True Potential Portfolios Key Themes – September 2022
Chris Leyland, True Potential Director Of Investment Strategy, looks back on the key themes around the True Potential Portfolios over the past month.
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- Economic growth is moderating.
- Inflation to remain above Central bank targets through 2022/2023
- Developed market Central banks will continue to raise interest rates.
- The US dollar is expected to remain strong.
- Labour markets, company balance sheets and earnings at this stage remain robust.
- Valuations for equities and fixed income are now more attractive on a forward-looking basis.
- We maintain cautious portfolio positioning but are assessing opportunities within the multi-asset investment landscape.
Building out these points.
Economic growth forecasts have moderated further in August and September. In the US we have already seen two consecutive quarters of negative economic growth. With faster policy tightening, our view is that real growth (adjusted for inflation) in the US will be lower than the long term average (2.0%) for 2022 and 2023 as higher interest rates will lead to tighter financial conditions. Weakness in manufacturing and housing sectors will also be a headwind for the broader economy as we move into 2023.
There are balancing factors to these near-term headwinds. Corporate balance sheets are in a healthy position which should keep insolvency risks low. The strength of the labour market puts consumers in a position to demand higher wages.
In Europe, with an ongoing energy crisis economic growth continues to deteriorate with both business and consumer sentiment negatively impacted. We have also seen a considerable reduction in both industrial production and real consumption in the region.
In the UK, a mini-budget provided much-needed support to households and businesses to tackle rising energy costs. The energy support was overshadowed by higher financing costs as UK Gilt yields moved sharply higher and sterling weakened. In the near term, a weaker currency raises the cost of imports but longer-term makes exported goods and services more competitive.
In China, intervention taken by the Central bank to reduce borrowing costs and government support to stimulate growth is having a modest impact on demand.
Inflation targets in the developed world are typically 2-3%. Our expectation is that for the US, UK and Europe inflation will be above these levels through 2022/2023. In the US we have potentially seen headline inflation peak, the broadest measure of inflation factoring in more volatile components including energy and food prices. However, it is shelter/housing costs and wages which are expected to moderate at a slower pace, keeping inflation above target. In the UK and Europe, headline inflation is expected to remain higher for longer with the weaker currency making imported energy and food more expensive on a relative basis.
In this environment we anticipate Central banks to continue to increase interest rates and reduce the amount of bonds held on balance sheets. Slowly reversing the support provided during the pandemic. In the US interest rates are expected to be between 4.0% and 4.5% by mid-2023. While interest rates in the UK could increase above 6% in this cycle. This will feed into tighter financial conditions and help Central Banks progress towards their 2% inflation target.
The US dollar remains strong, supported by superior economic growth prospects and interest rate differentials. A weaker economic and challenging inflation backdrop outside of the US should continue to support the dollar against most major currencies. From a valuation perspective Sterling is undervalued, however, the increased debt levels required to fund the Chancellor’s mini-budget are likely to mitigate international investors’ appetite for sterling assets.
Corporate earnings in the US have demonstrated resilience. Forward guidance has also surprised on the upside as they continue to see revenue growth on a nominal basis. However, the contribution from the energy sector has been a key contributor increasing nearly 300%.
The change to the corporate earnings outlook has been slow as analysts focus on strong current levels. However, as we move forward, there is a real possibility that analysts will adjust estimates for 2023 lower.
Corporate sales revenue remains healthy, which will support dividends. Also, managements’ have been prudent in re-instating dividends and pay-out ratios coming out of the pandemic.
As a function of how equities and bonds have repriced year to date, valuationsare now more attractive. From a multi-asset perspective, this provides opportunities for investors, however, careful selection from our global investment managers is required.
True Potential Portfolio positioning.
Overall, the cohort of managers are positioned more defensively than their long term strategic asset allocation. Therefore our True Potential Portfolios are also positioned defensively. We have lowered equity weightings through the year as well as tilting to companies with strong balance sheets better able to weather an environment of higher input costs and reducing sensitivity to the health of the economy. Within fixed income, we remain cautious on duration exposure. Alternatives remain an important component, due to their ability to take directional and relative views offering true diversification in periods where performance for traditional assets could be challenged.