Asymmetric effects of the crisis

After a strong start to the year, March brought a sudden chill to global markets. The MSCI All Countries World Index fell 7.1%, erasing the gains of the first two months and pushing its first quarter performance to -3.1%. Bonds also performed negatively in March, reflecting the rise in yields driven by fears that a renewed surge in inflation would push central banks to adopt a more restrictive monetary policy.

The turnaround in market sentiment was triggered by events in the Middle East. The war launched by Israel and the US against Iran has led to the de facto closure of the Strait of Hormuz, once again jeopardising global supply chains. Energy is the sector most directly affected. Nearly 20% of global petroleum consumption is met with supplies from the Persian Gulf countries, which are also major natural gas exporters. But other sectors, from agri-food to steel and semiconductor production, risk sharp increases in production costs and a shortage of production inputs.

The asymmetric effects of the crisis on the global economy help explain the market reaction to the shock and can be a guide to future developments. The United States is less dependent than Asia and Europe on raw material supplies transiting the Strait of Hormuz. Accordingly, US equities and bonds outperformed in relative terms, and the US dollar strengthened against major currencies.

It has been noted, however, that whenever the news flow suggested the possibility of de-escalation, energy prices fell, non-US markets outperformed, and the US dollar weakened. Even within a context of extreme uncertainty, this template could be a useful guide for markets in the near future.

Confirming how difficult it is to read the current situation, the decline in the price of gold contradicted expectations that a perceived safe haven asset would benefit from increased geopolitical uncertainty. Instead, the need for investors, including some emerging market central banks, to raise liquidity to address potential emergencies appears to have prevailed. However, the medium- to long-term fundamentals of gold could continue to favour a progressive rise in prices.

Accordingly, the asset allocation of a balanced portfolio should consider turbulent markets and ongoing elevated uncertainty. As ever, one needs to avoid panicking and becoming overly risk-averse at the bottom whilst at the same time acknowledging increased risk.

Taking this into account, reducing the overall portfolio risk profile seemed appropriate amid the fog created by the war. Hence, we moved to a neutral equity position to reduce the overall exposure to market risk but also considering that despite the increased geopolitical risk, corporate profits have continued to improve, and markets had already derated from somewhat expensive levels.

Furthermore, we reduced exposure to high yield bonds given tight spreads and some signs of stress in private credit markets. We increased exposure to hedge funds and cash.

Asset Allocation

Global Allocation

Markets remain volatile following the escalation of the conflict in the Middle East, with no sign of a potential resolution. The narrative continues to evolve day-to-day with markets having to deal with the unpredictability of Trump’s comments. However, it is important to remember that before the developments in the Middle East the overall economic picture was robust. Close attention will be paid to incoming data, particularly inflation for an indication of how much impact the surge in energy prices has had. But right now it is important to avoid entering a panic mode. We note that corporate earnings remain strong. However, over the coming quarters, there will be downside risk to earnings per share expectations.

On asset allocation, we reduced our equity exposure to neutral to reflect the uncertain environment. If we were to see further weakening in markets, it could provide an attractive entry point to increase exposure. Meanwhile we are increasing our overweight to alternatives, particularly hedge funds, as a source of diversification. In addition, cash is being increased to neutral. No changes were made to overall fixed income allocation, although within the asset class we have reduced credit risk. The duration and outcome of the Middle East crisis will be key to future asset allocation adjustments.

Fixed Income

Credit spreads have remained relatively tight, albeit with some minor widening. As a result of this tightness, and the possibility of increased economic risks if oil prices remain elevated, we have taken credit risk down, extending the underweight. Global high yield is being cut from a marginal overweight to an underweight position. Within this, USD high yield is to be reduced further into an underweight, while EUR bonds are reduced to neutral. Also, within credit, emerging market bonds are being cut, reflecting the high oil price sensitivity in the region. While we were already underweight in EM hard currency bonds, we are reducing further our exposure to the asset class. Within EM local currency bonds, we maintain a small overweight even though real rates are high. Any resolution to the conflict will be positive for the asset class and therefore we would need to be quick to reallocate into the asset class. To balance out the reductions, allocation to short-duration high quality bonds will be increased, with focus on 2- to 3-year paper. Investment grade allocation across currencies is being added to, with a positive underlying macro environment.

Equities

While we acknowledge the cautious mood, having reduced overall equity exposure to neutral, in terms of regional allocations we do not see a current need to make any sharp moves at a sub-asset class level. Latin America has been favoured for some time owing to its commodity exposure, high real rates and fiscal progress. Therefore, we would use this time to take some profits, having previously been a strong performer. Despite the cut, Latin American equities remain an overweight position. This move was balanced by a small adjustments to add to the US overweight. In Europe, the region continues to see decent earnings growth, however the Middle East crisis and the spike in oil and gas poses a risk to earnings. In addition, interest rate expectations have shifted, although we don’t expect the European Central Bank will be inclined to raise rates in the short term. As such we hold our overweight European weighting. Asia Pacific remains underweight, with ASEAN markets a big underweight within the region. There has been marginal improvement in China, particularly as exports remain robust and improvements in the domestic economy. Although we maintain an overweight position, much of this is focused on Hong Kong. Korea and Taiwan have led the market higher, despite the recent pullbacks, so have added into Korea up to neutral position and increased exposure to Taiwan, to a small overweight.

Equity Sectors

Equity Sector Views

UK
Industrials remains our favoured sector, particularly defence. Energy is our second largest overweight, followed by utilities for their defensive characteristics. The ongoing conflict in the Middle East has caused significant disruption to markets and fundamentally changed the oversupply narrative in energy markets. Even if a resolution to the conflict is reached in the near term, we expect the impact from the closure of the Strait of Hormuz and damage to energy infrastructure to linger. As such, we have once again raised our exposure to energy and reduced exposure to materials and financials.

US
We remain positive on financials as we expect banks should benefit from deregulation, interest margin expansion and a pick-up in activity. We are neutral on technology as artificial intelligence and cloud spending continue to grow, but there are elevated concerns on the return of this spending as well as disruption risks. Healthcare and consumer staples exposure were trimmed, as we believe that bond proxies could underperform in a context of rising inflation concerns. With energy price fluctuations energy is being added to but remains underweight.

Europe
We are awaiting further clarity on market direction following volatility through March so we have not made any adjustments. In February we had reduced the allocation to technology to a slight overweight, owing to uncertainty surrounding potential artificial intelligence disruption of software stocks. Consumer discretionary exposure was also cut as the earnings recovery in the luxury sector was taking longer than expected to materialise. Communication services was increased to take advantage of improving sentiment for telecommunication stocks. The industrials weighting had increased in line with the market drift, owing to strong earnings and stock momentum, particularly within capital goods.

Alternatives

Hedge fund dispersion is high, and we would add to them as a source of diversification, increasing our overweight position. Amongst strategies, equity long/short and equity market neutral can offer downside protection. We also like Commodity Trading Advisers (CTAs) and Macro, and should we see a deterioration in the situation and a more prolonged downturn they tend to offer countertrend properties. Inflation linked securities should also help with diversification. To balance out the addition to hedge funds we will reduce exposure to commodities, with gold accounting for the majority of the weighting. Our insurance overweight will also be slightly lowered.

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