When the fever curve in equities goes down, equity markets usually get boring. Thus, when the VIX index (a measure of nervousness on stock exchanges) is above 20, things get exciting. When it is above 30, panic usually prevails. But when it falls below 15, as it has done in the past 6 months, this usually indicates a lull in markets.
However, this was not the case in 2023, perhaps due to the bond markets. The fever curve of bond markets is still way above any high we witnessed in the 2010s. After all the ups and downs following the bond sell-off last year, many investors are surprised by the recent relative calm in financial markets overall. Yet this may continue far into the second half of 2023.
The performance spread between the best performing and worst performing assets was more than 90% in the first half of 2023. These sharp return differences between assets only reverse some of the major gaps from last year, when the opposite happened. So, to some extent, the violent snapping back of beaten-down assets is what the pros call ‘mean reversion’. This is similar to witnessing major floodings after protracted droughts; on average, the rainfall is near to the mean in the bigger scheme of things.
Now, the tables appear to have turned. Fixed income assets entered a structural bear market in 2022, while real assets (e.g. equities) have benefited. In the months ahead, we expect some of the recent mean reversion to continue, but at a slower pace.
Reduce risk by focusing on quality in corporate bonds
Staying with fixed income, returns show that the lowest-quality corporate bonds are still in the top ranks following the first half of 2023, despite an acceleration of issuer defaults. We believe that the majority of investors still expect growth to remain solid enough to keep even the weakest issuers solvent and that rates will decline fast enough to keep the most leveraged issuers liquid. Yet these remain ‘rosy’ assumptions, and we cannot share their optimism.
We maintain our focus on bonds with an investment-grade rating given their attractive yields from a historical perspective. Furthermore, credit losses are likely to be higher than average in the eurozone given the most recent economic data. The purchasing managers’ index for the manufacturing industries came in at 43.4 this week, which is historically consistent with an acceleration of the default rate in the near term.
With the benefit of hindsight, our strategy call to turn to a more defensive stance last November may have been slightly premature, but we see more risks than chances in holding lowest-quality debt at this juncture. We thus maintain our call for better-quality bonds with a longer duration.
US equities offer safer haven when growth slows
A staggering first half of the year has seen quality and growth stocks strongly outperforming in equity markets. We have long vouched for these two investment styles given the uncertain economic environment. We want to stay invested in companies with healthy and solid balance sheets that can sustain the economic slowdown and higher refinancing costs. In an environment of growth scarcity, companies that point to higher sales and earnings growth in the medium-to-long term typically outperform.
Regarding our country allocation, we maintain our preference for the US equity market versus the European equity market. The main reason relates to the above-mentioned factors, with the US enjoying a much higher degree of exposure to growth and quality styles than Europe.
At the same time, the rather cyclical bias of European stocks will also translate into a headwind given the economic slowdown we are facing. Equities in Europe are essentially pointing towards a strong economic recovery rather than a slowdown, which just does not fit with the current state of activity. In addition to being value markets, European markets are also cyclical in nature, while we see less of this in the US.
Within Europe, we favour Swiss equities given their defensive tilt. We thus maintain our Overweight rating on US stocks given the higher factor exposure, and we are Neutral on Europe and Overweight on Swiss equities.
Further gains in equities expected in second half of year
The first half of 2023 was quite spectacular. In terms of total returns year to date (as at 30 June 2023), the S&P 500 rose by 16.9%, while the Nasdaq 100 increased by 39.4%. We are seeing a broad-based risk appetite, especially in Europe and the US, where equity markets and credit markets performed well.
Looking at history for some guidance, we can see that, in the past, strong first-half returns lead to further gains; if the S&P 500 had already risen by more than 10% in the first half of the year, then it rose another 6% in the second half.
Furthermore, the global equity market is broadening, as US small-cap stocks and Asian equities outside of Japan are stabilising. Thus, we expect further gains in equities in the second half of this year, albeit lower than in the first half. Hence, we recommend that investors stay invested in equities, with a preference for US growth stocks.