Deflating bubbles
August turned out to be a month of two halves for markets: initially increasing bond yields pushed down equities, this was then followed by declining yields helping equities recover again. In late June, as we reduced our equity holdings in our multi-asset portfolios from being significantly overweight to positions closer to neutral weights, we allocated the proceeds into short-term high-grade bonds. As a result, our mandates and funds delivered strong performance throughout July and experienced only modest declines through the volatility in August. The volatility itself stemmed from persistent negative developments originating in China and the renewed fears about the possibility of an extended period of elevated government bond yields. As seen in Figure 1, US treasury yields have continued their upward trajectory, reaching new highs in August, and only declining marginally on the back of the welcome softness in US labour market data in late August. In this month's edition of our Global Market View publication we are therefore exploring the ever-relevant concept of “When the tide goes out, you can see who is swimming naked”. Up until this point, increasing rates and tightening liquidity have resulted in the downfall of meme stocks, Chinese equities and a definitive end to a four-decade-long bull market in bonds, contributing to the conclusion of the global housing boom. The key questions for the remainder of 2023 and 2024 revolve around whether Chinese policymakers can effectively navigate the correction in the Chinese economy, driven by both the Fed and Chinese policy mistakes and thus if the ongoing bull market in US equities can endure the full Fed hiking cycle.
Figure 1: US government bonds reached peak yields in late August
In this particular business cycle, the largest risk is that tightening measures already implemented could potentially trigger a global economic downturn, or conversely, that the US economy continues to grow at a pace deemed “too fast” for comfort, prompting the Fed to enact more rate hikes than currently expected and thereby potentially cause a final correction in equity markets. Until now, growth in the US has remained stronger than nearly everyone expected this year. Nevertheless, the trend in inflation has been on a declining path, while interest rates have been on an upward trajectory for almost a year. This is good news for multi-asset class portfolios and active asset allocation as it has placed us in a situation where we can reasonably expect negative correlations between bonds and equities in case of a recession. The short-term challenge at hand is to assess whether the US economy will maintain its growth momentum and if China can effectively stabilise the construction sector and the associated bond and structured product “markets”. As seen in recent European data, China’s sluggish economy is a drag on the export-dependent European economy. It is also an internal concern for Xi. With his leadership compromised by lockdowns, declining house prices and a surge in youth unemployment, Xi needs to show a possible way out and towards achieving common prosperity. The outcome of the Chinese "Lock-down-Clamp-Down" experiment and the Fed's imminent decisions on interest rate levels thus remain the key factors deciding if our next move will be up or down in risk and when we will implement such moves. For now, we maintain the follow positioning:
In our growth strategies, with up to 100% equities, we hold equity allocations close to neutral levels around 60%. In EDGE Sustainable Growth, these positions remain concentrated in the low-pollution, high-growth sectors, such as IT and Healthcare.
In our balanced multi-asset strategies, we hold equity allocations close to average levels which, in most cases, means we have reduced our allocation from 50% to around 30%. We maintain significant holdings in high yield bonds in these strategies.
Across our Global Fixed Income Opportunities portfolios, we have reduced our overweight in high yield bonds by allocating 20-30% to high grade bonds. We maintain a short duration.