Ten Investment Convictions for H2 2023

The second half of 2023 offers a potential tipping point for the global economy. Inflation pressures are receding and risks are shifting to growth. While large economies continue to avoid recession and services look resilient, manufacturing indicators are weakening. Headline inflation is easing, but excluding energy the data is proving more stubborn. Fears of contagion in March from US regional banks have dissipated, and lending conditions tightened less than first feared.

In combination with tight labour markets and robust consumer spending, these trends give central banks space and the incentive to maintain restrictive monetary policies. Still, the end of the rate-hiking cycles is close. Central banks will keep rates high, and may even raise them further if needed, until the economic engine cools. The Federal Reserve is therefore unlikely to ease monetary policy before early 2024. We are closely watching the impact on small businesses and their employees who make up the bulk of economic production and labour. We expect that any recession in the US would be both mild and short-lived, and GDP growth of 0.9% for the full year.

In Europe, the energy shock is now past, core inflation has just started to decline, and wages continue to rise. We see the European Central Bank continuing its hiking cycle and weak economic growth of 0.7% in 2023. Meanwhile, China’s post-pandemic recovery has been slower than anticipated, and real estate vulnerabilities remain. However, inflation remains contained and consumer spending is holding up with China’s authorities maintaining their support. We see China’s economy expanding by 5.5% over 2023.

Globally, investors’ risk sentiment has been improving as inflation slows. Yet with growth also slowing, and gains in equity markets this year heavily skewed by the performance of mega-cap stocks and the technology sector, we retain a balanced investment stance and a neutral positioning in risk assets, focussing on areas with a greater safety margin, or a stronger growth outlook. This helps to balance mixed economic data and tightening credit conditions against valuations in risk assets that appear consistent with a soft economic landing. However, given the recession risks, the balance between risk and reward in equity markets does not look compelling. Costlier capital will weigh on corporate growth and earnings in the US, where we expect a decline of 8% in earnings growth over the full year in the S&P 500 index, followed by a 13% gain in 2024. In Europe, earnings should rise 13% in 2024, and by 15% in both Japan and China.

After a decade of low-to-negative interest rates, high quality fixed income again offers attractive returns. At this stage of the cycle, we like government and investment grade corporate bonds.

Any examination of opportunities is not complete without closely monitoring the associated risks, especially in the wake of the steepest monetary tightening cycle in decades. The dangers of persistent inflation and a monetary policy mistake remain a major risk, along with tighter credit seeping into the broader economy, and high geopolitical tensions. Further, we cannot rule out a sharp decline in corporate earnings, or markets underestimating recession risks.

In this publication we set out our ten strongest investment convictions and portfolio principles as we look ahead to the rest of 2023, and beyond.

1. Long-dated bonds offer yield and diversification

We like longer-dated government bonds (5-to-10 years), especially US Treasuries, then German Bunds and short-term UK government gilts. Our preference is based on our expectation of slowing growth and peaking rates. Higher yields make sovereign debt attractive and government bonds offer diversification in the event of a sharper economic slowdown, making these assets a useful addition to portfolios. Historically, government bonds tend to outperform cash after rates peak.

2. Prefer higher-quality segments on developed credit markets

We also favour attractive yields in investment grade credit, which is competitive with equities for the first time in many years. Here we focus on higher quality issuers such as 3-to-5-year European credit. In the high yield segment, valuations now look expensive compared with historical levels, and misaligned with the potential credit risk as growth slows and rates remain at high levels in the second half.

3. Favour emerging market local over hard currency bonds

Emerging market local currency debt offers a return and diversification opportunity through attractive local rates and currencies. We favour markets that offer high carry yields, and continue to prefer a defensive stance on emerging hard currency bonds as valuations seem expensive given the macroeconomic uncertainties. We look for carry opportunities in Brazilian government bonds, which provide an attractive yield over developed and other emerging markets, as well as potential gains from future interest rate cuts.

4. Prefer quality stocks and non-US markets

There is still some potential for upside from equities, but much depends on earnings and therefore the depth of any recession. We see three important areas of focus: the path to an earnings recovery, the end of rate hikes, and broadening market returns away from the technology sector that has driven 2023’s performance to date. Overall, we prefer markets outside the US and see opportunities in Europe, Japan and China. In contrast to the US, much investor pessimism has built up around China. With growth expectations weak, investor positioning reduced, and room for further policy stimulus, Chinese equities offer potential upside. More broadly, defensive sectors offer better prospects than cyclicals, which are already discounting a potential recovery in economic activity. From a sector point of view, we prefer staples and healthcare along with industrials and financials.

Quality stocks tend to outperform in uncertain environments and lend themselves well to an active investment management approach. We concentrate on earnings compounders and pricing power, and while valuations for such businesses will rarely be cheap, they do not look excessive.

5. Commodities to present opportunities in a broad portfolio context

We believe that gold can deal with current economic headwinds of higher-for-longer rates and see the potential for prices to rise to USD 2,100 per ounce by early 2024. Prices may be driven by a peak in US real rates, a weakening US dollar, and robust demand for the metal from investors, central banks and consumers. In the short term, we expect Fed decisions to drive gold prices. Meanwhile, energy and copper should see some medium-term support from tight supply thanks to demand from emerging markets and the transition to greener energies.

6. Swiss franc, euro and Japanese yen to strengthen against dollar

We see wide divergence in currencies. Beyond the short term, the US dollar is likely to experience further weakness, especially against the Swiss franc, euro and Japanese yen. Overall, we remain cautious on currencies that are sensitive to global growth and that offer lower yields, including the Chinese renminbi. Instead we favour the high carry yield offered by emerging markets such as the Brazilian real, which is benefiting from an environment of falling inflation and improving fiscal and external balances.