UIC retains neutral risk positioning
Strategic portfolio influenced by four topics
- Slightly brighter growth picture, but mild recessions remain likely in the US and Europe
- Persistent inflationary pressure although it is gradually easing
- Strategic portfolio influenced by China’s reopening, yield pick-up for bonds, rising yields and the Japanese yen
Outcome and justification
The Union Investment Committee (UIC) adhered to its neutral risk positioning (RoRo meter at level 3) at its meeting on 24 January 2023, the first scheduled meeting of the year. The UIC did not make any changes to the strategic portfolio either. However, it had already reduced the weighting of government bonds from core eurozone countries and US Treasuries at the start of 2023. In mid-January, the committee then bulked up equities from emerging markets (EMs) and commodities (by adjusting the exposure to industrial metals and energy) and, in return, increased the underweighting of equities from industrialised countries. This means that the strategic portfolio is currently underweight in terms of fixed income and equities, with the UIC preferring to hold cash.
The UIC’s decisions are based on four trends in the capital markets: the reopening of the Chinese economy, yield pick-up for bonds, rising yields on safe-haven government bonds (short duration) and the appreciation of the Japanese yen. The strategic portfolio is positioned accordingly at asset class level, in part with very significant displacements.
The UIC believes that this positioning is appropriate at present because conditions still do not appear right for a more opportunity-oriented approach. Given the ongoing phase of economic weakness and the expectation priced into the capital markets that US interest rates will be lowered in 2023, the risk of setbacks is high, especially after the positive start to the year. The UIC is therefore adhering to its neutral positioning and, instead, is opting for a more pronounced positioning at sub-asset class level.
Economy, growth, inflation
Global economic conditions remain difficult, although glimmers of hope for the economy are growing in number. For example, the European economy is doing better than was thought, partly because it has been spared an energy crisis. This was confirmed by the announcement on Germany’s gross domestic product (GDP) for 2022, according to which economic activity grew by 1.9 per cent. This was despite the turmoil created by Russia’s invasion of Ukraine and the fallout from the coronavirus pandemic (which remained substantial, at least in the first half of the year). Considering the many challenges, this is an impressive figure and represents surprisingly robust growth.
The main reasons for this were the lifting of coronavirus restrictions and rising consumer spending, which revealed significant pent-up demand for services such as tourism and hospitality. And unlike in previous crises, the labour market held steady too. Fewer shortages of intermediate products enabled manufacturers to work through the plentiful orders on their books. The winter recession predicted by Union Investment was therefore milder than first feared. Nevertheless, the upturn is likely to be very lacklustre this year. Although gas prices have fallen to pre-invasion levels, they remain far higher than they were in mid-2021 and before the pandemic. Industry will therefore continue to act as a brake on growth for the time being. Tighter funding conditions are not helping matters either. Union Investment’s economists anticipate a 0.7 per cent fall in German GDP this year, followed by growth of 0.8 per cent in 2024. Not until then is the German economy expected to return to pre-crisis growth rates across the board.
China is currently providing support for the global economy and particularly for Germany and the rest of the eurozone. Following the Beijing government’s U-turn on its zero-COVID strategy, signs are emerging of a pick-up in growth. Some market observers fear an increase in (global) price pressures as the Chinese economy reopens – as was the case in the US and Europe – but Union Investment’s experts do not expect this to happen. Lower levels of excess savings and relatively high unemployment in China make significant inflationary pressure unlikely after the country’s reopening. Moreover, the service sector is smaller than in western countries.
In the US, however, much of the macroeconomic data has recently been rather weak. Both retail sales and industrial output fell short of the majority of analysts’ expectations. At the same time, the labour market showed further signs of a slowdown. The UIC anticipates that this trend will continue, although it does not predict a marked slump. And a recession is probably unavoidable, both in the US and in the eurozone.
Nonetheless, the weakness of the economy is likely to dampen inflation. There are already indications that it is easing, particularly in the US. The UIC forecasts a further fall in both headline inflation and – with a slight delay – core inflation. Looking at 2023 as a whole, the committee expects consumer prices to rise by 4.0 per cent in the US. The inflation data for the eurozone at the start of the year is harder to interpret due to one-off effects. However, wages have recently been rising more strongly, which suggests to the UIC that core inflation will remain elevated for slightly longer. Union Investment’s economists are raising their eurozone inflation forecast slightly (despite the fall in energy prices) and now expect an annual inflation rate for 2023 of 6.8 per cent.
Monetary policy: US cycle of interest-rate rises approaching its end
The easing of inflation in the US gives the US Federal Reserve (Fed) more scope to end its cycle of interest-rate hikes in the foreseeable future. Since it embarked on its course of tightening, the central bank has raised the key interest rates markedly and rolled back its unorthodox forms of support. Now, the Fed is likely to give the measures time to take effect. The latest public pronouncements by high-profile Fed representatives also point in this direction. The UIC therefore anticipates just one more interest-rate rise in February, which is likely to be the final one for the time being. After that, the Fed will probably take a break in its main scenario. Interest-rate cuts – as are already being discussed in some corners of the market – are not expected in 2023 and are unlikely to be back on the agenda until 2024 at the earliest.
The situation is slightly different in the eurozone, where inflationary pressure remains elevated. Union Investment’s economists predict that the European Central Bank (ECB) will raise its interest rates by a further 125 basis points before ending the cycle of interest-rate hikes with the deposit rate at 3.25 per cent. Specifically, they anticipate increases of 50 basis points in both February and March, followed by a final rise of 25 basis points in May.
However, discussion about monetary policy in recent weeks has centred not on the Fed or the ECB but on the Bank of Japan (BoJ), which is the only one of the major central banks to keep its monetary policy expansionary. In particular, the strategic management of the yield curve, known as yield curve control (YCC), is provoking heated debate. Japan too is seeing increasing signs of higher inflation, albeit at a much lower level than in other countries. Moreover, it becomes harder and harder to keep using such an instrument, the more that the other central banks switch to a path of easing.
Consequently, Tokyo’s first monetary policy meeting of 2023 was eagerly awaited. However, it ended without a new decision being reached. Contrary to market speculation, the BoJ is therefore adhering to its existing strategy. The UIC does not expect this situation to change before the BoJ’s governor, Kuroda, leaves office in April 2023. Only then is the subject likely to rear its head again, especially as the fundamental picture will probably provide more of an argument for the gradual normalisation of monetary policy in the second half of the year. The committee therefore anticipates an adjustment in the second half of 2023 (with a rise in the target yield for ten-year paper from 0 per cent to 1 per cent) and for YCC to be discontinued in 2024.
Positive performance contributions from all sources of return for commodities; shortages for energy
Positive performance contributions from all sources of return
Supply of diesel remains under pressure
Fixed income: interest-rate hikes priced out too soon
After a brief trend reversal in the second half of December, US government bond yields resumed their downward trend and reached new lows of 4.08 per cent on two-year paper and 3.37 per cent on ten-year paper last week. Bond market participants continue to pin their hopes on an imminent pause in the Fed’s cycle of interest-rate rises. Yields on German Bunds have also fallen across all maturities since the start of the year. In December, however, they had climbed rapidly, meaning that the net change over a two-month period still amounts to a rise of just over 50 basis points for two-year maturities and 20 basis points for ten-year maturities. However, Union Investment’s economists believe that interest-rate hikes are being priced out too soon both in the US and in the eurozone. Consequently, we are maintaining our underweight positioning in US Treasuries and government bonds from core eurozone countries. In recent weeks, the ECB has been emphasising that bringing inflation under control will require interest rates to be raised further. Meanwhile, the inversion of the German yield curve has become more pronounced. Two-year Bunds are currently yielding 2.45 per cent – 30 basis points more than their ten-year counterparts. The UIC’s prediction for ten-year Bund yields is an increase to 2.5 per cent over the course of 2023, especially as the German Finance Agency will ramp up its issuance volume in order to fund higher fiscal spending. As a result, the shortage of lodged collateral for funding transactions should reduce. Swap spreads in the eurozone have already started to fall in recent weeks. This trend is likely to persist a little longer. Bond segments such as investment-grade corporate bonds, which use these spreads for pricing, should thus continue to enjoy favourable conditions. The start of the new year has also marked the reopening of the primary market in this segment, which many investors seem to have been keenly awaiting. An abundant supply of new bonds has been met with even higher levels of demand, allowing the attractively priced new issues to be absorbed well by the market. Investment-grade corporate bonds remain the UIC’s favourites in the current environment, even though yield spreads have narrowed more quickly than anticipated. Government bonds from the emerging markets also remain interesting at their current spread levels. By contrast, the UIC continues to take a cautious approach to eurozone periphery bonds. The Italian government’s substantial net funding needs are likely to have had an adverse impact on yield spreads, which have recently been quite low.
Equities: Europe makes a strong start to the new year
After a period of consolidation in December, the equity markets have started to pick up pace again in January. Key economic data turned out better that many had feared, which allowed investors to breathe more easily and gave share prices worldwide a boost. European equities led the field thanks to sharply falling oil and gas prices. The reopening of the Chinese economy is also likely to be particularly favourable for many European companies. Given that European equities are trading at attractively low valuations and that many investors currently hold only small exposures to them, there is scope for these assets to catch up further with US stocks. Much like the macroeconomic data, corporate profits did not turn out as poorly as many had feared. On balance, the declines in profits reported so far for the final quarter of 2022 have been moderate. The tech sector will probably remain in recession for now and companies have started to respond by cutting some of the jobs they had added amid the ‘post-pandemic tech hype’. This news in being received favourably by the markets, but general sources of downward pressure (low growth, high inflation, restrictive monetary policy) continue to exert their influence. Against this backdrop, higher revenue and profits – i.e. growth – are likely to be the exception rather than the rule initially, but the situation should brighten again in the medium term. The situation in China continues to be an important factor for shares from the emerging markets. Following the easing of Beijing’s zero-COVID policy, share prices continued to rise in the stock markets in Hong Kong and China until the markets closed for the Chinese New Year holiday period. It remains to be seen what impact holiday-related travel will have on the renewed spread of coronavirus in China and how this might affect the Chinese economy. Nonetheless, the overweight exposure to equities from the emerging markets has been confirmed.
Commodities: positive performance contributions across the board
In the first weeks of 2023, cyclical commodities were boosted by the fact that macroeconomic data for the US and Europe turned out better than first feared. In the industrial metals segment, investors are banking on a stimulation of demand by the abandonment of the zero-COVID policy in China in the short term and higher demand in connection with the transition to a green economy over the long term. Meanwhile, the North Atlantic energy market remains characterised by limited supply. Although gas prices were recently driven down by a spell of mild weather, Union Investment’s experts believe that there is very limited potential for prices to fall further. In the oil sector, refinery margins in the US grew robustly again as diesel in particular remains in short supply domestically due to exports to Europe. Alongside fundamental drivers, the other two sources of returns also supported the commodity markets. Higher interest rates mean that collateral is now generating positive returns (investments in commodities are made exclusively via derivatives with cash collateral being invested in bonds). Moreover, the roll yields for the prolongation of derivatives transactions are very attractive for energy commodities and also slightly positive for industrial metals. In this respect, precious metals are the only sector that is currently unattractive.
Currencies: all trends intact
The depreciation of the US dollar that began in the middle of October 2022 carried over to the first few weeks of the new year. Hopes that the Fed might conclude its cycle of interest-rate hikes sooner than other major central banks remain a key driver of this trend. Due to this constellation of monetary policy, the interest-rate differential is set to shift towards other currencies, such as the euro or pound sterling. Due to persistent inflation in Europe, both the ECB and the Bank of England remain focused on curbing inflation and are therefore not yet in a position to mirror any step changes by the Fed. Consequently, the euro and the pound sterling – as well as the currencies of all other countries whose central banks have not yet concluded their cycle of interest-rate increases – remain better supported than the US dollar. The Japanese yen initially also continued to recover. However, at its most recent meeting, the Bank of Japan (BoJ) disappointed the hopes of market participants that it would change its monetary policy regime. This prompted a temporary reversal of the overall appreciation trend of the Japanese currency. The UIC continues to believe that the BoJ will adjust its monetary policy approach over the further course of the year and is therefore maintaining its long position in Japanese yen, of which half is against the US dollar and half against the euro.
Convertible bonds: an encouraging start to 2023
Convertible bonds were also able to benefit from the upward trend in the equity markets. From a global perspective, only Japanese convertibles were a little sluggish. The average equity market sensitivity continued to rise, reaching around 55 per cent. Overall, convertible bonds now offer a very well-balanced risk profile and a good level of convexity. Valuations are gradually climbing towards expensive territory, although most convertibles are currently still valued fairly. Issuance activity in the primary market for convertible paper was very muted over the Christmas holiday period and at the start of the new year.
Unless otherwise noted, all information and illustrations are as at 24 January 2023.