Top of mind -
Have we reached the bottom and what does that mean for investments?
The Arbuthnot Latham Investment Committee (IC) met in October to take stock of the global macroeconomic environment and our portfolio positioning.
Heading into this quarterly IC series, client portfolios were defensively positioned - we were underweight bonds and equities and overweight cash and defensive alternatives in our active portfolios. A key driver of negative performance in both debt and equity this year has been global interest rate rises in the face of generationally high inflation. This coupled with high valuations and slower global growth accelerated the downturn.
Have we reached the bottom?
Through our analysis, we believe inflation is starting to peak globally and economic growth is approaching the trough. These signs are tentative, but if inflation is indeed peaking, central banks will likely slow the pace of rate increases in 2023.
We expect equity markets to bottom close to, or possibly before, inflation tops and economic growth bottoms out. These developments, combined with low valuations compared to the start of 2022, warrant reducing our underweight position in both equities and fixed income and moderately increasing risk across our portfolios.
Portfolios will remain defensively positioned and broadly diversified—we acknowledge there are some signs inflation is peaking, but the outlook remains murky.
It is possible central banks will continue raising interest rates longer than expected, which will likely weigh on economic growth and, if they are too aggressive, possibly lead to a deeper recession than expected. However, the low equity and fixed income valuations simply cannot be ignored. Low valuations reduce the risk of permanent capital loss, and we feel this justifies adding risk in a structured manner in line with clients’ risk appetites.
Timing the bottom of the market is nearly impossible. However, given the sharp drawdowns markets have experienced this year, we believe adding some risk to core assets will benefit clients’ long-term returns.
Here are some of the key decisions to come out of our latest IC series:
Government bond yields have climbed to levels not seen since before 2008. US 10-year bond yields are trading above 4%, with UK bond yields not far behind, which has caused their capital value to fall significantly from the start of the year.
If inflation starts dropping, bond investors should benefit through yields stabilising relative to 2022. We are particularly keen on short-dated government bonds. US two-year Treasury bonds yields are currently trading above 4.5%, providing an attractive yield for relatively low risk.
We will also look to add investment grade debt and high yield exposure to take advantage of higher interest rates offered in this space.
Following a tumultuous year in equity markets, valuations are starting to look attractive long-term, and outright cheap in some cases. These low valuations provide a good entry point to add more exposure to portfolios.
If economic growth bottoms, we could see stock markets rally and recover lost ground. There was a preference among committee members to increase exposure to value-orientated companies, namely banks, energy firms and industrial companies, sectors that tend to outperform in the early stages of an economic recovery. These shares are potentially less risky if bond yields were to remain high. For this reason, we have not increased technology exposure. Furthermore, we believe growth companies remain overvalued compared to the rest of the market.
While we see good opportunities in fixed income and equity markets, there are areas we remain concerned about short-term. One is direct property. Our global commercial property is now yielding less than low risk debt markets.
The capital values of commercial properties have increased in the last few years, supported by low interest rates. With interest rates rising sharply this year, property values are now at risk of declining. These risks are being discounted in listed property (REITs), with the index down around 17% in GBP terms . However, the direct property funds we hold are still up significantly this year.
Given this contrast, we felt it prudent to exit our direct property funds, locking in the gains made over our holding period. We previously halved this position at the last committee series and plan to exit it entirely in coming months, a unanimous decision.
Commodity markets struggle when global economies contract. The JP Morgan Global Manufacturing PMIs dipped below 50, indicating global manufacturing output is contracting.
As growth continues to slow, commodity markets will feel the pinch. On the flipside, commodity markets, namely oil, base metals, and agriculture are in short supply, which should support future prices. Commodities provided strong diversification benefits over the past year for us. Weighing out these factors, we decided to halve our commodity exposure, noting we are increasing risk elsewhere in the portfolio.
How are portfolios changing
|Government and corporate debt
|Increase exposure to neutral weight
|Attractive yields for relatively low risk.
|Increase exposure though remain underweight
|Valuations are starting to look attractive long-term, and outright cheap in some cases.
|Global direct commercial property
|Exit exposure completely
|Our global commercial property is now yielding less than low risk debt markets.
|Halve exposure though retain off benchmark position
|Commodity markets struggle when global economies contract. We believe there are better opportunities elsewhere.
What does the future hold?
There are several scenarios that may play out and it is very likely the remainder of the year will remain volatile.
Equity and bond markets may fall further, which means we were slightly early in adding risk. But this possibly may provide us with a better opportunity to increase risk further at even lower valuations, as we still retain a lot of liquidity for future attractive opportunities.
The other possibility is that the risks we are concerned with today abate slightly, which means global markets recover more quickly. By adding risk in a slow and structured manner when prices are depressed, we can capture the opportunity set the market turmoil has presented.
This document is provided for information purposes only. It does not constitute advice, a solicitation, recommendation or an offer to buy or sell any investment, banking or lending product or service.
The contents of this document are based on opinions or conditions as at the date of writing and may change without notice. To the extent permitted by law or regulation, no warranty of accuracy or completeness of this information is given, and no liability is accepted for its use or reliance on it.
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