In a nutshell
Investor focus has shifted from inflation to growth – uncertainty about which remains unusually high. Equities and government bonds moved back into negative correlation, which benefitted multi-asset investors.
Purchases by systematic strategies and a positive liquidity supply have supported equities recently – despite scepticism from discretionary investors. With the higher equity positions of systematic investors and the threat of liquidity withdrawal, we expect at best a back-and-forth in the markets.
Bond yields are no longer likely to rise sharply, which makes interest rate duration more interesting. Commodities are pricing in a significant economic downturn. We are more cautious on equities.
Portfolio positioning at a glance
After the strong start to the year, we reduced the equity quota in several steps to a slight underweight in the first quarter, starting in February. In the second quarter, we took advantage of phases of strength to make further reductions to a now moderate underweight.
In return, we further expanded the bond side. In view of the economic risks and the foreseeable end of interest rate hikes, we raised the interest rate duration to near neutral. We also consider the risk premiums of good quality corporate bonds to be attractive, but are sticking to shorter maturities here, as risk premiums above the historical median could also widen further in the event of economic weakness. Overall, we have reduced credit risk in favour of interest rate risk, for example by exiting USD high-yield bonds. Emerging market bonds, especially in local currency, remain attractive given higher real interest rates and the chance of earlier rate cuts.
Commodities are already pricing in an economic downturn the most. In conjunction with the structural demand from the energy transition, we remain overweight cyclical commodities. Gold as a diversifier also remains overweighted.
Second quarter review: slightly reduced momentum
For the markets, the picture from the first quarter continued, superficially, at a reduced pace. Equities and bonds continued to rise, while industrial metals and energy commodities fell further and gold stagnated. Under the surface, however, there were several trend reversals. In contrast to the first quarter, defensive stocks outperformed cyclicals for a long time in the second quarter, US equities outperformed European equities and the US dollar strengthened. EUR/USD is now almost unchanged since the beginning of the year. Together with the relative weakness of small caps vs. large caps and of emerging market equities vs. developed market equities, this signals a more sceptical assessment of global economic development by the markets than in the first quarter. In view of the problems of individual banks, higher central bank interest rates and very mixed economic data, this is not surprising.
Continued high uncertainty about economic development
The economic upswing expected for spring has so far failed to materialise in the Eurozone – economic data have increasingly disappointed from April onwards.
Besides the less bad than feared winter in the Eurozone, China's somewhat weak recovery following the end of its COVID-19 restrictions is one reason for this. The US economy is also showing signs of weakness, especially in manufacturing. However, the labour market and services continue to prove more robust than expected – positive and negative economic surprises balance each other out. The question remains whether a "soft landing" succeeds, i.e. can a recession be avoided? Less fiscal stimulus and liquidity withdrawal after the agreement to suspend the US debt ceiling, tighter credit conditions and weakening credit demand support our expectation of a further economic slowdown and a possible recession until spring 2024.
One should not forget that effects of monetary policy usually show up in the economy only 12-18 months later – currently with an additional delay, e.g. because many consumers initially still had COVID-19 savings and fiscal policy remained expansionary. We maintain our view that the longer the economy proves robust, and the longer inflation and central bank rates remain high, the harder the landing could ultimately be.
Liquidity withdrawal likely to weigh in the coming months
In addition to the economic risks, sharply falling net liquidity is likely to become a headwind for the markets in the coming months. The Fed and the ECB are already continuously withdrawing liquidity through quantitative tightening. Since the beginning of the year, liquidity has nevertheless increased in the US and supported the markets.
On the one hand, the Fed has once again provided liquidity with an emergency programme in the wake of the bankruptcy of the Sillicon Valley Bank. On the other hand, the reaching of the debt ceiling in the US in January prevented the issuance of new government securities, so that the US government drew on its "savings" until the cash reserves were exhausted at the end of May. With the suspension of the debt ceiling until early 2025, the issuance of large volumes of US government securities is now expected, and cash balances are to be replenished quickly. Analysts at Morgan Stanley estimate that USD net liquidity will fall by 8-14% over the next six months – a level that has recently been a drag on equity markets. In the Eurozone, in addition to the monthly quantitative tightening, there is also a significant withdrawal of liquidity due to the ECB's TLTRO loans to banks coming to an end. In the event of stress, the central banks are likely to step into the breach again. However, this will probably only happen after a stronger sell-off.
Position building by systematic investors makes equities more vulnerable
While discretionary investors, like us, tend to be sceptical, as sentiment surveys confirm, rule-based investment strategies have significantly increased their equity positions from low levels in recent months. Momentum indicators increasingly turned positive as equity performance is now also positive over six and twelve months in Western markets. Implied and realised volatilities declined. The VIX Index, a measure of the implied volatility of US equities, fell from an average of 25.1% in Q4 2022 to 17.1% since the beginning of April. In June, the VIX index closed below 15% for the first time since February 2020. Realised volatility, which is even more important for most systematic investment strategies, fell even more. This allows them to build up risk positions. The fact that volatilities fell more for equities than for bonds favoured the relative build-up of equity positions in risk parity strategies.
Another driver is the return of the negative correlation of equities and government bonds. The correlation of US government bonds and US equities over the last 60 trading days has fallen from over +0.4 in January and early February to below -0.5 in early June. As the diversification effect increases, the overall risk of multi-asset portfolios decreases significantly. Rule-based strategies then continued to expand risk positions. With the build-up of equity positions through systematic strategies, however, equity markets have again become more susceptible to setbacks. In the event of a significant increase in volatility and/or a renewed synchronisation of equities and bonds, rule-based strategies may be forced to sharply reduce equity positions in a sell-off. If this leads to a stronger correction, we would likely seize the opportunity and expand equity positions again.
Prof. Dr. Bernd Meyer
Prof. Dr. Bernd Meyer has been Chief Investment Strategist at Berenberg Wealth and Asset Management since October 2017, where he is responsible for discretionary multi-asset strategies and wealth management mandates. Prof. Dr. Meyer was initially Head of European Equity Strategy at Deutsche Bank in Frankfurt and London and, from 2010, Head of Global Cross Asset Strategy Research at Commerzbank. In this role Prof. Dr. Meyer has received several awards. In the renowned Extel Survey from 2013 to 2017, he and his team ranked among the top three multi-asset research teams worldwide. Prof. Dr. Meyer is DVFA Investment Analyst, Chartered Financial Analyst (CFA) and guest lecturer for "Empirical Research in Finance" at the University of Trier. He has published numerous articles and two books and received three scientific awards.