We’re staying defensive in equities during the last quarter of 2022

On any measure, it has been a grim year. Financial markets have remained febrile in the face of rising interest rates, an energy crisis and political uncertainty. As we look ahead to the next quarter, we see few reasons to shift our defensive position, as we wait for the Federal Reserve to ease its stance on interest rates.

The energy crisis has lingered through the last quarter. A potent symbol of the extent of the crisis was President Biden’s visit to Saudi Arabia to source more oil. Necessity is pushing Western leaders to make unpalatable choices. The energy crisis is contributing to inflationary pressures. Inflation is still at multi-decade highs across much of the world.

The roots of this inflationary crisis are not just the supply shortages created by the war in Ukraine, but also the effects of the pandemic stimulus packages. It is worth noting that 42% of all the dollars in existence since the Federal Reserve’s inception in 1913 have been created since 2019¹. Central banks have been behind the curve in addressing inflation, but interest rates are now rising sharply.

This has been a difficult backdrop for markets. Value markets, such as the UK, have done relatively well, while areas such as technology struggled. European markets have been hardest hit by the energy crisis. The only game in town for currencies has been the dollar with sterling losing 18.8% since the start of the year². The gold price has held up. Bonds were the real weak spot, however, recording one of their worst years on record.

Looking to the Federal Reserve

From here, all eyes will be on the Federal Reserve. Any sign that it plans to slow rate rises could prompt a recovery in stock markets. The Federal Reserve has demonstrated its resolve and further interest rates rises are likely. However, if signs of significant financial stress emerge in capital markets, it may prompt a change of heart.

There are other headwinds facing financial markets. For many developed economies recession now appears inevitable, with only the length and depth up for question. Equally, energy shortages remain a real possibility this winter.

Nevertheless, there are also tailwinds amid this bleak outlook. The first is a potential peak in inflation: index linked treasuries are showing a lower estimate of future inflation. Core inflation is still holding up, but there are some signs it is peaking in the US. In particular, wage growth has started to slow. This is an important sign that inflation may not become entrenched.

Company earnings have also been holding up quite well, leaving valuations relatively attractive. As it stands, the price-to-earnings ratio for the market is slightly lower than during the pandemic³. Of course, there is the likelihood that corporate earnings will dip next year. However, this gives a starting point for equities to rally, but we need evidence that the US interest-rate cycle is about to turn. With this in mind, we are keeping a close eye on payroll data and US CPI.

Five key themes

For the remainder of the year, our asset allocation is built around five key themes.

1. Focusing on defensive sectors

We will be maintaining our pro-defensive stance, focusing on areas such as healthcare, staples and utilities, which are less sensitive to growth and interest rates. As part of the same view, we are avoiding those areas that are sensitive to interest rates, higher energy costs or slow growth such as some stocks in the information technology and consumer services sectors.

2. Avoiding the more expensive US mega caps

That also means avoiding the more expensive US mega caps. They are vulnerable to higher interest rates, a change in growth expectations and valuation adjustments. They are unlikely to see a recovery before the Federal Reserve changes direction.

3. Potential opportunity within the UK stock market

There is relative value in the UK stock market, largely because of its international focus and, more recently, the weight of commodity stocks in the market. Capital expenditure discipline among the oil and gas majors is driving up returns, dividends and share buybacks. They are also much cheaper than other parts of the market because earnings have been strong. The sector is still cyclical and future earnings are still dependent on both the oil price and the global economy.

4. US treasuries versus gilts

We prefer US treasuries to gilts for portfolio insurance. The US market and US dollar, in particular, remain the defensive assets of choice. The gilt market has been volatile, making them a more difficult choice for portfolio protection. Equally, in the last 20 equity market drawdowns, gilts have performed less well. Within treasuries, we are focused on the five-to-10-year maturity range.

5. Going for gold

Our final theme is gold. It has a strong correlation with real yields. The price has held up relatively well and it has fulfilled its role as a portfolio diversifier. It has also benefited from the weakness of sterling this year. It is also seeing structural demand from central banks, as nations look to buy gold rather than treasuries in case of secondary sanctions.

This is still a difficult moment for the global economy. The energy crisis is ongoing, creating significant economic disruption. Liquidity is being withdrawn from the market through quantitative tightening and interest rate rises. This argues for a weighting to defensive sectors, and to companies with pricing power, less sensitivity to interest rates and economic growth. There is relative safety in the UK and in commodities, and far less in US mega caps. In the meantime, we await signs that the Federal Reserve is changing direction.

Sources

[1], [2], [3]: Refinitiv/Evelyn Partners