A structurally tighter policy era

We don’t expect developed market (DM) central banks to come to the rescue as they have in the past as economic growth slows – a consequence of some of the fastest rate hike cycles in history amid still-elevated inflation. We are entering an era of structurally tighter monetary policy, in our view. That means growth headwinds are likely to persist – we look up in quality across asset classes as a result, and evolve our view on European assets accordingly. Relatively strong sentiment towards the region vs. the US so far this year further strengthens the case for resilience through the quality factor and quality-tilted sectors, in our view. We also turn more constructive on European government bonds, moving to a neutral view with a preference for core exposures vs. the periphery.

While markets are catching up to our view that the US Federal Reserve (Fed) and other DM central banks won’t cut rates this year, we believe they are close to a peak – meaning duration could once again have a part to play as the risk of further large-scale hiking recedes. We see granular opportunities in the belly of the curve, which tends to be more stable than long duration exposures that are exposed to higher term premium amid still-uncertain policy paths. Investors have added to rates ETPs this year, with $75.2B of inflows globally year to date (YTD).1 We also like inflation-linked bonds as a hedge against the risk of further upside inflation surprises as we see price pressures remaining sticky, and look to a quality approach in credit given the challenging macro backdrop.

Opportunity in volatility

We look to opportunities in assets where the economic damage appears better priced – it’s all about valuations and what looks under-owned, in our view. The key opportunity? Emerging markets (EM). With EM central banks further ahead in their rate cycles – with many having already paused or started cutting rates – we see policy tailwinds for EM assets. A weaker US dollar also favours EM assets, while stimulus from Chinese policymakers to address slowing growth could provide an additional boost as the reopening loses steam. Inflationary pressures are less prevalent in EM, particularly in Asia. From a structural perspective, we see longer-term tailwinds for EM commodity exporters such as Brazil, thanks to megaforces that are likely to spur higher demand for certain materials, including the transition to a low-carbon economy, electrification and automation.

We also see a case for increased allocations to Japanese equities. The region has benefited from strong sentiment recently: $1.9B was added to US- and EMEA-listed Japanese equity ETPs in May, building on the $1.4B of inflows in April.2 While we choose not to chase the short-term rally in Japanese equities, a more strategic case is emerging, with the tailwinds of corporate governance reform and a backdrop of slowing but positive growth. A gap is opening up between Japan and the rest of DM, as the US, UK and euro area grapple with below-trend growth in the face of tighter credit conditions and higher-for-longer interest rates. As a result, Japanese equities could help investors who are looking to diversify their DM equity exposure.

Harnessing megaforces

We believe the new regime calls for new ‘whole portfolio’ approach that blends long-term themes with traditional stock and bond asset classes, while incorporating private markets, in a nimble fashion. We look to build exposures to megaforces that have been important near-term return drivers this year, such as AI, and those where entry points look attractive.

The advent and widespread adoption of generative AI has put the spotlight on companies directly involved in the space as well as indirect beneficiaries. In particular, we focus on semiconductors, which could be set to benefit not only from increased demand stemming from the development of AI, but also from their use in cloud computing data centres, electric vehicles, the internet of things and various other structural trends. We see further adoption of such technologies adding to potential for efficiency gains – and disruption in some parts of the economy. Given this, we think the full opportunity set is yet to be priced in by markets.

The low-carbon transition is another key trend that we see driving persistent demand for certain raw materials, such as copper, as well as clean energy technologies. We also see a significant opportunity to participate in and drive the transition through investment in companies that are currently significant carbon emitters, but which are investing to adapt and evolve business models, supply chains and energy sources to reduce their overall climate impact.

Our view on Swiss assets

We have a preference for Swiss equities relative to broad European equities (where we remain underweight) and are neutral on Swiss government bonds, in line with our broad European government bond view.

With domestic demand remaining resilient alongside a strong labour market and supportive economic policies, the overarching global macro slowdown should have less of an effect on Switzerland, in our view. Switzerland has fared relatively well so far this year in the face of global macro headwinds, off the back of the pandemic and following Russia’s invasion of Ukraine, especially compared to its European neighbours. This has been helped in part by the fact that Switzerland’s main energy sources are nuclear and hydropower, giving the country only limited exposure to Russian energy imports and surges in the prices of other energy sources. That said, the country is not immune to the indirect effects of the Russia-Ukraine conflict, including higher commodity prices, supply disruptions, elevated uncertainty and appreciation of CHF as a perceived safe haven currency, as well as the recently-confirmed eurozone recession. Given this backdrop of global macro uncertainty, the defensive composition of the Swiss equity market – which tilts towards healthcare and consumer staples – could be favourable, despite relatively high valuations and a strong currency that could weigh on export competitiveness.

On the bond side, we don’t see the Swiss National Bank (SNB) hiking to the same levels as the European Central Bank (ECB), given Switzerland’s relatively subdued inflation backdrop and strong currency. Inflation has picked up, breaching the SNB’s 0-2% stability range, but remains considerably lower than in other developed market economies and is expected to have peaked in early 2023. In a major turnaround, the SNB quickly hiked rates back to positive, despite the highly valued CHF, and we see a slower pace of hikes ahead. We also see the backdrop of global macro uncertainty limiting the prospect of further upward pressure on yields.

Any forward-looking statements may not come to pass.

1,2Source: BlackRock and Markit, as of 31 May 2023.

Karim Chedid
Head of the Investment Strategy team and chief strategist for EII EMEA