Global Asset Allocation: December Insights

1. Market Perspective

• Uncertainty persists for the global economic outlook as hawkish central banks battle with high inflation in the face of weakening growth expectations
• The US Federal Reserve has signalled a moderation in the pace of tightening but remains committed to taming inflation, acknowledging the potential for a higher-for-longer terminal rate.
• Heading into the winter months, the European Central Bank (ECB) faces a more challenging energy-driven inflation battle. Having remained steadfast, the Bank of Japan (BOJ) may be forced to ease yield curve controls as inflation takes hold and rate differentials have weakened the yen.
• Emerging market (EM) central banks are nearing the peak of their rate hiking cycles but may need to hold rates firm to defend against weakening currencies. Uncertainty surrounding Chinese economic growth is increasing as officials ease economic policy while balancing COVID lockdowns and recent unrest.
• Key risks to global markets include central bank missteps, persistent inflation, potential for a sharper slowdown in global growth, China’s balance between containing the coronavirus and growth, and geopolitical tensions.

2. Portfolio Positioning

As of 30 November 2022

• We are underweight stocks, remaining cautious on the weakening outlook for growth and earnings amid still elevated inflation and active central banks.
• We remain modestly overweight cash relative to bonds given attractive short-term yields, while longer rates remain vulnerable to inflation and potential headwinds from duration if rates rise further.
• Within equities, we are nearly balanced between value and growth. The slowing growth backdrop is unfavourable for cyclicals, while higher rates weigh on growth-oriented equities. 
• Within fixed income, we are overweight emerging market debt, where attractive valuations offer reasonable compensation for risks and fundamentals remain generally supportive. Default rates are expected to rise from today’s historically low levels towards longer-run averages with higher yields providing a buffer should credit spreads widen. We also hold a modest overweight to high quality government bonds as a risk-off ballast to equities.

3. Market Themes

Took the Pain, Now the Gain?

The year 2022 is shaping up to be one of the worst years of performance across global fixed income markets as yields were driven sharply higher by central banks battling decades-high inflation. The pain was not unique to fixed income markets as equities broadly moved in sync, leaving investors in diversified portfolios with few places to hide. As painful as the year has been, fixed income markets are looking more attractive today than they have in more than a decade. With yields now at higher levels and expectations for inflation moderating amid slowing growth next year, fixed income markets could be well positioned for positive returns as central banks’ tightening slows. Even for investors on the sidelines awaiting a better entry into risk assets, cash is finally getting compensated. Credit markets also look more appealing today with high yield bonds yielding more than 9%, providing attractive income and a buffer should spreads widen. And while there is a high probability of recessions hitting major economies next year, credit fundamentals remain relatively strong, supporting our analysts’ expectations for a modest increase in defaults towards longer-run averages. So as markets enter 2023 still facing significant risks to the growth outlook, fixed income markets could prove their value through both higher income and a return to providing diversification benefits.

Pace Yourself?

Minutes from the Fed’s November meeting pointed to a growing consensus to moderate the pace of interest rate hikes, while at the same time suggesting the potential for a higher terminal rate which could be sustained for an extended period. After having raised rates at a historically fast pace of 75 basis points for the fourth consecutive time, a growing contingent of members cautioned that the level of rates may ultimately prove higher than necessary to contain inflation. Given that tighter monetary policy implemented today can take more than a year to flow through the economy, it is increasingly difficult for the Fed to judge if they’ve provided enough medicine to contain inflation or unnecessarily overdosed the economy. The release of the minutes coincided with multiple Federal Open Market Committee (FOMC) members publicly suggesting a downshift was in the works and the market certain of a 50-basis-point move in December. The Fed is not the first central bank pulling back on the pace of hikes, as several other developed and emerging market central banks have already slowed their trajectories. So, while a downshift seems warranted by the Fed, by citing the potential for rates remaining higher for longer, they have given the market notice to pace itself, as they intend to achieve their goal no matter how high the climb or how long it takes.

For a region-by-region overview, see the full report (PDF).