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August 2023

Asset allocation Outlook

  • Deteriorating economic outlook for Eurozone
  • Fed and ECB may have reached end of interest rate hike cycle
  • Cautious investment policy unchanged

The investment outlook for investors in July revealed relatively stable financial markets, with rising yields in the US and Germany and a slight decline in the UK. Stocks performed well (MSCI AC World: 3.7%), with emerging markets leading the gains, followed by the Pacific region, the US, and Europe. Corporate bond spreads decreased, while real estate and commodities, particularly oil prices, experienced notable increases.

The Fed seems increasingly comfortable with the idea that the US will manage to sidestep a recession and smoothly navigate towards a gentle economic slowdown. This confidence seems to have bestowed the Fed with a level of overconfidence in its ability to sustain its rate hike strategy. That view is reinforced by the initial assessment of annualized second-quarter gross domestic product growth of 2.4%, which surpassed predictions. Such a perspective could entail risk, considering the substantial time lag between policy implementation and its actual effects. It's still premature to claim outright success. Core inflation (4.8%) remains a challenge, and the delayed effects of high rates are still unfolding through the system as fixed-rate loans come due. Jerome Powell has indicated that upcoming policy decisions will hinge on available data. However, considering our conservative perspective on economic growth, we anticipate no additional rate hikes in this ongoing cycle. The S&P 500 advanced markedly (+3.2%) on the positive economic data and the approaching end of the hiking cycle.

In the eurozone as well, future rate hikes are not a foregone conclusion anymore if we correctly interpret the statement of ECB President Lagarde. The economic situation in the eurozone diverges from that of the US, as its recent resilience is less apparent. The flash eurozone composite Purchasing Managers' Index (PMI) has hit an eight-month low, although the services PMI still indicates expansion. Conversely, the manufacturing sector continues to weaken. Business Climate indicators (ifo, Economic Sentiment Index) suggest sentiment is getting bleaker. The convergence of elevated credit costs and tighter access to credit has unsurprisingly led to decreased credit demand, a trend that raises concerns for future business investment and consumer spending. However, despite this softer growth outlook, the MSCI Europe ex-UK Index gained 1.3% on the month.

The Bank of Japan surprised by allowing more flexibility in its yield curve control policy amid rising inflation concerns. Governor Kazuo Ueda clarified that a 10-year bond yield of 1% wasn't expected. The BOJ will manage the yield curve via bond-purchase and fixed-rate operations. This impacts investments; the yen's weakness may reverse, affecting Japanese stocks that benefited. The BOJ's recent "unscheduled" Japanese government bond purchases of 300 billion yen highlight this. A stronger yen could lead to underperformance in previously boosted Japanese stocks.

While most strategists grow more positive about the US economy, their outlook on China's economy darkens. The difference primarily lies in diverging employment trends. In the US, the tight labor market cushions the slowdown caused by the Federal Reserve. Conversely, China grapples with notably higher unemployment, particularly among the younger generation, dampening consumer confidence. Chinese consumers have exhibited unexpected prudence due to reduced property values and stagnant income growth, prompting households to prioritize saving over spending. Authorities have realized that aggressive stimulus is needed to boost economic activity. During July’s Politburo meeting, robust high-level directives were issued to invigorate China's economy, particularly focusing on bolstering consumption and the property sectors. While the declaration lacked details on concrete, timely actions, it was sufficient to push the MSCI China significantly higher in July (+ 10%).

We're currently amidst the peak of the second quarter earnings season, and although results have shown relative positivity, they've been based on lower expectations. This is why many stocks haven't experienced significant surges when delivering positive earnings surprises. Moreover, there have been some notable earnings misses this time. In any case, the market assumes that we have reached the bottom of the earnings recession and that earnings will recover in the following quarters. We doubt this trend is consistent with falling new orders, a contracting manufacturing sector, and tighter credit conditions.

Amid the evolving economic dynamics, uncertainty remains. The interplay of monetary policy, inflation, consumer sentiment, and sectoral challenges makes the economic landscape a patchwork of opportunities and potential pitfalls, requiring a nuanced approach to investment decisions. As policy rates are expected to stay higher for longer, we see limited room for global equity valuations to improve. The equity risk premium for global equities continues to fall and currently stands at 3.9%, the lowest since the 2008 global financial crisis. Compared to high-grade bonds, equities have lost relative attractiveness, especially in the US. We stick to our strategy and refrain from increasing risk in our asset allocation.  

Please find attached our last Asset Allocation Update for August.

Asset allocation outlook Aug 23

Jan-Willem Verhulst

Jan-Willem Verhulst


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