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July 2023

Asset Allocation Outlook

  • Leading indicators pointing to a slowdown
  • Central banks insisting on further interest rate hikes
  • Cautious investment policy unchanged

Global stock markets rallied amid optimism that the Federal Reserve will engineer an economic soft landing. The MSCI All Country World Index returned 5.6% in June. US and Japanese stocks were at the forefront of the advance, returning 6.5% and 7.4% respectively, for the month. The stock market seems to be pricing a near-perfect economic outcome, with rapid disinflation and resilient growth. Bond investors, though, seem to disagree. Short-term bond yields in developed markets rose last month as markets priced policy rates staying tight for a longer period after data confirmed persistent core inflation and central banks pointed to further tightening. The two-year US Treasury yield pushed above 4.90%, pulling the yield curve near its most inverted level since the 1980s. Yields also rose in the Eurozone. German 2-year Bund yields climbed from 2.76% to 3.27% within a month.

The strong market momentum reflects the conviction that the widely predicted US recession has been called off. Economic growth and earnings have so far proven stronger than expected, as excess savings, stable asset prices, and a strong labor market let consumers feel financially secure. Additionally, inflation is falling more quickly than nominal wage growth, leading to real income growth and further upside surprises in consumer data. However, investors are walking a fine line as the sources of economic resilience are both a blessing and a curse: a blessing because they prevent economy from entering a recession; a curse because they increase the risk that central banks will continue their rate hike cycle as they fear a second wave of inflation if spending patterns, the job market, or Wall Street prove too robust. Ironically falling inflation may be sowing the seeds of its own demise. On the other hand, a few disappointing economic data points could quickly undermine optimism about the labor market or consumer resilience and fuel doubt about a soft-landing scenario. As investor sentiment has improved sharply over the past few months, the potential for disappointment has correspondingly risen as well.

Our baseline scenario, however, is that demand will continue to sink to the point that the economy slips into recession without the need for substantially higher rates. While a restocking cycle in manufacturing will add to aggregate demand, the lagged effects of tighter monetary policy will subtract from it. Credit growth, too, tends to respond to tighter lending standards with a lag. Thus, while credit availability is not yet a problem, that could change in the next year. This might occur right around the same time that pandemic savings have melted away and more homeowners are facing higher mortgage payments. In past business cycles, the unemployment rate has moved sideways for 21- to 23 months before starting to rise. This time might not be different.

Consumer price inflation in the US slowed to 4% year-over-year in May, the lowest level since Q1, 2021. Core inflation, however, remains stubbornly high at 5.3%. However, a period of disinflation is likely ahead as growth in unit labor costs and prices-paid indices (ISM) is slowing; supply chain pressures are easing, the moderate growth in asking rents, and energy prices have retreated. The preliminary inflation prints for June in the major euro area economies show a similar picture: core inflation rates stayed elevated (5.9% in Spain, 5.8% in Germany, and 5.6% in Italy). The positive news is that the European Commission’s business and consumer surveys point to a softening inflation backdrop. Consumer inflation predictions one year out reached a seven-year low, and factory selling prices expectations three months out dipped to levels last seen in 2020 before the pandemic. However, the June uptick in Europe’s largest economy, Germany, will keep the ECB biased toward another rate hike in July. Beyond that, slowing growth, the waning influence of last year’s energy price shock, and easing inflation expectations should limit any additional hikes beyond the September ECB meeting. Nevertheless, the resumption of interest rate increases by the Australian and Canadian central banks and the outsized rate hike by the Bank of England indicate that policymakers’ battle against inflation is not over. While the Fed refrained from hiking rates at its latest meeting for the first time, it signaled further policy tightening. However, as the presidential election season approaches, the Fed might delay a bit longer.

Global economic activity remains divergent. In the past, we have highlighted a dichotomy in the global economy characterized by weak manufacturing conditions versus a robust service sector activity. The June flash PMIs imply that momentum has also slowed significantly in the service sector. The manufacturing sector continues to bear the brunt of the global economic weakness. The Global Manufacturing PMI’s declined to a six-month low in June (48.8). The forward-looking New Orders components fell deeper into contraction territory, while factory output shrank after expanding in the prior four months. Both input and product prices continued to fall steadily. Manufacturers are lowering output, cutting prices, and reducing headcount in response to weaker demand.

The current macro backdrop is still not friendly for broad-based asset class returns, and selectivity remains key. With global interest rates potentially staying higher for longer, there is limited room for global equity valuations to expand in the second half of 2023. We stick to a relative preference for emerging market and Asia/Pacific due to better earnings growth prospects and undemanding relative valuations. The US remains our least preferred region for equity investments, although it is important to differentiate between the technology megacaps and the more attractively valued areas. Within fixed income, we have a preference for sovereign bonds, which have both attractive yields and the potential for capital gains if economic risks mount. Among the riskier segment of the fixed income market, we continue to prefer emerging market bonds.

Please find attached our last Asset Allocation Update for July.

Asset allocation outlook Jul 23

Jan-Willem Verhulst

Jan-Willem Verhulst


Email Jan-Willem

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