A tougher start to the second quarter
The latest economic data from the US has not been particularly supportive for either bond or equity markets. This year’s inflation readings have all come in higher than expectations, with the latest figures even suggesting that inflation may be starting to reaccelerate. Investors are now questioning whether there will be any interest rate cuts this year, after expecting as many as seven at the start of the year. This is putting pressure on bond markets, despite a brief rally following data showing that US economic growth fell below 2% in the first quarter. Having started the year at just under 4%, the US 10-year bond yield now stands at 4.7%, slightly below its peak from autumn 2023. Equities have been relatively resilient in the face of this bond market sell off, as well as rising tensions in the Middle East. As of the end of April, the MSCI All Countries World Index was 3.4% below a record high set in March.
Middle East risks remain
The missiles that Iran and Israel fired at each other in mid-April marked the first time that the two countries have directly attacked each other’s territory. There is concern that crossing this line will open the door to further conflict in the Middle East, though both sides have indicated that they want to avoid further escalation. However, as Schroders’ senior adviser General Sir Nick Carter pointed out in a recent podcast, there is always a risk of miscalculation in such charged situations. Somewhat more encouragingly, the episode also showed that diplomacy and new regional alliances can help to defuse tensions. While oil prices have largely shrugged off the latest developments, the risk to commodity supplies – and inflation – from geopolitics remains significant. More than two years after the invasion of Ukraine, metal prices have been rising again after the UK and US government imposed new restrictions on trading metal sourced from Russia.
Some reason for cheer in the UK
Following all-time highs for stock markets in the US, Japan and the Eurozone, the FTSE100 is now also setting records. However, its latest advance has not come with a huge amount of celebration. For one thing, the more domestically-focused FTSE250 remains 17% below the peak it reached in late 2021. The better performance of UK equities has also been fuelled by a flurry of takeovers, including a £30 billion bid for one of the world’s largest miners. While some of these deals have been welcomed by shareholders, the steady exit of companies from the stock market is leading to renewed concern about long-term prospects for the UK’s capital markets. At the same time, there have been some signs of improvement in the domestic outlook. Unlike in the US, inflation in the UK has continued to fall, making interest rate cuts more likely. UK mortgage approvals also hit their highest level for 18 months in March and are now just below the average of the past decade.
Positioning
Our overall equity exposure is broadly in line with our long-term strategic targets. A peak in interest rates, and the potential for interest rate cuts, should be supportive for the asset class. On the other hand, valuations now look high relative to other asset classes and, in the case of the US, relative to history. Bond markets have been under pressure as interest rate cuts look set to be delayed. However, with yields now at attractive levels, we remain overweight with a slight preference for shorter-dated bonds, given uncertainty around interest rates. We still see appeal in alternatives and have benefited from this year’s rally in gold and commodities. However, the relative appeal of alternative investments has fallen as interest rates have risen and we are now slightly underweight. High levels of inflation in the UK have made meeting inflation-plus return targets more challenging in the near term. Despite this, we remain confident in the ability to meet inflation-plus targets over the longer term.
Key
🟢 Positive
⚪ Neutral
🔴 Negative
Outlook
| Economics | Interest rates are weighing on growth, but a soft landing is looking increasingly likely as consumer demand remains resilient (particularly in the US).Headline inflation has fallen significantly, but core inflation is likely to remain above central bank targets in the near term.Labour markets have started to soften but are likely to remain tight in the near term, adding pressure to wage inflation.Whilst sticky inflation and tight labour markets may delay rate cuts, central banks appear to be comfortable with cutting rates ahead of inflation falling back to target, if the general trend remains disinflationary. |
| Valuations | US large cap equities remain expensive based on traditional metrics, but fundamentals are strong. Most other regions look fair vs history, but expensive vs cash and bonds.Credit spreads remain tight (especially in the US) although absolute yield levels remain reasonable as government bond yields are elevated relative to the last decade.Valuations of both equities and credit remain vulnerable to a meaningful deterioration in corporate earnings. |
| Sentiment | Investors have become less bullish over the last month. Market volatility has risen from recent lows but remains well below long term averages.Consumer sentiment remains close to 2-year highs across many developed markets, although concerns around unemployment have grown. Sentiment in China remains weak.Business sentiment appears to have bottomed with most regions moving in positive territory, although smaller business sentiment remains weak.Improving consumer and business confidence should be supportive for markets, whilst a pullback in investor sentiment reduces the risk that markets have overstretched. |
| Risks | A resurgence in inflation, which would warrant continued hawkish central bank policy.Labour market weakness could challenge the developed market growth outlook. Potential spillover effects from slowing growth in China on the global economy.Escalation in geopolitical tensions, e.g. Middle East, Russia/Ukraine, US/China.Large number of elections taking place, with the US election likely to create volatility. Mounting levels of government debt, particularly in the US, pose a longer-term risk. |
Asset Classes
| Asset classes | Current positioning | Current views |
| Equities | ⚪ | We are neutral equity having been increasing exposure over 2023. A peak in rates is supportive, with falling inflation likely limiting the need for further rate rises (although risk is to the upside). Earnings were robust in 2023 and reasonable so far this year, particularly for the US and Japan. US valuations remain expensive relative to history (albeit with strong fundamentals) whilst other regions are expensive vs bonds/cash. |
| Bonds | 🟢 | Government bond yields look attractive relative to the last decade, having risen again this year. We marginally prefer shorter duration assets, which should hold up better if inflation surprises to the upside – as has been the case this year. We continue to prefer the credit of investment grade issuers, as well as emerging market debt where yields are reasonably attractive and growth prospects are generally brighter. |
| Alternatives | 🔴 | Select alternatives continue to offer diversification in a potentially volatile environment, albeit with a higher hurdle given yields available on bonds and cash. We favour assets with the ability to deliver less correlated returns to traditional markets and those which hedge against risk scenarios, such as gold and other commodities. |
| Cash | ⚪ | Rising interest rates offer more attractive returns relative to recent history, whilst cash offers optionality in potentially volatile markets. |
Terms
Spread: the difference in yield between a non-government and government fixed income security.
Duration: approximate percentage change in the price of a bond for a 1% change in yield.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.
All data contained within this document is sourced from Cazenove Capital unless otherwise stated.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
