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Top of mind -
Why diversification is key to protecting capital
The first five months of this year have seen a positive step-change compared to 2022.
Current economic snapshot
Equities and global bonds performed strongly in the first quarter, as did non-dollar currencies. Government, corporate and high-yield debt have also performed well, a welcome relief after the challenges of last year. Technology stocks rebounded over recent months - accounting for most of the gains on US equity indices - although these remain expensive. Energy, which was a significant outperformer last year, is lagging.
A divergence in data has made us more cautious in our immediate outlook. As such, we have become slightly more defensive in our positioning and continued to focus on capital protection through a well-diversified investment approach.
Following the Arbuthnot Latham Investment Committee’s meeting in April, where we evaluate the global macroeconomic environment and our portfolio positioning, we decided to shift capital from hedge funds into government bonds, reduce some of our equity allocations, and adjust remaining equity to hold a less cyclical bias. Cash levels increased slightly.
We increased our exposure to government debt
During the recent turmoil in some parts of the banking sector, government bonds re-established their defensive characteristics, rising as equites fell following the fallout of Silicon Valley Bank and Credit Suisse. The opposite was true last year where both equities and bonds fell together due to high inflation and rising interest rates. But the stars are finally aligning for bonds. The rapid interest rate increases across developed markets this year have pushed bond yields up, while the global economic outlook remains uncertain. Government bonds perform well in periods of falling inflation and softening growth. This has made government bonds attractive, hence our decision to move to an overweight position.
A recession is certainly possible, although the severity and length remain uncertain. As it relates to corporate debt, our analysis shows that during the later phases of recessions, corporate bonds provide strong risk adjusted returns, relative to other asset classes. We therefore maintained our large allocation to corporate debt.
During the recent banking crisis involving Silicon Valley Bank and Credit Suisse, we took advantage of debt market weakness and increased exposure to European debt, specifically bank convertible bonds. Yields on these bonds spiked to levels not seen since the pandemic and following extensive research in this sector we allocated a further small portion of our fixed income bucket to these bonds, which are yielding above 10%. European banks are better capitalised and pose much less risk than the US regional banks, in our view.
We reduced our overall equities exposure
The recovery in global manufacturing has stalled, while services continue to rebound. Services are particularly important to developed markets, but it is the manufacturing segment that drives equity markets. This divergence between the two leading indicators, combined with high central bank rates, the US banking crisis, and high inflation have muddied the outlook.
Global manufacturing is yet to pick up pace for markets to perform strongly. Without the synchronised growth from both segments, we are more cautious on equities, particularly those in more cyclically sensitive sectors. Overall, we have reduced our exposure to energy stocks, which are highly sensitive to falling economic growth. We have also reduced risk more broadly, by reducing the cyclicality of our equity bucket.
Disinflation continues. US inflation, which peaked last June at 9%, now stands at 5%. The biggest factor affecting inflation in the US are shelter prices, such as mortgage payments and utility bills, which remain sticky. Based on the latest US National Home Price Index figures, which tend to lead shelter inflation by up to a year, it appears shelter inflation should decrease. Global food prices meanwhile continue to fall, which should also filter through to food inflation. But the weakness in manufacturing compared services data, stress in the US banking sector, and high valuations mean the economic backdrop remains uncertain. We are maintaining our underweight position in US equities and the US dollar, electing to reduce our exposure to US technology companies, which contributed a larger amount of risk to the equity book and have performed strongly year to date (YTD).
Compared to its peers, the UK has a tepid growth outlook and is suffering from higher inflation. However, UK stock market valuations are attractive versus historical averages. Easing energy prices and modest growth should act as a tailwind for domestic stocks. This supports our previous decision to shift some capital into UK small cap companies, although the bulk of our UK allocation is in the FTSE 100. We like the composition of the FTSE 100, which is defensive, high dividend, and value orientated.
European shares posted strong returns in the quarter despite extreme volatility in the banking sector, buoyed by falling gas prices, which plunged from highs last August. Quite simply, falling gas prices kept the continent from entering a deep recession. We experienced strong outperformance from cyclical companies. As such, we took profits and deployed to quality/growth orientated companies and continue to monitor for more opportunities.
China’s recovery after three years of strict Covid lockdowns has been mixed. The manufacturing sector experienced sharp rebounds at the end of last year once lockdowns ended but started to taper off this year. Chinese steel prices, a good proxy for manufacturing growth, fell last month. Meanwhile, services in China have been increasingly steadily, as the Chinese consumer returns. We had hoped the world’s manufacturer would lead global growth this year. Instead, what we are seeing is a buoyant Chinese consumer boosting the domestic economy, and to a lesser degree, emerging markets. As such, we have maintained our overweight position to Asia, with a slight trimming to our direct exposure to Chinese technology companies.
Japan should experience the largest growth this year compared to its developed market peers based on domestic activity continuing to rebound following a relatively delayed reopening post Covid and trade tailwinds from China. This coupled with cheap valuations and a strengthening yen provides tailwinds to maintain our overweight.
We maintained exposure to commodities
While we are positive on the long-term outlook for commodities, due to chronic underinvestment across most of the commodity complex, should the global economy fall into a recession, we would expect most commodities to perform poorly. The attraction to commodities, particularly oil, however, are its inflation hedging properties. Oil and inflation expectations are closely linked and if inflation stays higher for longer, allocating to commodities provides diversification benefits to our portfolios.
We reduced our hedge funds exposure
Hedge funds provided protection in 2022 at a time when both equities and bonds underperformed. This year, there are better opportunities in other asset classes. We have trimmed our hedge fund allocation to fund other opportunities, mainly in government bonds.
What does the future hold for investors?
The dichotomy of data points is concerning. We still have a backdrop where central banks are reducing liquidity by rapidly increasing interest rates. As financing costs for consumers and businesses increases, money supply has contracted. US money supply year-on-year growth is in negative territory for the first time since World War II. This will have real world implications for the economy as well as stocks.
Banks have been tightening lending standards, which typically reduces loan growth, slows the economy, and leads to a recession.
We are closely watching the US manufacturing cycle. Historically, an increase in manufacturing data pushes forward equity earnings higher and is positive for stock markets. Although markets have posted strong performance YTD, we are cautious—it is possible they have outperformed too much too soon. We are poised to deploy capital should manufacturing recover.
Diversification remains key. Corporate and government bonds are performing well, but we remain more cautious on equities and have less conviction on hedge funds. By diversifying, our portfolios are positioned to weather near term risks, while we remain nimble to take advantage of the opportunities the market presents to achieve our long-term goals of preserving and growing client wealth.
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Author -
Suzy Waite
Investment Writer, Arbuthnot Latham
Suzy joined Arbuthnot Latham in 2021 from Bloomberg. An experienced financial journalist, she previously worked at Euromoney Institutional Investor and Haymarket Media. She’s covered a variety of areas including hedge funds, commodities, equity capital markets and asset management while living in New York, London and Hong Kong.
Working closely with the Investment Committee, Suzy covers committee meetings, client events and writes macro thematic pieces. She also contributes to flagship campaigns.
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