Is the rally running out of steam?

While still in positive territory for the year, global stock markets have been drifting lower. The FTSE100 made headlines by rising through the 8,000 level for the first time ever but quickly retreated. Overall, global equities fell 2.5% in February and government bond yields rose, in some cases sharply. The combination suggests that investors are again growing concerned about inflation and the path of monetary policy. Despite the significant rise in interest rates over the past year, economic activity remains surprisingly robust. This is especially true in the US, with early estimates suggesting that the economy added over 500,000 jobs in January. The resilience makes it more likely that the Federal Reserve will continue raising interest rates, increasing the probability of an eventual recession. Schroders’ economists now expect a shallow US contraction in the second half of 2023.

What will China’s economic reopening look like?

China’s post-Covid reopening has generated a now familiar surge in consumer spending. Yet there are also important differences from the recovery seen in the US and some other developed economies. The US provided significant direct support to households, creating a large savings buffer that boosted consumption long after pent-up demand from the pandemic had been exhausted. In China, by contrast, savings have only risen modestly. This makes it less likely the economy will overheat, as arguably happened in the US. Historically, faster Chinese growth has boosted global manufacturing and has been associated with strong demand for industrial metals. This may be less evident in 2023, given China’s recovery is being driven by services rather than more resource-intensive sectors.

The next phase of the Ukraine war

Putin did not envisage a multi-year war when he invaded Ukraine just over a year ago. The fact that the conflict has lasted this long reflects a series of misjudgements by Moscow – including its own military capability, Ukraine’s determination to remain independent and Western resolve to support the country. Despite these miscalculations, there appears to be little appetite in Moscow to retreat or negotiate. The picture on the ground remains grim, with both sides preparing new military offensives. US officials have also raised the worrying prospect that China is considering providing more military support to Russia. This could lead to a very unwelcome escalation of the conflict as well as a significant deterioration in Sino-US relations. The consequences for the global economy could be severe.

Portfolio positioning

We still think the US economy will slow significantly as a result of interest rate rises and are wary of adding to our equity exposure before this is reflected in economic data and earnings expectations. Other markets look relatively more appealing and we have been increasing our exposure. High-quality corporate bonds offer attractive yields and performed comparatively well in previous downturns. We also favour commodities, which stand to benefit from strong long-term demand as a result of the energy transition. They could also provide a valuable hedge against an escalation of the conflict in Ukraine. 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	We continue to expect slowing global growth, with the US and UK falling into recession. The depth and duration of any economic contraction remains uncertain. The likelihood of better economic outcomes has increased, in part as a result of the faster-than-expected reopening of the Chinese economy. We expect inflation to continue to moderate gradually, although remain above central bank targets. Interest rates could continue to rise in the near term, with central banks potentially pausing further rate rises later in the year.
	Valuations	Global equities have 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 have seen over the past 12 months. Valuations of both equities and credit remain vulnerable to a meaningful deterioration in corporate earnings. There are attractively-valued opportunities across asset classes.
	Sentiment	Sentiment has improved as investors have priced in better-than-expected economic growth and a pause in further US interest rate rises. Sentiment could be tested by disappointing earnings data and / or continued interest rate rises Consumer confidence has improved but remains weak compared to historic levels and could be tested further if interest rates continue to rise.
	Risks	Both downside and upside risk scenarios exist. Persistently elevated levels of inflation, which would warrant 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 risen, while the European economic outlook has also improved.

Asset Classes

Asset classes	Current positioning	Medium term view	Current views
Equities			Equities have enjoyed a strong start to the year as markets reflect an improved economic outlook. Sentiment could, however, be tested by more meaningful weakness in corporate earnings and the potential for more restrictive monetary 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			Government bonds have defensive characteristics in an uncertain economic environment and look more attractively valued relative to recent history. Within credit we continue to prefer higher quality securities with attractive yields which 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 allows us to take advantage of tactical opportunities in potentially volatile markets.

Equities

Asset	Current positioning	Medium term view	Current view
Equities			Equities have enjoyed a strong start to the year as markets reflect an improved economic outlook. Sentiment could, however, be tested by more meaningful weakness in corporate earnings and the potential for more restrictive monetary 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. Whilst domestic companies face an uncertain backdrop, valuations are cheap and opportunities remain.
Europe			A mild winter has helped to reduce the near-term economic impact of the Russia Ukraine war and its disruption to energy supplies. Sentiment has adjusted to reflect improved near-term prospects, although 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, although a resilient labour market and continued inflationary pressure may prompt the Fed to maintain its hawkish policy stance in the near term. Valuations remain elevated relative to other global equity markets while recent corporate earnings reports have been more mixed.
Japan			The reopening 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, however it is likely to remain relatively supportive for risk assets in the near term.
Asia/ Emerging markets			The relaxation of China’s “Zero Covid” policies and earlier-than-expected reopening of the economy represents a significant economic support for China and the region more broadly. Equity markets have rallied in response, however valuations continue to be supportive and there remains the potential for further recovery after a challenging 2022.

Bonds

Asset	Current positioning	Medium term view	Current views
Bonds			Government bonds have defensive characteristics in an uncertain economic environment and look more attractively valued relative to recent history. Within credit we continue to prefer higher quality securities with attractive yields which potentially offer strong risk-adjusted returns.
Government bonds			Valuations look more attractive given the sizeable yield moves we have seen over the past 12 months, although remain vulnerable to more material interest rate rises. UK gilts could benefit from a potential dovish shift in monetary policy as the Bank of England looks to support growth. We prefer shorter-maturity bonds at this stage, although could look to add longer-dated bonds to increase the defensiveness of 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 1.5% for the first time since 2010. Market expectations of future inflation have moved higher this year and remain above long-term averages.
Emerging markets			The rapid reopening 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 can help to protect portfolios in the event of a meaningful equity market corrections or economic growth shocks. It may, however, continue to face headwinds from rising real yields.

Key

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	Up from last month
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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.