive from Neutral. We recommend keeping a short duration as bond yields are likely to increase.

Still good reasons to buy US IG credit

Strong fundamentals: fundamentals remain strong. Leverage is very low: companies have on average 3x more debt than earnings. The interest coverage ratio is declining but remains historically high. Companies have nearly 9x more earnings than interest expense.

Elevated yield: the average yield is 5.1%, a level not seen since 2009. The investor is thus remunerated for holding low-risk bonds (Investment Grade). The default risk is very low. Rating agency S&P has calculated that US investment-grade credit has averaged a paltry 0.1% per year since the 1980s.

Valuation: the average spread of 1.26% is in line with the historical average. The asset class is therefore neither expensive nor cheap. However, the asset class is relatively cheap if we consider that we are at the end of an economic expansion phase. We expect spreads to widen modestly due to the large number of upcoming issuance and the risk of downward earnings revisions, while corporate fundamentals are sound and buying flows should continue. The asset class should generate positive returns mainly through carry.

Investment Conclusion

Our view: we are Positive on US and eurozone investment grade bonds. We recommend a short or close to benchmark duration (7 years) following recent interest rate moves. These maturities are also relatively cheap compared with long maturities on a historical basis. We particularly like Financials because their fundamentals are good, bond supply is likely to be reduced this year (the six largest US banks may cut new issuance by one third compared with 2022) and valuations are decent.

Why you should buy Base Metals

Bullish on battery metals

We like critical battery metals, such as lithium, cobalt, nickel and copper for the following reasons:

1. Economic driver = high oil and gas prices: at higher diesel and petrol prices, consumers are incentivised to buy electric vehicles (EVs) to replace their existing cars. Widespread leasing of these EVs makes this transition more affordable too, particularly as the number of EV models available explodes and the price points come down.

2. Political will to electrify the economy: in Europe but also increasingly elsewhere, e.g. in China and the US, politicians are creating powerful incentives for electric vehicles. There is a huge need for greater energy security in the wake of the Russia-Ukraine conflict, obliging countries to reduce their need to import oil and natural gas. There are also powerful disincentives for fossil fuel-based transport, including increasing city "congestion charges" or city-wide bans (e.g. in London) on internal combustion-engine cars. Greater investment in electric public transport, such as buses and trams, is another element.

3. Carbon credit prices to go higher, especially in Europe: political pressure will see increasing restrictions on carbon credits in Europe, potentially driving carbon credit prices higher. This will create greater pressure for low- or zero-carbon forms of transport and energy generation, which in turn will require greater storage capacity for e.g. electricity generated from renewable energy sources.

4. Demand to steadily increase, but where is the extra supply? Supply of these critical battery metals remains limited. This is one reason why prices of lithium carbonate, nickel and even now copper are increasing. There is a potential to see a supercycle in these battery metals, given the powerful long-term growth drivers.

In the short term, copper has staged a sharp recovery on the back of greater optimism over the Chinese economy, given a reversal of their zero COVID policy (towards reopening) and the announcement of measures designed to support the domestic property market. Global stockpiles of copper are today close to historic lows. So, a near-term recovery in copper demand should translate into further price gains. 

Investment Conclusion

Upgrade to Positive on Base Metals. There are two ways to buy into this battery metals trend - buy exposure to the underlying raw materials, such as nickel and copper, via futures or even ETFs. Better still, in our view, is to buy exposure to the mining companies that produce these metals, also possible via individual shares in the US, UK, Canada and elsewhere, or via funds and ETFs of these commodity producers. 

Frequent client questions (1)

On Stocks and Real Estate

A number of key questions have been raised by clients during meetings and conferences in January: 

1. Is it too late to invest in global stocks, after the impressive rally to date? No, not at all! Most professional and retail investors remain cautious and have not invested in this latest stock market rally. As an example, US retail investors continue to reduce exposure to stock funds and ETFs according to the Investment Company Institute – hardly the behaviour of confident investors.

Moreover, in the eurozone, UK and Emerging Markets, stock market valuations remain lower than average, suggesting the potential for higher-than-average long-term returns.

2. Given higher long-term interest rates and the prospect of recession in the US and Europe, should one sell real estate exposure today? Real Estate investment is by nature a long-term investment, given the relatively illiquid nature of property assets and the high transaction costs. In the short term, weakening economic growth prospects and higher mortgage rates are headwinds for both residential and commercial property markets.

But long-term interest rates have already started to fall, and we expect only a modest hit to growth in the near term, followed (inevitably) by economic recovery.

In most Real Estate markets, I believe that the best course of action is to retain property assets today, and even look for value opportunities to add exposure selectively over the next year or two. 

Investment Conclusion

World ex-US stocks: we like UK, eurozone and Emerging Market exposure (including China). Focus on commodity-related sectors such as Mining and Energy, plus Financials.

Real Estate: hold commercial real estate for now and await the turn in the economic cycle. Over the medium term, look to selectively add value opportunities in regions such as the UK. 

Frequent client questions (2)

US dollar, mega-cap technology, US credit

3. Where next for the US dollar, after an 11-year uptrend? Major currencies including the US dollar tend to trend both up and down in multi-year cycles. Since 2011, the primary dollar trend has been higher, peaking in September last year. We believe that the dollar cycle has now turned lower as peak Fed Funds rate approaches fast (1 February), while other central banks, such as the European Central Bank, should continue to raise rates over a longer period.

Moreover, the status of the US dollar as the dominant reserve currency for global central banks and for world trade is being slowly eroded in favour of alternatives such as local currencies and Gold. We thus expect the US dollar to trend lower against other major currencies and Gold over the medium term. This suggests that clients with portfolios heavily skewed towards US dollar assets may consider rebalancing their currency exposure towards other currencies over time.

4. Can US mega-cap technology companies regain their former stock market leadership? Despite the 29% drop in the Nasdaq 100 tech-heavy index since late 2021, the US tech leaders remain expensive both versus history and versus other US sectors/stocks. 

Today, these technology mega-cap companies are valued 24% higher on a P/E basis than the rest of the US stock market. At the same time, their earnings are suffering from a combination of weaker post-lockdown IT  demand, sensitivity to the weakening global economic climate, and regulatory challenges both in Europe and the US. To this we can now add the risk of new disruptive technologies in the form of OpenAI’s ChatGPT Artificial Intelligence software, which potentially threatens the oligopoly of US internet platform companies in the digital marketing industry.

If we are in a new bull market, we should remember that the leaders of a new bull market are almost never the same companies that led the previous bull market. We thus remain cautious on US mega-cap tech companies, and prefer mid-cap and value exposure.

5. Why rush to invest in US corporate Bonds today? We see the 5%+ yields available from US investment grade credit (the highest since 2008) as a historic opportunity for investors to capture bond market income, after being starved of such opportunities for so long. Falling US inflation is supporting a rebound in US bond prices, thus lowering entry yields. We think that it is best not to wait to lock in these attractive yields.

Investment Conclusion

US dollar trend: after a sharp bout of depreciation against the euro and yen, expect consolidation around current levels in the short term. Beyond that, we expect the US dollar to continue to trend lower over time, thus boosting other G10 currencies and Gold.

Mega-cap tech companies: as a group, we do not believe that they will regain market leadership. In the US, we would rather favour Value and mid-cap stocks.