Global Asset Allocation: The View From the UK

1. Market Perspective

• While global growth and inflation are expected to trend lower, much variation exists across regions and countries in terms of the level and pace of deceleration.
• US and Japanese economies are proving more resilient, although the US is seeing some evidence of a cooling consumer. While weakness is seen across Europe as countries work through softer growth and elevated albeit softening inflation, Chinese growth is mixed as recent slowing is being met with a broad range of incremental stimulus measures amid growing concerns surrounding its property sector.
• While global central bank tightening has likely peaked, the US Fed’s pledge for “higher for longer” rates has had worldwide impacts on raising yield levels that could create vulnerabilities.
• Key risks to global markets include impacts of the sharp move higher in rates, a deeper‑than‑expected decline in growth, central bank missteps, reacceleration in inflation, the trajectory of Chinese growth and geopolitical tensions.

2. Portfolio Positioning

As of 30 September 2023

• We maintain a balanced view on risk with a modest underweight to equities. We remain overweight the US, Japan and small caps, where valuations have priced in significant downside. We are underweight Europe, which faces an economic slowdown and still elevated inflation.
• Within fixed income, we remain overweight inflation‑linked bonds as a hedge against inflation settling in above central banks’ targets. It also reflects the potential for higher commodity prices over the intermediate‑term, due to continuing capex decline and moderating productivity trends.
• We remain underweight bonds in favour of cash, as cash offers attractive yields and liquidity should we see opportunities in a period of market dislocation. We have reduced our underweight in gilts and US Treasuries. However, persistent inflation and elevated government bond supply could keep upward pressure on rates.
• Within fixed income higher‑yielding sectors, we reduced the overweight in high yield to take some profits. We also remain overweight emerging market bonds on still attractive absolute yield levels and reasonably supportive fundamentals.

3. Market Themes

Costly Capital

Longer‑term global bond yields have gone nearly parabolic over recent weeks, led by US yields, with the 10‑year Treasury yield hovering near 4.8%, a 16‑year high. The sharp move has been attributed to the Fed’s commitment to ‘higher for longer,’ despite signs of slowing inflation in the pipeline. Further exacerbating the sharp move higher has been the recent rise in energy prices, impending US Treasury supply on rising deficit spending, Fed’s quantitative tightening policy reducing its Treasury holdings and concerns over waning foreign demand for US debt. The recent volatility in global yields has unsettled markets fearing the implications of much higher financing costs and what impact the growing losses have on current bondholders. Although higher rates may be warranted to a degree, as markets adjust to a higher inflation regime ahead, as well as the likelihood of higher deficits, it’s hard to believe that such an abrupt reset won’t end up being too costly for someone.

Tapped Out

Although off recent highs, oil prices are still up more than 20% off their June lows as supply has tightened following the announcement of production cuts by OPEC+,¹ rising demand expectations from China and a depleted US Strategic Petroleum Reserve (SPR). The almost year‑long decline in oil prices since June 2022 had played a large role in supporting the decline in inflation in the first half of this year, but the recent sharp rise is disrupting the deflation trend that markets had hoped would move central banks to the sideline. While some of the rise can be explained by near‑term supply/demand dynamics, the market has started to recognise that productivity gains over the recent decade contributing to lower energy prices appears to be past peak, leading to higher prices ahead. While a recession could curb demand and lead to lower energy prices over the short term, the new reality that productivity gains may be tapped out is yet another factor that could contribute to higher levels of inflation ahead.

 

For a region-by-region overview, see the full report (PDF).