Markets start the year on good form

Equities and bonds have both continued the recovery that began late in 2022, as investors anticipate a peak in interest rates and a decline in inflation. As at the end of January, global equities were 14% above the low point of last year and global bonds a more modest 5% (both in GBP). There is certainly some justification for the better performance. Recent data suggests that core US inflation is falling and that the economy is coping with interest rate rises better than many anticipated. China’s Covid exit wave also appears to have been less disruptive than feared and the country may well provide a boost to global growth this year.

Central banks nearing end of rate rises

The start of the month was a busy one for monetary policymakers, with the Fed, the Bank of England and the ECB all increasing interest rates. Markets added to January’s gains in response to the Federal Reserve’s press conference. Fed Chair Jay Powell said that the “disinflationary process” had begun and suggested that a peak in interest rates was very close at hand. However, markets may be too optimistic about the pace at which inflation will fall and the level at which it will settle. Both the Fed and the BoE noted labour markets remained very tight, with the Bank of England warning that “risks to inflation are skewed significantly to the upside.”

Debt ceiling battle looms

While there are no national elections in major economies in 2023, politics could still be a source of market volatility. In particular, negotiations over the US “debt ceiling” could turn into a flashpoint over the coming months. The US has a legal limit on the amount of debt it can issue and any increase requires Congressional approval. With a divided Congress, this may be difficult to achieve, raising the prospect of a US government shutdown. In 2011, the near-failure to reach an agreement led to the downgrade of the US credit rating and steep falls in global stock markets. A repeat of that year’s brinkmanship could once again raise broader worries about government debt. As the UK found last year, these can be a source of significant economic disruption.

Portfolio positioning

While we have not been adding to our equities allocation, our core exposure has benefited from the rally of the past few months. We would prefer to see softer labour markets and more evidence of falling inflation before adding to the asset class. In the meantime, we have also been benefiting from our exposure to high-quality corporate bonds. We believe that credit markets can deliver attractive returns with lower risk than equities. High levels of inflation in the UK have made meeting inflation plus return targets more challenging in the shorter term. Despite this, we remain confident in the ability to meet inflation plus targets over the longer term.

Outlook

	Economics	Our base case remains that developed markets will fall into recession in 2023. However, there is greater uncertainty over the depth and duration of any economic contraction. “Upside risks” have increased, notably faster than expected re-opening of the Chinese economy. We expect inflation to continue to moderate but remain above central bank targets. Central banks may continue to raise interest in the near term before pausing later in the year.
	Valuations	Global equities have meaningfully de-rated over the past year and now look better valued, particularly outside of the US. Government bond valuations look relatively more attractive given the sizeable yield moves we saw in 2022. Valuations of both equities and credit remain vulnerable to a meaningful deterioration in corporate earnings.
	Sentiment	Sentiment has improved in the near term as investors have priced in a pause in further US interest rate rises. Sentiment could be tested by disappointing earnings data, a worse than anticipated recession or continued interest rate rises. Consumer confidence remains weak and consumer spending could slow.
	Risks	Both downside and upside risk scenarios exist. Continued hawkish central bank policy poses the most significant market risk. A further escalation of the Russia Ukraine conflict and the European energy crisis remains a possibility. The probability of a US “soft landing” has improved but remains unlikely.

Asset Classes

Asset classes	Current positioning	Medium term view	Current views
Equities			Equity markets have enjoyed a strong start to the year as investor sentiment has recovered from overly-bearish levels to reflect an improved economic outlook. Sentiment could be tested, however, by more meaningful weakness in corporate earnings and the continued potential for “hawkish” central bank policy. Valuations are more supportive relative to recent history, particularly outside of the US. We remain underweight but we are looking for opportunities to add back to equity markets over the medium term.
Bonds			Nominal government bonds have defensive characteristics in an uncertain economic environment and look more attractively valued relative to recent history. Our exposure is focused on short-dated bonds which are more sensitive to policy changes. Within credit, we continue to prefer higher-quality securities which offer a relatively attractive yield and potentially offer strong risk-adjusted returns.
Alternatives			Alternatives continue to offer attractive diversification characteristics in a potentially volatile environment. We favour absolute return strategies with the ability to deliver less correlated returns as well as real assets with long-dated visible revenue streams and commodities.
Cash			Rising interest rates offer more attractive returns relative to recent history. Cash offers optionality in potentially volatile markets.

Equities

Asset	Current positioning	Medium term view	Current view
Equities			Equity markets have enjoyed a strong start to the year as investor sentiment has recovered from overly-bearish levels to reflect an improved economic outlook. Sentiment could be tested, however, by more meaningful weakness in corporate earnings and the continued potential for “hawkish” central bank policy. Valuations are more supportive relative to recent history, particularly outside of the US. We remain underweight but we are looking for opportunities to add back to equity markets over the medium term.
UK			The UK economic outlook remains challenging. While inflation should moderate, we expect it to remain elevated in comparison to recent history. The UK consumer could remain under pressure and sentiment may continue to be weak. Domestic companies face an uncertain backdrop but valuations are cheap and opportunities remain.
Europe			A warm winter has helped to reduce the near-term economic impacts of the Russia Ukraine war and its disruption to energy supply. Sentiment has adjusted to reflect improved near-term prospects, although these challenges remain with the potential to cause further uncertainty. Valuations remain supportive despite the recent re-rating and corporate earnings continue to be relatively resilient.
North America			Better-than-expected economic data has increased the probability of a shallow recession, but the resilient labour market may prompt the Fed to maintain a hawkish policy stance despite softening inflation data. Valuations remain elevated relative to other global equity markets and recent corporate earning reports have been more mixed.
Japan			The re-opening of both Japan’s international borders and the improved outlook for China could benefit the Japanese economy. However, large-cap exporters could face headwinds from a global recession. The Bank of Japan remain under pressure to tighten monetary policy but it is likely to remain relatively supportive for risk assets in the near term.
Asia/ Emerging markets			The end of China’s “Zero Covid” policy represents a significant economic support for China and the region more broadly. Equity markets have rallied in response. However, valuations remain attractive and there remains the potential for further recovery after a challenging 2022.

Bonds

Asset	Current positioning	Medium term view	Current views
Bonds			Nominal government bonds have defensive characteristics in an uncertain economic environment and look more attractively valued relative to recent history. Our exposure is focused on short-dated bonds which are more sensitive to policy changes. Within credit, we continue to prefer higher-quality securities which offer a relatively attractive yield and potentially offer strong risk-adjusted returns.
Government bonds			Valuations look more attractive given the sizeable yield moves we saw in 2022 but remain vulnerable to further interest rate rises. UK gilts could benefit from a potential dovish shift in monetary policy as the Bank of England look to support growth. We prefer shorter-maturity bonds at this stage which are more sensitive to policy changes, although could look to lengthen duration to add further defensiveness to portfolios.
Investment grade			Yields look attractive relative to other asset classes. We prefer shorter-duration and higher-quality credit in the near term given uncertainty around corporate earnings, but could look for opportunities to increase exposure to riskier credit if spreads widen. Opportunities remain within asset backed securities which benefit from floating rate characteristics.
High-yield			Higher yields and shorter duration characteristics look attractive. Default rates remain low although face headwinds from a rising cost of debt, weakening earnings and a more challenging economic backdrop. There remains the potential for spreads to widen if corporate earnings deteriorate which could present opportunities.
Inflation-linked			Valuations are looking more attractive with 10 year US TIPS offering a positive real yield of over 1% for the first time since 2010. Market expectations of future inflation have moderated but remain above long-term averages.
Emerging markets			The rapid re-opening of the Chinese economy and potential for further USD weakness is supportive for the asset class, although risks from a global recession remain. Valuations are attractive relative to other credit markets, particularly in select local currency markets.

Alternatives and cash

Asset	Current positioning	Medium term view	Current views
Alternatives			Alternatives continue to offer attractive diversification characteristics in a potentially volatile environment. We favour absolute return strategies with the ability to deliver less correlated returns as well as real assets with long-dated visible revenue streams and commodities.
Absolute Return			We see select opportunities in equity long/short strategies given increased stock dispersion and diversification characteristics. However, government bonds are now looking more attractively valued and may provide a better source of portfolio diversification over the medium term.
Liquid private real assets			Long-dated revenue streams and income characteristics remain attractive in select parts of the market. Within this space we see good opportunities in renewables, digital infrastructure, specialist property and exposure to private companies. Valuations are relatively more attractive following recent market volatility.
Commodities			Broader commodities can hedge against further disruption to energy markets, although areas of the asset class are sensitive to slowing economic growth. Longer term, increasing demand from energy transition could support industrial metal prices.
Equity-linked income strategies			Offer attractive returns especially in times of heightened volatility, but we acknowledge the shorter-term correlation with equities.
Gold			Gold should provide portfolio insurance in the event of a meaningful equity market correction or economic growth shock although could continue to face headwinds from rising real yields.

Key

	Positive
	Positive/neutral
	Neutral
	Negative/neutral
	Negative
	Up from last month
	Down from last month

Terms

Spread: the difference in yield between a non-government and government fixed income security.

Duration: approximate percentage change in the price of a bond for a 1% change in yield.