Stability through flexibility

AFTER an economic rebound in the first half of 2021, with strongly rising economic growth and inflation rates along with government bond yields, we have now entered a period of consolidation.

The pace of the reflationary bounce is clearly moderating, as evidenced primarily by the loss in momentum in manufacturing purchasing manager indices, such as the ISM in the United States.

We think that the downside risk to the ISM between now and the end of the year is limited. The need to rebuild depleted inventory stocks should keep producers busy for some time, and could lead to a re-acceleration of the ISM in H1 next year. At that stage, we would expect real yields to move higher.

Treasury yields have taken their cue from the loss in dynamic and have eased back from their highs in recent months with real yields falling back to the lows reached last year. The decline in yields on the government bond markets continued in July.

Ten-year US government bonds fell below the 1.30 per cent mark in the course of the month, and German bunds of the same maturity have once again solidified clearly in negative territory. Investment grade bonds on both sides of the Atlantic (EUR +0.8 per cent / USD +0.7 per cent) benefited strongly from this development.

Emerging market bonds also ended the month in positive territory (+0.5 per cent) despite high uncertainty in the Asian region. High yield bonds also posted a positive return of 0.4 per cent in July. However, a slight increase in credit risk premiums weighed somewhat on the asset class recently.

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The commodity sector (+1.8 per cent) remained supported despite economic uncertainty in July. After an initial period of weakness due to the expansion of the oil production by the Opec+ countries, the price of crude oil rose (+1.6 per cent) compared to the previous month. Gold (+3.3 per cent) has also been able to stabilise in recent weeks after the heavy losses in June and ended the month slightly above US$1,800 per troy ounce.

The initial post-pandemic recovery is nearing its peak. However, strong monetary and fiscal policy support, as well as limited private sector net debt, should allow most economies to achieve strong growth in the coming quarters.

The US and China were among the fastest to recover to their pre-pandemic activity levels, so it is no surprise that they are among the first regions to see their growth to slow, while Europe and Japan still have their economic peak ahead of them.

The spread of the highly contagious Delta variant is indeed a risk, however, mainly to emerging markets where vaccination against the virus has less progressed.

The better outlook is also reflected in the purchasing managers' indices for the euro zone, which rose to a 21-year high in July.

Although the manufacturing sector remained strong, the increase was mainly driven by an improvement in the services component, which exceeded 60 points for the first time since May 2006. The economic recovery is expected to continue accordingly in the second half of the year.

Even though US and European stock markets are still trading close to their all-time highs, investors' uncertainty about future economic developments, combined with declining government bond yields, has also been clearly evident beneath the index level.

In recent weeks, investors have again increasingly focused on growth stocks, while turning their backs on value stocks and cyclical sectors, as well as small and medium-sized companies.

The trend of rising inflation rates and government bond yields followed by capital inflows into small caps, emerging markets, commodities and other cyclical markets and sectors, has paused over the past two months.

Capital flows returned to high-growth and technology stocks. In our view, this pause will only be temporary as reflected in the recent strong reporting season, especially for cyclical companies.

There is still a great amount of uncertainty about the path of the economic recovery, so flexibility and agility are crucial for investors. We view our investment decisions within our multi-asset portfolios from this perspective, emphasising the need for adaptability and diversification across markets, regions and sectors to ensure flexibility in the face of changing macroeconomic and market conditions.

This is coupled with lower market liquidity over the summer months, which can lead to rapid and sharp movements in financial markets.

We remain overweight in alternative investments that are as uncorrelated as possible, such as Catastrophe bonds. The asset class has a strong positive diversification effect within the multi-asset portfolio and enables a certain degree of volatility smoothing.

The same benefits are achieved with dividend strategies, which we currently overweight within our equity allocation and have helped to stabilise portfolio returns in an environment of high uncertainty.

Overall, the performance of our multi-asset portfolios in the first half of the year is clearly in positive territory, driven mainly by strong equity market performance, resulting in particular in a strong performance for portfolios with a high equity allocation.

Balanced portfolios, with an even strategic allocation between equities and bonds, also delivered mid- to high-single-digit returns due to our underweight in government bonds and investment-grade corporate bonds.

• Ricardo Marques is co-head of Financial Strategies Advisory and Investment Consulting, Asia, Bank J. Safra Sarasin