Laurent Denize, Global Co-CIO ODDO BHF AM.
We are reweighting emerging markets, particularly China, given its attractive valuations and the expected acceleration in growth.
As outlined by Bruno Cavalier in his latest Macroview editorial, the global economy is sending out mixed signals. In terms of asset allocation, our role is to make investment decisions based on the macro-economic environment, micro-economic data, and what is commonly known as the “momentum”, in which we encompass different data points such as: investment flows, alternative data, technical analysis, positioning, sentiment indicators…
Half-empty glass
Let’s be franc and say that we’ve chosen our side and we believe risks are to the downside. Globally, economic growth in China has slowed to around 5%, in the US to less than 2%, and Europe is beginning to contract. It is therefore possible that global growth will fall below the 2% threshold that defines a classic recession. We are not there yet, but the recent trajectory of less than 3% in the 3rd quarter does not bode well.
Historically, rising unemployment has been the main factor contributing to a slowdown in economic activity. This may not be visible in developed countries, but take a look at China and its 11.6 million new graduates. In April, unemployment among young Chinese aged 16 to 24 reached a record level of 20.4%, almost double the pre-pandemic level of 12%. The arrival on the Chinese labour market this summer of millions of “Graduate 2023” young people could further jeopardise the government’s “social pact”. But China is not an isolated case. Germany has also seen unemployment rise by 0.7%, alongside a contraction of its economy.
What should we expect?
If the global economy were in the early stages of a classic recession, the following would be observed:
- Falling oil and metal prices, which is the case.
- Directionless price movements in the High Yield market, which is the case.
- Underperformance of cyclical sectors, which is the case.
- Equity indices down overall, which is not the case.
One explanation for the overall rise in equity indices lies in the spectacular performance of the “magnificent 7”: Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta and Tesla, whose combined market capitalisation now stands at $11,000 billion. The outperformance of these 7 stocks may continue for some time, but even the technology sector is not immune to a recession, let alone rising interest rates. Furthermore, the Nasdaq has announced that it will be reducing the weighting of MegaCaps in the Nasdaq100 to avoid excessive concentration. In this respect, it will be interesting to see how the price of these stocks develops until the index is rebalanced (24 July) and whether other index providers follow suit. This situation is reminiscent of the capping of DeutscheTelekom in the DAX in the year 2000…
So far, the signals of global deceleration have mainly been linked to China, as evidenced by the underperformance of metals and industrial commodities. In the months ahead, however, the weakness will no longer come from China, but from developed economies. Indeed, Chinese growth has become so worrying that the government is likely to intervene more significantly with stimulus measures to defend its 5% growth target. On the other hand, the dogmatism of central banks in trying to combat inflation, which they were slow to tackle, could push developed economies into a mild recession.
Our convictions in terms of asset allocation
The consequences of this paradigm shift are important to your future asset allocation.
Here are our convictions for this summer.
- We recommend a slight underweight in equities because of the negative economic repercussions of tighter credit conditions in developed markets (Europe and the US). An economic slowdown is becoming more likely as PMIs deteriorate. Against this backdrop, we prefer to shift our focus from overvalued equities to value equities with reasonable fundamentals and growth prospects. We are reweighting emerging markets, particularly China, given its attractive valuations and the expected acceleration in growth.
- Some companies may experience pressure on margins, as price increases are likely to remain limited in an environment of weaker demand, while increases in fixed costs, particularly labor costs, remain high. In that respect, the luxury goods sector remains attractive.
- We maintain our cautious stance on credit risk, particularly for highly leveraged companies, as the risk of financial stability translates into a more restrictive supply of credit. We are very cautious about the overleveraged real estate sector. Only shortduration bonds (maturity up to 5 years) can offer an attractive risk/return profile with a comfortable carry.
- We are keeping a close look at the potential drying-up of liquidity in the market, as central banks reduce their balance sheets and the expected issuance volumes of the US Treasury need to be absorbed in the coming months. As a result, we are taking profits on peripheral debt and further increasing our underweight position.
- The risk of a monetary policy misstep has increased. The financial system and the economy are vulnerable. Central banks must also strike a balance between the objective of price stability and the stability of financial markets in the context of accelerated monetary policy transmission. We need to add duration to our portfolios. We favour German and US sovereign bonds with maturities of 5-7 years. It is too early to play up the steepening of yield curves.
In conclusion
The simultaneous supply and demand shocks of recent years have temporarily broken the historical correlations between growth, unemployment and inflation. They continue to disrupt the reading of our macro and microeconomic environment. At this stage, the business leaders we work with remain very constructive in their outlook, a view at odds with the recent deterioration in macroeconomic indicators. The earnings season will give us a first indication of the trend in margins and earnings per share, and confirmation that a normalisation process is underway.
